Grantham: "No asset (or strategy) is so good that it can it be purchased irrespective of the price paid."

GMO forecasts negative returns for U.S. value and U.S. small caps over the next seven years, based on multiple and profit margin contraction [pdf].

"The latest deity (and one close to our hearts at GMO) admitted to the smart beta pantheon appears to be Quality. ETFs are being launched and papers written about the 'magic' of high quality businesses. Let us be clear that there is no magic to owning quality. There are only two interesting features about 'quality.' The first is of interest to economists, and that is that oligopoly appears to be a common industrial structure, as evidenced by the very slow mean reversion of the profitability of quality stocks. It is ironic that the outcome of the competitive process so beloved by most economists is not their heaven of perfect competition (with its infinite number of price-taking firms), but rather something more akin to imperfect competition."

Hussman Column

This week:

"One type of illusory yield is the earnings yield on stocks, where profit margins are presently 70% above historical norms, and where we’ve demonstrated both by accounting identity and with nearly 70 years of hard data (accurate even to the most recent 4-year period), that the primary source of this corporate surplus is a mirror image deficit in the combined savings of government and households. Stocks are not a claim on next year’s earnings. They are a claim on a very, very long-term stream of future cash flows that will actually be delivered into the hands of investors over time. At present, the 'forward earnings yield' on stocks is a terribly elevated and misleading representative of those cash flows, and investors are likely to find themselves disappointed if they use forward earnings as a 'sufficient statistic' for long-term profitability. The other type of illusory yield is on junk debt, where yields have fallen to the lowest levels in history, and where the majority – perhaps more than all – of the perceived 'yield' is actually a default premium based on the likely frequency of future default."

Latest Hussman

Link.

"The problem today is that the recent half-cycle has taken valuations back to historically rich levels. Presently, the Shiller P/E is 22.7, with a dividend yield of 2.2%. Do the math. A plausible, and historically reliable estimate of 10-year nominal total returns here works out to only 1.06*(15/22.7)^(.10)-1+.022 = 3.9% annually, which is roughly the same estimate that we obtain from a much more robust set of fundamental measures and methods.

Simply put, secular bull markets begin at valuations that are associated with subsequent 10-year market returns near 20% annually. By contrast, secular bear markets begin at valuations like we observe at present. It may seem implausible that stocks could have gone this long with near-zero returns, and yet still be at valuations where other secular bear markets have started – but that is the unfortunate result of the extreme valuations that stocks achieved in 2000. It is lunacy to view those extreme valuations as some benchmark that should be recovered before investors need to worry."

Horizon Kinetics, Owner-Operators, Indeterminate World, and the Predictability Arb

I had never paid much attention to Horizon Kinetics, an asset manager run by Murray Stahl and Steven Bregman, but I've been reading their market commentaries and research reports and they seem like a good buy and hold manager. [The problem with buy and hold, of course, is that it has such big drawdowns unless you get out of the market during periods of overvaluation that can last for ages.]

The 2012 Q4 letter [pdf] presents a rather unique idea that the metrics most investors focus on (P/E, P/B, EV/EBITDA) could in some cases be a manifestation of availability bias.

"[T]he idea of assessing a varied set of companies via one or even several metrics, as if a portfolio of companies can all fit within a handful of pre‐defined boxes, is a very limiting, unidimensional way to view businesses. It can miss a great deal of information content. What about all the data that has not been predefined and made available as individual fields in the databases that produce those ready made reports? In a sense, for people who rely on those tools, that data doesn’t even exist—and it might be very important. Availability error can be very costly"

Unfortunately, they use this concept to justify owning the Beijing Airport operator, which apparently trades at half the valuation per passenger as Heathrow and the Paris airport. Although the Beijing airport is growing more quickly, the GDP/capita of England is 3x Beijing (and 6-7x China as a whole), so it's not immediately clear that this discount is unwarranted.

They do call attention to another very interesting metric, and that is the rate of share repurchases. There's a lot of academic research about the effect of net stock issuance on future returns [study pdf], and there is a clear inefficiency where the market is too slow to recognize the effect of repurchases (Conrad Industries) or new issuance (say, GMX Resources).

If I was going to buy and hold equities, I would be interested in a lot of the big share repurchasers they mention: Berkshire, Dundee, Leucadia, Liberty Media. The common themes that unite their equity holdings are: repurchases, "owner-operators" (managements with very large equity stakes, not free options), and conglomerate discounts. 

