MARKET CONTEMPLATIONS (i)

Ray Dalio has a cool name and it seems that he understands how the Machine (or Mr. Market) works two thirds of the time. Not bad. He is an optimist as W. Buffett because he believes that the core multi century trend is a slow upwards move (2-3%). Then there are intermediary multi decade debt cycles and multi year mood (Fed imposed) swing cycles.

Situation is really bad in the world economy (as evidenced by Baltic Dry index below)...

... and a longer perspective...

..but the market seems to do not care and continues climbing up. What can derail it? Every time when Mr. Market is in doubt, central banks are pulling some new rabbit. Are there any left? At least it seems that they have some old ones, i.e. they can keep on extending the existing facilities (this is probably what Hugh Hendry calls going “nuclear”). There is no point of being angry on Bernanke because he is simply doing his job and Ray Dalio calls the outcome as “beautiful”.

The only credible answer on what can derail this climbing up is “what we do not know at the moment”. We know Portugal / Spain / etc EU, China, Japan, oil.  World is calm – volatility is down.

In Ken Fisher’s book “The Only Three Questions That Count” I found that S&P dropped 30%+ in 1937 because of recession triggered by capital spending & industrial production severe decline. Sounds very mundane but hard to fathom today.

Major indexes are overpriced as compared to the long term trend because of central bank actions. Will there be a run on a central bank or something very trivial like a butterfly flap?

INVESTING UPDATE (i)

This year I am trading a lot. Made 9 trades already (compared to 12 in the entire 2010 and 14 in 2009). Sold big 2011 winners (CRYP, INSW, TLB) and shorted XHL and IWO (R2000 Growth) last week to the tune of 40% of portfolio equity (in addition to 35% existing short ETFs).

With S&P @ 1,400, the market climbing a wall of worry (China, Europe, Japan, USA, oil/Iran) and profit margins at all time highs mainly fed by government deficits (James Montier of GMO – link), in support to mean reversion concept I decided to initiate a more aggressive hedging stance. It was painful to do, which gives a feeling of rightness.

I followed RSH for a long time and initiated 5% long position @ $7.06. The stock traded at this level back in 1982, 1984, 1990-1992, and 2009. Radio Shack will have to reinvent itself (between formats, hardware & service providers) once again but long term rear view mirror provides comfort for an investor with 2-3 year horizon. A vast convenience network must have higher value than 0.15x sales. The stock now is priced as if business would not generate any economic value in the future (priced at less than tangible equity) but it is making money. I would be happy if RSH delivers $0.5-0.6 EPS in 2012 (lower than consensus for what it is worth). In the meantime, it is paying 7.5% dividend and I plan to average down if RSH drops the dividend.

Other outstanding company longs are: CSC, CSCO, LOJN, IPAS, BRK.B, and GCA.

2011 Overview

2011 was exceptionally good generating 23% returns. I had small leverage, so equity returns were even larger. This was achieved despite having almost 50% of portfolio in SH and RWM (inverse S&P and Russell 2000 ETFs), which cost me dearly because of lack of diligence. A few spikes in intra year volatility knocked correlations down, which resulted in almost the same annual return for Russell 2000 and its supposedly inverse ETF of -5%. SPY and SH relationship was even worse – 0% (S&P) vs. -8% (SH). There are no limitations for human folly.

Fortunately, 4 holdings (KSP, INSW, CRYP, and TLB) were taken out during 2011 for quite a nice premium. Well, TLB is not acquired yet but it got a strong offer, which lead to my exit. At the end of 2010, I had only 6 company stocks (PCS and GCA in addition), so impact of takeouts was meaningful. Additionally, at the peak of EUR/USD in the end of April, I initiated 5% position in EUR/USD put option @ 1.45 maturing in January 2013 (via FXE), which generated 85% return in 2011. I plan to sell it on anniversary, and initiate a new 2-year option position.

Track Record

This spring is the 4^th anniversary of my active practicing of value investing, which started after a few years of extensive theoretical preparation. I am all my conscious life in finance but this does not mean anything because real things started only around 2005.

So, how am I doing? 22 positions initiated in total, 4 closed losses (incl. 1 “hedge”), 3 open hedge losses, 1 open loss (RSH), 13.5% IRR (xIRR Google Finance function), 50% portfolio return, and average weighted xIRR of 32%.

Seems like quite a lot of things happened since the spring of 2008.

READING RECOMMENDATIONS (iii)

Seth Klarman’s writings are always refreshing. In his 2011 Shareholder Letter (email me if you are looking for it) he gives a romantic summary of how a successful investment operation should look like: 

“You would see a sound process, highlighted by a calm, reasoned, and dispassionate atmosphere for decision-making. No second guessing or whining or double-jeopardy for anyone. A respect for and openness to all points of view. Decisiveness at critical junctures. The humility to know that a decision might be wrong, that we can never be completely sure, and the equanimity to live with both successes and mistakes and move on. You would never see us get deal heat, though you would often see us become intensely focused on timely exits. You would see the determination to separate emotion from our process, the effort never to confuse facts with opinions and, most importantly, the tireless pursuit of excellence. You would see portfolio actions taken never for the wrong reasons of ego, personal advancement, arrogance, fear, or greed, but for the proper, well-considered reason that it is the right thing to do for our long-term investment success.”

I would work for Baupost for free…

FOR BEGINNERS (PART V)

II. b) Market Valuation and Long-term Trend

Understanding of the current market level is essential for successful investing. It should provide guidance for your investment stance: is it advisable to be active or passive, hedged or fully long.

