Very seldom do we see six straight weeks of market weakness, especially without a notable bounce in the indices. This has caused many to question the validity of the bull market and ponder the possibility of the commencement of a full blown bear market.
In my view, odds remain high – despite the pain – that we remain in a bull market and we’re experiencing a normal garden variety pullback. We remain just 6% off the high for the S&P 500 while the Russell 2000 has retreated approximately 8% while that may not sound like much its enough to place our short, intermediate and long term sentiment indicators have moved into positive territory for the first time since late last Summer. Corporate earnings growth remains very strong and unlike what we’d expect to see if entering a recession. While the risk exists that weaker than expected economic reports could result in disappointing earnings preannoucements, any rush to presume this risk could be premature.
While the economy may be going through the proverbial soft patch with intermediate term Treasuries moving below 3% yield the primary causes appear to be resulting from the flood in the Midwest, rise in the dollar, Greece/Euro, earthquake in Japan and the serious move higher in oil prices. While the floods and earthquake are temporary in nature, the rise in oil is potentially reaching the point of demand destruction. However, I do believe that these issues are now absorbed into the prices of most equities and bonds.
Risks remain though and to the shock of many, the US has been a much better place to invest your money than the beloved Emerging Markets. Inverted yield curves are showing up in many countries: Greece, Ireland, Portugal, India and Brazil. Historically speaking, inversions almost always lead to recessions.
During this period of weakness we’ve sold several holdings that had fallen in our ranking system and have begun to add new names as I believe that the odds are growing that 1250 on the S&P will hold.
Deletions:
PKOH
NTL
CPWM
XIDE
GKK
Additions:
COOL
CMT
GKK (buying back in at lower price)
IEP
ITWG
HIT
As always be careful out there.
Brad Pappas
Long all mentioned.
After the successful investment returns in 2007 I began to spend considerable time developing a model that would assist is replicating the returns in future years. This project turned into a three year immersion into Quantitative Analysis and investment strategy development which combines both stock selection and market timing in one package. Anyone who knows me would probably agree I loathe hyperbole in the financial press but the back-testing and real time present day monitoring of the models results continue to be consistent. The returns generated in individual stock portfolios since this past October are exciting and an example of its potential. However, as in any case of investment modeling and strategy the standard warning of “Past performance is not a guarantee of future performance” is always true.
The model went into full time use for RMHI clients in October when the anticipated mid-term election rally (see 4th Quarter 2010 client letter) was emerging, the single largest rally in the four year Presidential term. So far, the results speak for themselves.
The RMHI models give our accounts a distinct advantage over mutual funds or large pooled portfolios in several ways:
- The model allows our portfolios to focus on the best 30-40 stocks our model identifies rather than diluting accounts with 200 to 500 or more common in most mutual funds. Included is, as always our screening for negative animal and environmental companies.
- Market timing with Hedging is built into the model which is not generally present in SRI or mainstream mutual funds.
- RMHI being a “small” investment management firm allows for a distinct advantage since not only does it allow for greater concentration of the best potential holdings but also for investments in smaller capitalized companies where larger funds must pass over due to size restrictions. As the studies below indicate “small” with a value bias tends to be relative outperformer.
- By and large the best investment managers in the world are capable of generating returns in the 30% zone and they frequently use some form of investment modeling. Our small size allows us to “be under the radar” which enables us to invest in small and micro cap stocks which provide higher rates of return* and which most mutual funds or hedge funds are unable to.
A portion of the initial foundation of research for the model can be attributed to James O’Shaughnessy exhaustive research in his book “What works on Wall Street” where his research suggested that value factors such as Price/Earnings, Price/Book, Price/Cash Flow and particularly Price/Sales have consistently exceeded their benchmark indices and offer better guidance in stock selection rather than many Growth oriented factors. In other words, stocks that are valued cheaply tend to outperform their peers.
The model has two primary functions: Stock Selection and Market Timing.
Stock Selection: Stock selection is based on the time tested method of identifying potential investment candidates based on three measures:
Low Price to Revenue with Low Price to Cash Flow: In addition to O’Shaughnessy’s research there is a significant amount of research which has determined the effectiveness of value-based selection criteria:
Robert Shiller stated in 1984 that fundamental value was probably the most important determinant of future price expectations.
Labonishok, Shleifer and Vishny (1994) determined that Value consistently outperformed “glamour” aka Growth stocks regardless of size or business cycle.