Another recent letter was about companies with dormant assets [December 2012 pdf]. For example, Dish Network has several billion dollars of wireless spectrum that the market doesn't really give it credit for; Icahn Enterprises had not really been getting credit for buying the $2b Fontainebleau resort for $156mm, etc.

The big discounts for conglomerates and dormant assets reminds me of Peter Thiel's "indeterminate world" idea from last summer. As he wrote, "any company with a good secret plan will always be undervalued in a world where nobody believes in secrets and nobody believes in plans." As HK put it in an earlier 2012 letter

"If one were to draw a Venn diagram of the critical, motivating elements in the financial markets today, two of the largest intersecting circles should be labeled Ultra-Low interest Rates/Reinvestment Risk and ETF Proliferation/Equitization of Asset Classes."

Think about what is really expensive in the market right now: fixed income and assets that share the salient property of fixed income: predictability. So in addition to bonds, that means utilities, REITs, MLPs, royalty trusts, apartment buildings, even single family rentals which investment managers are trying to scale for the first time (won't work).

Why is predictability so valuable? I'd argue that, just as Thiel says, investors have largely lost faith in the ability of managements to plan and execute for the benefit of shareholders. The opportunities for cash to disappear on the way to one's pocket are too numerous: poorly timed buybacks or capital expenditures, dumb acquisitions, obscene salaries and options grants.

So public markets put a huge premium on predictable, non-divertable cash flows and more attractive (lower) multiples on cash flows that are seemingly uncertain. As for conglomerates, nothing gets punished like moving parts. A bird in the hand is worth three in the bush.

[Obviously, there are various exceptions to the idea that investors don't believe in plans. For example, investors clearly believe in the Amazon plan. But it's clearly the case that there is a predictability premium.]

Think about this in relation to Conrad Industries. We know that shipyards are essentially booked for this year and next year, and that we are finally embarking on a number of years of steady GOM drilling again after the ban. Conrad will make at least $35mm EBITDA in a good year. The current enterprise valuation, net of excess cash and the probable BP settlement, is about equal to two years' EBITDA. It's as if the company gets no credit for the future years' earnings that aren't already known.

Hunger for predictability is also why the arb opportunity for David Einhorn's opportunistic use of preferreds exists. That hunger has created a wide disparity between the cost of capital of debt or preferred stock and the existing common stock of most companies.

A Conrad Industries preferred stock would trade at a single digit yield; say 6 percent. The earnings and cash flow yield on the common stock is much higher than that at the current share price. [For Conrad, it's something well north of 20 percent depending on whether you look at net income, EBITDA, or FCF; and depending on how much excess cash is on the balance sheet.] If the company issued preferred stock and used the proceeds to buy back common, it could capture that spread. So $20 million would mean several million dollars in additional annual income to common shareholders, assuming that many shares could be bought back near the current trading price.

Another arb that it creates is what I call the predictability arb. Chesapeake has thought of this because they mentioned it in an investor presentation.

"recognize the world is 'short yield' and [want to] provide various investment opportunities to yield-hungry investors who are willing to pay more for select assets than core E&P investors are willing to do."

It looks like E&Ps, like Chesapeake, can be thought of as a bundle of two dissimilar types of assets: producing properties that income investors would pay a huge multiple for, and undeveloped resources that investors are suspicious of because no one believes in plans. Rightly or wrongly, the claims of high potential IRRs on new wells seem to fall on deaf ears.

The predictability arb is to develop producting wells - with the predictible cash flows that investors crave - and spin them off into trusts. With each sale, use the cash flow for drilling new wells or share buybacks if that has a higher IRR.

If the public markets are skeptical of your plans, take anything predictable and drop it down into a REIT, an MLP, a trust and spin it off. Then decide whether the best use of the proceeds is stock buybacks, capex, or acquisitions.

What I find interesting about Horizon is that Stahl and Bregman seem to have this idea, and it is the most likely to work out of the ways that I see people allocating long-only capital. Oddball Stocks wrote a post about Investing in Horizon Kinetics through the back door with FRMO, which is an entity run by Murray Stahl and Steven Bregman that owns about 1 percent of HK.

Asset management is a fantastic business, and the end of the interest rate cycle will reorder the industry. Rising interest rates will be brutal for those who are too far out on the curve. But surviving asset management firms will be worth more in a higher interest rate environment.

Annual Report for Hussman Funds

Just reading the latest Hussman annual report for his funds (as opposed to his weekly market comments, which I frequently post quotes from).

"From the inception of Strategic Growth Fund on July 24, 2000 through June 30, 2012, the Fund achieved an average annual total return of 5.55%, compared with an average annual total return of 1.29% for the S&P 500 Index.