Alice Schroeder started her brilliant The Snowball, the best book about life of Warren Buffett, with a memorable lecture the value investing grandmaster gave to the wealthiest and successful businessmen back in 1999, a few months before an important market top.

In the long run economy grows because of fundamentals: population size and productivity change. Stock prices depend on profit size (% of GDP gives a good perspective, too) and multiple of earnings, which is dictated by prevailing interest rates and inflation expectations – gravity force of the market. Share price can go up via growing profits and expanding multiple. Dividend payback is also a very important part of the total investment return. That is a brief summary of how the markets work in the long term.

In 1999, W. Buffett made his first prediction in 30 years that market would grow by 6% annually for the next 17 years (he highlighted a period between 1964 and 1981 when Dow Jones Industrial moved from 874 to 875 while economy grew fivefold).

Dow Jones in July 30, 1999 - 10,655

Dow Jones in July 31, 2011 – 12,143

17.27% up in 12 years or 1.1% annual cumulative returns. Presently, it seems that W. Buffett was an optimist and based on his frequent and recent media appearances he still is. We have 5 years to go, so who knows… And you have to remember that he speaks his book.

From 1900 to 2011 S&P 500 generated 5% cumulative return (dividends provided another 4%+). Coincidentally, 4.8% is a historical S&P 500 profit growth rate and 6.2% is historical nominal GDP growth rate (Ed Esterling’s Crestmont Research website). Long term simple average inflation is 2.9%, population growth rate is 1.3%, therefore, the rest (or 2.0%) is productivity driven growth. Noteworthy, GDP growth is slowing down during the last 30 years because accumulated leveraged started to weight economy down.

Multiples awarded by Mr. Market or a fellow with fast swinging mood are probably the most unpredictable. Jeremy Grantham of GMO nicely put it in Risk Management and Investing Part II (Q1 2006):

“Exhibit 1, the “Exhibit of the Quarter,” shows the incredibly low volatility of the U.S. GDP, which two-thirds of the time has a volatility that is a mere ±1% around its long-term trend of about +3.5% a year real. This trend is stable because the economy is mean reverting, and bad times (like the 1930s) that produce spare capacity in both labor and capital are followed by strong times as the economy works to use up its excess resources. This ultra stable GDP engine can be thought of as the engine driving corporate profits and dividends. They in turn, although far less stable at a yearly level, follow the GDP in its mean reverting tendency towards a ‘normal’ level. Because of this, if you were clairvoyant in 1882 about the entire actual stream of corporate earnings and dividends until today, and used your clairvoyance to calculate a fair value, and then did the same for 1883 and so on for every year, it would produce a very stable trend of stock market fair value, as first revealed by Robert Shiller 18 or so years ago. Perhaps, not surprisingly, the volatility of this fair market value also stays within ±1% of its long-term trend two-thirds of the time. But what a contrast these two series are to the actual stock market, which manages to spend two-thirds of its time within only ±19% of fair value. This means that the market is 19 times as volatile as the underlying fundamentals would seem to justify! Understanding this 19 to 1 discrepancy would put us a long way along the road to understanding risk.”

A few highly respectable investors estimate that now fair market value of S&P is 900-1,000 (2012), which probably means that it is better to be cautious.

Media pays most of attention to short term forecasts, which are mainly based on estimated next year’s operating earnings. It may really look reasonable to apply 10-15 earnings multiple to a basket of equities, however, one has to remember that currently profits command unprecedentedly high share of the economy, which - history tells - should mean revert. Problem is that nobody knows when.

Stock market as % of GDP - Link

Inflation adjusted S&P 500 compared to the trend - Link

4 different methods (Tobin's Q Ratio including) compared to the trend - Link

Dollar value against stock returns - Link

Make your own conclusions but I am fully hedged. 

READING RECOMMENDATIONS (ii)

I wanted to document a few good reads.

First, I reread a few times a few weeks old John Mauldin’s Outside the Box with Dr. Lacy Hunt of Hoisington Investment Management. If you are going to read a single piece on macro this year this one qualifies quite well. It is a very powerful reminder on where we currently stand – protracted deleveraging; and on the trend direction of treasury rates – down. Consumers are spending their savings and are taking more debt – this does not spell well on growth prospects. There are plenty of graphs and non-noise insights.

Second, I recommend always reading Jeremy Grantham’s quarterly missives. His latest one resonates well with my thinking about individual investor’s edge – it is simply absent, at least in terms of thinking of a professional investment manager.

A few interesting thoughts from the letter: 

“You don’t have to be a PhD mathematician to work out that if the average Chinese and Indian were to catch up with (the theoretically moving target of) the average American, then our planet’s goose is cooked, along with most other things.” 

“…: there have been several recent decades in which the BTU equivalent price of natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term.” 

Jeremy Grantham made an interesting twist on S&P fair market value. He is saying that top quality quarter of S&P is fairly priced (5.5% real annual returns for next 7 years), while the poor quality 75% is moderately overpriced and will deliver negative returns over the next 7 years. At current price GMO projects 1% real annual return for S&P 500 for the next 7 years.

I believe that he still thinks that FMV of S&P should be close to 950 – 1,000. Therefore, S&P at 1,370 clearly warrants a fully hedged position. I think that IWO (Russell 2000 Growth) could be the most convenient hedge – it is volatile and @ 93 has only 0.65% yield (if you have no time to identify the most mispriced poor quality stocks).

Interestingly, J. Grantham and L. Hunt views differ on long duration treasury rates. The first believes that long duration bonds is almost the most risky investment at the moment. The second projects that 30Y Bond will go down to 2% (now ~3.1%). Maybe they do not contradict each other because interest rates may go down first before jumping up.