Fama and French (2007) determined that Value stocks (with low ratios of price to book value) have higher average returns than growth stocks (high price-to-book ratios) see graph below.
The ability to invest in the “Smallest” “Value” stocks will provide our investors with a distinct advantage over large institutional investment managers and mutual funds. As the chart from Eugene Fama reveals: The ideal sweet spot for stock selection is the crossroads of “Smallest” company size and “Value” which outperforms “Biggest – Growth” by almost 300%.
Short Interest: Research shows that growth stocks are more heavily shorted than value stocks and that short sellers tend to be right. Asquith and Meulbroek (1995), Desai et al. (2001), and Dechow et al. (2001) provide evidence that more heavily shorted stocks tend to perform poorly. A reduction in short selling/interest over recent months indicates less bearishness and potential future price appreciation.
Price Momentum: Simply stated, stocks that are cheap based upon their balance sheet assets relative to the stock price tend to outperform over extended time periods. But! It’s not enough to have just a cheap stock….you need a cheap stock that is moving higher, otherwise the market could be rising but your cheap stocks are stuck in the mud and not making any progress.
Jagedeesh and Titman (1993) observed a pattern of price momentum whereby past winners tend to outperform past losers over the next three to twelve months.
Conclusion: Value stocks and in particular Small Value stocks have provided a much better return historically than popular Growth Stocks. Using the historical results and applied with the use of Quantitative Analysis a diversified portfolio built upon the RMHI model should improve the expected rate of return without a significant increase in volatility, resulting in a much better risk-reward than could be achieved without the model.
In the RMHI model approximately 5000 stocks are scanned daily and ranked based upon our formula. Stocks selected for investment are generally ranked in the top 2% and are held until they fall out of the top 5% category.
Market Timing: The goal of the RMHI Market Timing module is not to attempt to identify average market downdrafts but to catch major market swings up or down which tend to be driven by earnings. In addition, it’s impossible to anticipate news events that could drive the stock market lower such as 9/11 or the JFK assassination. Such events are random and typically short-lived. Eventually markets resume the path they were on before the random event. In addition, I wanted to avoid unnecessary trading or frequent signals that could have us trading excessively. Essentially we’re looking for the big moves and ignoring the minor moves that would create unnecessary trading and reduce returns.
There are many tools that can be utilized to aid in predicting future market direction. The accuracy and predictive ability of an indicator can and do change. One of the most accurate in the past decade has been the rate of increase or decrease in earnings expectations by analysts for the S&P 500 Index. Markets have moved in the direction of earnings expectations quite closely for the past 20 years.
In the past 10 years the stock market has been especially vulnerable when earnings expectations for the S&P 500 begin to falter.
In the 1990’s Dr. Ed Yardeni, based on statements made by then Federal Reserve Chairman Alan Greenspan developed the “Fed Model” as a method of valuing stocks versus bonds. Simply stated, the original Fed Model was a tool that assisted in determining whether stocks were a better value relative to bonds.
The financial theory was simple enough: money would flow to the asset value which was relatively more attractive and away from the overvalued asset. In reality, the Fed Model by itself was a relatively poor indicator by itself but the basic theory was a good foundation to start from.
From 2000 to mid 2002 the Fed model gave a good account for itself as the model determined that stocks were of poor relative value to bonds and stocks did endure a prolonged Bear market.
In an effort to bridge the gap from theory to actionable buy-sell signals I experimented with many alternative indicators (including Sentiment, Monetary Policy, simple moving averages for the stock market) but determined that the Consensus Earnings Estimate for the S&P 500 provided the best indicator when combined with the Fed model.
As the red line in both charts below show, risings estimates for the S&P 500 index tend to be associated with good returns for investors even when bonds are of better relative value to stocks. But rising earnings estimates combined with an attractive stock to bond comparison as determined by the Fed Model foretold extremely strong returns. And, declining earnings tend to be associated with declining returns as well, especially when equities were poor value relative to bonds.
Blending the Fed Model with current forward looking earnings estimates proved to be an accurate and reasonable combination of effective and actionable buy – sell signals for U.S. equities since 2001.
The chart below shows the timing mechanism of selling when earnings move below the 20 and 40 week moving average and buying when rising above the 20/40 week average. In case you’re curious, the last sell date was June 2008.