2012, Strategic Growth Fund had net assets of $4,936,808,483, and held 116 stocks in a wide variety of industries. The largest sector holdings as a percentage of net assets were health care (33.1%), consumer discretionary (24.1%), consumer staples (17.5%), and information technology (17.3%). The smallest sector weights were in energy (3.4%), telecommunications (1.4%), financials (1.0%), and materials (0.8%).

Holdings with losses in excess of $20 million during this same period were BMC Software, Research in Motion, Dell, Best Buy, Endo Health Solutions, Illumina, SunPower, and First Solar."

I've mentioned before that Hussman has great macro commentary, but I really do not like his stock selection.

His equity losses were in hopeless, failing businesses. What is he still doing in Best Buy and photovoltaic solar companies? Why doesn't he write a weekly letter about what he sees in Dell?

I'd also like to see weekly letters about why he is massively overweight health care (especially pharma) and massively underweight energy. He has more allocated to Coke and Pepsi in the strategic growth fund than to the entire energy sector!

He writes a lot about macro issues like market valuation, profit margins, etc - and I think he is write about those issues and invests appropriately (through decisions to hedge or not hedge). He never writes about business models, company valuation, or the attractiveness of different sectors - and I see that lack of thought showing up in the makeup of the equity portfolio.

Latest Hussman

"Long-term interest rates have plunged to record lows, and real interest rates are negative after inflation. What interest rates are telling you; what the Federal Reserve is telling you; what the equilibrium created by lenders and borrowers is telling you – is that time is economically worthless and that economic malaise will extend for years."

Latest Hussman

From yesterday:

QE is effective in supporting stock prices and driving risk-premiums down, but only once they are already elevated. As a result, when we look around the globe, we find that the impact of QE is rarely much greater than the market decline that preceded it.
[...]
The way out is to restructure bad debt instead of rescuing it. Particularly in Europe, this will require numerous financial institutions to go into receivership, where stock will be wiped out, unsecured bonds will experience losses, senior bondholders will get a haircut on the value of their obligations, and loan balances will be written down. Bank depositors, meanwhile, will not lose a dime, except in countries where the sovereign is also at risk of default.

Latest Hussman

"['S]econd half' of the primary bear market reflects the view that - unlike most bear markets and economic downturns - the downturn that began in 2007 was never really resolved, but was instead just pushed off and deferred by massive monetary interventions, accounting changes, and the like."

Hussman on Growth

At the end of this week's Hussman essay is the best thing I have ever read on growth.

Consider a very large, untapped market for some product. We can model the growth process in terms of how quickly that product is adopted by new users, whether there are any "network" effects where new buyers are attracted to the product because other people already use it, how frequently existing users replace their products, whether late-adopters come in more slowly than early-adopters because of budget constraints, how quickly the untapped market grows, and a variety of other factors.

Whether you do this sort of modeling with a spreadsheet or with differential equations, you'll get essentially the same results. Specifically, growth rates are always a declining function of market penetration. Most strikingly, the growth rates begin to come down hard even at the point that a company hits 20-30% market penetration. Network effects accelerate the early growth, but also cause growth to hit the wall more abruptly. Replacement helps to accelerate the early growth rates too, but ultimately has much more effect on the sustainable level of sales than it has on long-term growth. In fact, if the replacement rate (the percentage of existing users that replace their product each year) is less than the adoption rate (the percentage of untapped prospects that are converted to new users), it's very hard to keep the growth rate of sales from falling below the rate of economic growth.

[T]he key feature is that growth rates are a rapidly decreasing function of market penetration.

Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak.

This really reveals the silicon valley VCs as a bunch of hacks and hucksters. Isn't it telling that they cash out when they IPO the companies? Is this a country of such rubes that they don't realize that companies without significant demands for capital are just listing on the public markets in order to hang paper on suckers?

Also, the short AAPL / long natural gas (aka the "Gundlach") is sounding more and more awesome. We are going to start tracking this trade on the blog. However, rather than spot natural gas or one of the awful natural gas ETFs, we will use CHK as our proxy because it's so undervalued.

Tonight's Hussman

"I can't emphasize enough how badly standard P/E metrics are being distorted by record (but reliably cyclical) profit margins, which remain about 50-70% above historical norms. Our attention to profit margins and the use of normalized valuation measures is nothing new, nor is our view that record profit margins have corrupted many widely-followed valuation measures."

Hussman on Abnormally High Profit Margins

"The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely. Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins. With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street's embedded assumption of a permanently high plateau in profit margins as myopic."