Back Test Results of the RMHI Model: The data and test results date back to March 2001. The effects of compounded returns over the 10 year period are self evident which accounts for the accelerating appreciation in value (red line). The shaded areas are periods when the Market Timing module indicated that risk was very high for stocks and Hedging of portfolios was in place. Hedging consisted of selling 50% of the value of the portfolio of stocks and replacing them with the Proshares Ultra Inverse S&P 500 ETF (symbol SDS), creating a market neutral risk profile.
| Annualized Rate of Return net of trading expenses |
54.86% |
|
Average Total number of positions
|
30 |
| Total Return net of trading expenses |
7139% |
| S&P 500 return |
11.87% |
| Annual Turnover |
241% |
| Maximum Drawdown |
-28.4% |
| Percentage Winners |
52.77% |
| Sharpe Ratio |
1.87 |
| Standard Deviation |
Model 28.4% versus 26.19% S&P500 |
Model Returns by Year including trading expenses gross of management fees
| |
2001* |
2002 |
2003 |
2004 |
2005 |
2006 |
2007 |
2008 |
2009 |
2010 |
| RMHI Model |
106.96% |
78.99% |
158.43% |
112.9% |
21.46% |
59.38% |
2.02% |
23.94% |
72.51% |
39.21% |
| S&P 500 |
-1.38% |
-23.37% |
26.38% |
8.99$ |
3.00% |
13.62% |
3.53% |
-38.49% |
23.45% |
12.78% |
| Excess Return |
108.34% |
102.36% |
132.05% |
103.91% |
18.45% |
45.76% |
-1.51% |
62.43% |
49.06% |
26.43% |
Investors are typically loath to endure a cyclical Bear Market which can last for 6 to 9 months or more. My hope is that the use of Hedging of portfolios during periods of predicted market weakness will incline antsy investors to stay put.
Frequently asked questions:
“If your model indicates risk is high and the chances of a big market selloff are large, why not sell off all your stocks and put 100% into the SDS?” A very valid question, back testing this concept showed that volatility of the portfolio would be much larger without any stocks to offset the “SDS”. Bear Markets tend to have some very strong rebound rallies or whipsaws which cut into the gains made on the SDS and make any investor nervous. You could get lucky and sell at or near the bottom, that’s certainly possible since investor sentiment at bottoms is extreme. My preference is for the less volatile strategy.
“Is there an aspect to the model that you’re not completely happy with?” Yes, the market sell signal in 2008 was excellent but the buy signal, which required earnings to exceed the 20 week moving average was slow in my opinion. The absolute bottom for most stocks was November 2008 but the model did not go into buy mode till May 2009. Ideally the hedges should have been removed when sentiment was truly extreme in November and slowly adding stocks afterwards.
“Is this the only model you have developed? Are there others in case this one loses effectiveness? Yes, in addition to the present model there are at least three others that I continue to monitor closely. However, models can run hot or cold from one year to another. I gave special preference for long term consistency which is why I’m using the present RMHI model.
“No model is perfect, what do you consider your models biggest weakness?” There remains the risk of annual short term draw-downs or pullbacks in the portfolio. I wish those could be smoothed but it’s not realistic at present and trying to do so can severely impair returns. In an effort to temper this risk I’m considering employing the Ned Davis annual cycle chart as a roadmap. It is predicting the start of a Bear Market in equities beginning in August 2011.
“Have there been any extended time periods where you believe the model would not have been effective?” Yes, but this based upon experience rather than data. The late 1990’s when the mania for Growth stocks, particularly Technology stocks was a rough time for Value stocks in general. However the pendulum swung back sharply in the early 2000’s and the normal outperformance of Value reinstated itself.
“Why not simply sell all the stocks and just hold cash instead?’ This is another “all or nothing” approach which has significant risk in terms of “Opportunity Cost” or what you could have made had you held on to the portfolio with hedging. The chart below shows this option:
Using cash in lieu of the SDS Hedge drops the annualized rate of return to 48.5% but the real cost is the impact on the compounding when compared to the chart using the hedge.
To sum it up, I’ve attempted to be as comprehensive as possible with this presentation by detailing the academic and data research that is the foundation for the model. Some aspects such as Momentum and the weightings of the model elements must remain proprietary. No model is perfect but based on everything I’ve monitored to date, the model does work effectively. There are also the normal risks associated with any equity investments in particular surprise events. However, one very important lesson that must be acknowledged is that subjective opinions will, in general hurts returns. Maintaining discipline is essential to the performance of the model and I will maintain the effort to do so.
Disclosure regarding the SDS: Each Short or Ultra ProShares ETF seeks a return that is either 300%, 200%, -100%, -200% or -300% of the return of an index or other benchmark (target) for a single day. Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.
Investing involves risk, including the possible loss of principal. ProShares are non-diversified and entail certain risks, including risk associated with the use of derivatives (futures contracts, options, forward contracts, swap agreements and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. There is no guarantee that any ProShares ETF will achieve its investment objective. Please see the prospectus available at www.proshares.com for a more complete description of these risks.
Green and SRI investors along with investing professionals are always asked to make the best decisions under pressure, and the most common one we face today is should “Socially Responsible Investors abandon stocks in favor of bonds?”
It is my opinion based on close to thirty years of trading that the best trades are those done when you’re in the minority not the majority opinion, otherwise who’s left to buy or sell?
For this question of stocks sold off in favor of bonds, bad news has to be considered good news. Any good news on the economy will be treated negatively at this point in time for bonds. Today’s stock market strength and weakness in bonds is due to the better than expected August PMI report which came in at 56.3 versus the consensus of 52.9 and the August report is an improvement upon July’s 55.3. Adding fuel to the rally is survey from Investors Intelligence which shows that just 29% of newsletter writers are bullish which is the lowest percentage since the crash in 2008. Remember folks, the more extreme the consensus the greater chance of a reversal in market direction. A bull figure at just 29% might be enough to halt the decline at worst…..but its certainly in the range to mark the bottom where a new rally can emerge.
Good news is bad news for bonds. The 10 year Treasury has moved from 2.48% to 2.6% today while the 30 Year Treasury Bond has moved from 3.53% to 3.68%. Bond yields are now at levels seen in late 2008 and very early 2009 and we all know how productive it was to buy bonds in February of 2009.
The stampede into bonds has been nothing short of epic and the Consensus Survey of bond investors maxed out at approximately 80% recently. Rarely has such a consensus opinion been profitable. These are the kinds of surveys we frequently see at major market tops which begs to ask whether bonds are in a Bubble. Bubble talk has been pervasive in the media much just as talk of Deflation has been over commented upon.
Frankly there’s more contradictory information and confusion in the media to rival a Republican politician who wants to reduce the deficit while maintaining tax cuts. The bottom line is we do not have Deflation in the U.S. at present as Deflation is a very rare event here.
But are bonds really in a Bubble? My answer would be “not at present”. My definition of Bubble for the any investor including the Green Investor or the Socially Responsible Investing community is that for a Bubble to truly exist the risk of a significant and permanent loss of capital must be present. A Treasury bond will eventually pay off at par upon maturity, so while its very possible to lose 20% or more in a bond, the loss would be temporary if you were patient enough to wait till maturity. The reality is only a very few investors have that kind of patience. In addition, many of the investors who are retirees and have been buying Treasuries will not be around in time for their bonds to mature, so a loss could be taken.
With Consensus opinions at present in the range of 70% to 80% Bullish on Bond prices, should the tone of economic data change (I believe its starting to happen now) the rush to exit bonds could be swift and very dramatic, especially in this day of algorithmic and program trading.
A by product of the rise in bond prices and drop in yield is the relative valuation of bonds to stocks.
As the chart above highlights, the relative valuation of bonds to stocks is at extreme levels and the other two times in the past century this relationship was reached, buying bonds in lieu of equities was a significant mistake. Can we say that in the two past examples that bond investors lost money? No, not unless they held to maturity but they lost “opportunity” to be in equities as the mean relationship between stocks and bonds eventually asserted itself once more.
We’re faced with the challenge of “getting back to pre-crash levels” and by over allocating to bonds now is essentially giving up that goal at time when the odds are stacked against you.
To be a successful Green or Socially Responsible Investor sometimes means enduring pain and the pressure of the media, not to mention friends who offer their opinions in an effort to “help”. Diversification between bonds and equities is always a good thing and proper re-balancing when one asset class becomes overvalued is essential, but to join the mass entrance into bonds at this stage may very well lead to a mass exit when the weak patch of our economy passes and moderate growth re-emerges.