Verbal Reasoning in Investing

I like to talk about things that are overrated and underrated. For example, I've said that Security Analysis by Ben Graham is seriously overrated compared to Moyer's Distressed Debt Analysis.

I also think that quantitative ability is systematically overrated by most investment shops, relative to verbal reasoning. A Tom Brakke post made me think of this:

Many years ago, a leading light in the investment business wrote that one of the best predictors of investment success was how someone scored on the Miller Analogies Test. I have never taken the test or read research about it, but from my experience I agree with the provider’s assertion that the ability to understand analogies is “one of the best measures of verbal comprehension and analytical thinking.”

As does the reader of a novel, an investor seeks an apt and insightful analogy, not a worn or misplaced or stretched one. Of course, that’s true in most every human endeavor and economic decision making activity.

I think about analogies all the time. And I think the quants miss the forest for the trees. They can tell you to the penny what an MBS security is worth given a set of assumptions. But then they completely botch the assumptions, because they have no sense of history. What they come up with is falsely precise.

More on Hussman

Followup from the comments section of the previous post.

Hussman is beating the market because he has world-class macro sense regarding valuation and sentiment. I wouldn't bother reading or mentioning his letter if I didn't think he was incredibly competent at this. It's why we link to his market commentary virtually every week.

However, his stock portfolio was shockingly bland and uninspired.

Pepsi AND Coke? Three newspaper stocks? Starbucks? Huge pharma overweight (very troubled sector; probably the next subprime). Solar stocks (come on!) Microsoft (tired, dying monopoly).

No oil *services*, period. He is something of a frustrated academic - as Mark mentions.

Hussman Annual Report

Hussman has published the 2011 annual report for his funds. I thought this was notable:

As of December 31, 2011, Strategic Growth Fund had net assets of $5,772,828,014, and held approximately 150 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were health care (33.5%), consumer discretionary (23.9%), information technology (22.0%), and consumer staples (12.4%). The smallest sector weights relative to the S&P 500 Index were in energy (2.8%), telecommunications (2.3%), financials (2.3%), materials (1.2%), and industrials (less than 0.1%).

Why is Hussman underweight energy? I understand being underweight financials, but a huge consumer position and next to no energy exposure?

I really do not like his stock selection. He owns a lot of hopeless failing businesses (value traps) like Best Buy and newspaper companies. And none of the good energy values that are on sale right now!

He is really good at macro and index valuation, but I think that being long-biased and his security selection hurts returns.

Good Observation

Why is it necessary for there to be 50 analysts covering Apple or 35 analysts covering Cisco or 29 analysts covering Intel? Is that really worthwhile for every single firm who is paying a guy to listen to these conference calls, be spoonfed a guidance number and then work backwards to arrive at a DCF calculation? How about five guys do the company basics, they're all going to be within a certain range of estimates anyway (they all went to the same colleges and took the same courses), freeing up the other 20 or so analysts to find ways to make that research profitable or actionable to the clients? More analysts should be focused on investing ideas rather than earnings estimate spreadsheet work that everyone else has already done satisfactorily.

As much research as there is, there is definitely a huge untapped market for research that is actually good. (And worth reading, let alone paying for.)

Latest Hussman

"As of last week, the stock market remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome, coupled with an "exhaustion" syndrome that has historically been followed by declines on the order of -25% over the ensuing 6-month period."

Hussman

I'm sometimes characterized as a "perma-bear." This is because the period since 2000 has been generally characterized by unusually rich valuations, which is duly reflected in the abysmal 0.80% average annual return, including dividends, that the S&P 500 has achieved from the 2000 peak through last week's close. That is not an accident, but instead matches the total return that we projected more than a decade ago, based on our standard valuation methodology. Given that, it should be clear that my generally defensive stance during this period is not some fixed aspect of my personality or temperament, but instead owes far more to the repeatedly and predictably disastrous overvaluation of the stock market since the late 1990's.

Hussman's Fascinating Hypothesis Regarding The Economic Data Uptick

the extraordinarily weak economic data in late 2008 and early 2009 may have produced an upward bump in a wide variety of seasonal adjustment factors for data around the turn of the year, adding to the short-term noise we're already observing in various economic series

"Leading Indicators and the Risk of a Blindside Recession"

The weekly Hussman is up.

He and I agree that the potential market outcomes are asymmetrically bearish, because the market has essentially been tricked by invalid indicators into excessive bullishness.

Latest Hussman

[I]nvestors face a perfect storm - risky assets priced to achieve dismal long-term returns (except in comparison to equally dismal alternatives), coupled with the risk of an oncoming global recession.