In the wake of the collapse of 2008 investors are frequently choosing to make radical and rapid decisions since the urge to do something can be overwhelming at times. While our accounts have made meaningful progress in the return to the values of 2007 the remaining balance will require persistence, patience and discipline from our clients and me. In times of stress I think back to a book I purchased solely due to the title: “Tough time’s never last, tough people do” by Dr. Robert Schuller. Sometimes the boldest move an investor can make is simply be patient and allow the haze to eventually burn itself off where clarity in begin anew.
Investors who would not allow themselves to be intimidated by fear and confusion should value the fact they did not lock in their losses by cashing in and taking 3% or less in government bonds. Many investors took permanent losses in failed banks, mortgage companies and home builders, not to mention toxic mortgage backed securities, areas we largely avoided. In due time should our economy begin to pass the current soft phase those 3% bonds could turn insult into injury as the value of those bonds would be in peril should our economy surpass its current weakness but in fairness more attention needs to be devoted to government bonds later in this letter.
While I am far more optimistic about the intermediate term return potential for equities with the current high levels of investor pessimism versus the universal optimism in January, the future is far from clear. Despite the present uncertainties, the degree to which these issues are factored into the prices of the stock market is of larger importance. While I do continue to expect second half weakness for the remainder of 2010 as the inventory buildup, housing recovery begins to waver and federal stimulus wanes. We face an unusual amount and degree of non- traditional headwinds from sectors that normally provided stability like local municipalities. The decline in tax receipts from real estate have hurt many states which in turn have actually resorted to laying off employees for the first time in decades. Adding to the headwinds are the rise in government debt in relation to GDP and the corresponding rise in the clamor for Austerity. While there are a multitude of issues many of these issues are already factored into share prices and the repeated drumbeat of fear from Deflation and a Double Dip recession has begun to lose its effect for 2010.
Austerity can take many forms from the withholding of unemployment benefits, elimination of tax benefits along with tax increases to cover the cost of entitlement programs in 2011. Japan should serve as reminder to the effects of snuffing out fledgling economies as every time there economy has shown signs of life they’ve killed it. In 1997 with the Japanese economy showing promise the government raised the consumption tax by 2% which threw the economy back into recession. The Austerity-Hawks do represent a risk to the emerging economy that harken back to the Great Depression. Christina Romer Chair of the Council of Economic Advisors gave a speech in 2009 highlighting six lessons learned from the Great Depression:
1. Small Fiscal Expansion has only small effects. This would imply that Paul Krugman’s editorials in the NY Times stating the needs for Stimulus II might be spot on, as Stimulus I was not enough.
2. Monetary Policy can help heal and economy even when interest rates are at zero.
3. Beware of cutting back on stimulus too soon.
4. Financial recovery and real recovery go hand in hand.
5. The world will share the benefits or burdens of expansionary or austerity policies.
6. The Great Depression eventually ended.
Should our government fail to continue the expansionary policies as espoused by Democrats but bow to favor Austerians by talking of the reduction of debt then Deflation could continue to be a dominating trend and the value of our overvalued government bonds with feeble yields could be of great value to our portfolios.
There is in fact a study authored by Alesina and Ardagna* which analyzed the effects of 107 fiscal retrenchment/austerity plans within OECD countries (Organization of Economic Cooperation and Development) between 1970 and 2007. The authors found that only 26 of the 107 periods of fiscal restraint occurred with growth and the rest were deflationary. The 26 did share the commonality of being small open economies with weak currencies but accommodated by worldwide economic growth, not quite the situation we face today.
Investment returns relative to Deflation or Inflation
Source: Leuthold Group 6/30/10
The potential for a wide variety of outcomes from our economy might be the greatest in our lifetime. Hence equity allocations are being reduced into strength from our 70% weight of 2009 and early 2010. Chmn Bernanke appears to have a firm grasp on the risks of Deflation and has hinted that the Fed could further add stimulus to the economy with the purchase of long term government bonds with the hopes of reducing long term interest rates, which would help the housing industry. **This potential action by the Fed would drive long term government bond prices higher and thus be a counter balance to equity risks. Timing is key as it always is and as we have slowly reduced our equity exposure we have held the proceeds in cash rather than invest in bonds as by our measures there could be a better entry point for bonds down the road. If the ten-year Treasury were to move to 3.6% in yield we’d be a buyer.
The fear of Deflation remains very real with our current jobless recovery which may take much longer than in past cycles and extend into 2012. However, a Double Dip recession does not appear in the cards at present as was noted in our blog at www.greeninvestment.com/blog. But the risks are rising that 2011 could be trouble when higher taxes begin to have an effect.
Ultimately this economic cycle will end and just as Warren Buffet is fond of saying: “You can’t tell who’s been swimming naked until the tide goes out”, the inverse is just as true with gold dealers harp on FOX about fear and the decline of our economy while gouging customers with exorbitant fees to purchase gold. Who can say they won’t be swimming naked as well when the tide turns back in?
The methods of investment selection we employ within the RMHI Equity Model date as far back as the days of the 1930’s and The Great Depression, but with a few modern quantitative changes. Benjamin Graham and “The Intelligent Investor” created the concept of Margin of Safety which is arguably the best quantitative method of investment selection ever devised. Our focus is on balance sheets and the traditional relationships of Price to Book Value and Net Current Assets in relation to the stock price. In such uncertain times the pursuit of high growth equities could represent a serious danger without the underlying protection of the “Margin of Safety” which is defined as the value of the equity in sharp discount to Net Current Assets (NCAV). The RMHI model is based on several very Old School techniques of valuation. The Margin of Safety concept may be easier to grasp to the non-financial geek, where ownership of a share is considered a stake in the company rather than a short term trading widget as espoused by the folks of Fast Money and James Cramer.
We need our clients to understand that risk reduction does not necessarily mean returns must suffer, that is if we’re able to buy a stock cheaply….the profit is essentially made on the purchase if we can buy the shares below the Net Current Asset Valuation and remain patient for the value to be discovered. At present there are no publically available Socially Responsible Investment (SRI) funds or management companies that actively employ the Margin of Safety concept.
Margin of Safety
An example of the Margin of Safety concept authored by Benjamin Graham is the shares of Gravity Co. Ltd where the cash per share on the books minus current liabilities is actually greater than the share price.
Gravity Co. Ltd. Symbol “GRVY”: Based in South Korea, develops and publishes online games. Owns flagship Internet game Ragnarok Online.
Data as of 12/31/09 Audited by Korean member firm of Pricewaterhouse Cooper
Total Current Assets $ 71 million minus Total Current Liabilities $ 7 million = Net Current Assets $64m
Debt $ 0
Shares outstanding 27.8 million
Net Current Asset Valuation per share $2.30
Stock price as of 07/27/10 $1.50 a share
Margin of Safety 34%
Despite this absurdly cheap along with an impeccable balance sheet, is the fact that revenue for GRVY grew approximately 20% in 2009 along with positive cash flow with earnings before taxes and interest of $11 million.
Our thesis: An investor has a form of downside protection offered by the cash on the books. The stock would have to rise by 34% to simply comply with the Net Current Assets, the underlying online game and software business along with future growth are thrown in for free.
I believe at some point in the future the shares of GRVY will trade for at least the NCAV or $2.30 a share which would be just over a 50% profit. However should the company continue to execute their business plan as they have recently the shares could travel farther than $2.30 per share. In addition, potential takeover by majority owner? Softbank-controlled Japanese game publisher GungHo (Gravity’s largest licensee, increased its stake to 59% in 2008). Gravity’s below-cash valuation may entice GungHo to make an offer.
As with any company Gravity is not without its risks. The company has long delayed the sequel to its Ragnarok Online franchise which is its largest source of revenue. Hopefully, the company will release the sequel within 6 to 12 months which would sharply boost revenues and earnings.
The Ragnarok franchise will satisfy many social profiles since the game does not include any violence, adult themes or explicit graphics.
Many of our present holdings have similar balance sheet / share price relationships and a few were outstanding performers thus far in 2010: within the past two months we have had two holdings be either the target of a good old 1980’s hostile takeover: RCM Technologies or have hired investment bankers to determine how to maximize the assets of the company: Hawk Corporation.
A third company telecom services company IDT Corp. was our best performer of the quarter. Shares were purchased on average between $10 and $12 a share. What brought it to our attention was the fact that IDT had $9.63 per share in cash with emerging profitability. The cash on the books was our Margin of Safety and at present shares trade for over $18.
In addition, we’re looking at several small holdings which pass the RMHI model but also have a very unique valuation where the Net Current Assets exceed the price per share. These are equities (in addition to Gravity)that have a cushion of safety inherent due to their current assets and become very attractive for sharp price appreciation due to mergers, takeovers or return of capital to shareholders (dissolution of the corporation).
Future considerations: What I’m about to write is considered financial blasphemy and the irony cannot be lost on even the most dense of investors. But I have a belief that as an investor I should look under every rock and every neglected corner of the world and not be bound solely to the U.S. market. With all the references being made to the US resembling Japan I did not just a double take but a quadruple take and shook my laptop in disbelief when in the process of running investment screens with the RMHI model I noticed a new crop of equities showing up in clusters. I won’t keep you waiting but here it is…………..what they had in common were they were Japanese stocks: Hitachi, Nippon Telegraph and Telephone, Interactive Initiative ads, Canon, Fujifilm, NTT Docomo.
Japan: The Land of the Rising Stocks
- Cheapest market valuation in the world on a Price/Book value basis at 1.2x book value which compares to over 3x book value for India and China while the US is just over 2x book value.
- The Nikkei topped out at nearly 40,000 in 1989 while today it rests just under 10000.
- The contrarian trade to Emerging Markets: In a recent Merrill Lynch survey over 60% of investment managers were overweight in their asset allocation to Emerging Markets while approximately 50% of managers surveyed revealed they were underweight Japan. Manager sentiment is frequently an inverse barometer of future performance.
- June 2010 the Wall Street Journal reported that for the first time in three years foreign investors are increasing their exposure to the Japanese stock market.
- Very little correlation to GDP growth and 7 year stock performance. For Japanese equities to perform relatively well very little growth in Japanese GDP will be required, it may just take growth regardless of the rate.
- Most major Japanese companies which took losses in 2010 are expected to produce profits in 2011 which coincides with new Japanese business reforms. 2011 earnings do not appear to be reflected in share prices as very high quality companies are selling cheaply. Hitachi sells for just 13x 2011 estimates and 1.3x book value.
- Byron Wien of Blackstone Group added Japan to his 2010 list of surprises with a prediction that the Nikkei would surpass 12,000 for a gain of over 20% based on its current value. Personally speaking a move to 11,000 seems more likely, which is still a very nice gain.
Summary: We face an unusual set of economic headwinds with a myriad of possibilities for the end result. But investors are still faced with the normal quest for retirement funds and a better life where investing in CD’s or bonds yielding 1% are not a realistic option for the investor with a long term horizon. In addition, while investor sentiment has deteriorated sharply (a very good thing going forward) we do not have the values present that existed in late 2008 and early 2009 which allowed us maximum equity exposure. Hence, I believe going forward equity positions should be reduced into market strength with our average equity allocation will be approximately 55%, ideally 30% for bonds and 15% in cash. “Ideally” is relative since the bonds class offering the best counter balance to equities would be US Treasuries in the 10-20 year range and are quite overvalued at present. Until the over-valuation is worked off we’d be better off holding cash in lieu of bonds.
As for equities, the RMHI model which identifies the best prospects for finding Value along with price appreciation potential. Top of the list in the RMHI equity model in recent weeks have been shares of major Japanese companies which have endured over 20 years of malaise and may be near a pivot point in performance going forward. As a statement of fact, the Nikkei is the most undervalued market based on price to book value in the world and investment managers worldwide are severely under allocated to Japanese shares.
Brad Pappas
August 1, 2010
RMHI is long shares of RCMT, HIT, HWK, NTT, IDT, GRVY
*Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spending,”2009; forthcoming in Tax Policy and the Economy,available at http://www.economics.harvard.edu/faculty/alesina/recently_published_alesina
**Bullard, James of the St. Louis Federal Reserve. “Seven faces of The Peril” July 2010
“Malaise” seems to be the word of the day as markets cope with incompetence in both business and political realms.
Will the leak caused by BP in the Gulf ever end?
Will the war in Afghanistan as highlighted by Rolling Stone ever end or remain in FUBAR?
Will the Obama administration ever make job creation are real priority rather than lip service?
Will China (which is much more important than Europe) achieve the soft landing in its economy?
Despite the chatter about “double dip recessions” economic data just doesn’t support the dd premise. Growth isn’t robust but it moderate and lumpy and expectations have pulled back sharply in expectations since the start of the year……..a good thing.
Capital Goods orders were up 2.1%.
Durable goods orders were up 0.9% and now have been up in 5 out of the last 7 months and up to 20% ytd.
“Malaise” as been bantered about now on CNBC and Jim Cramer is not the type of attitude existent at market tops but more often at market bottoms when economic blemishes are visible to all and the bulls have turned to bears.
The soft patch we find ourselves in presently could change in quick order should something good happen.
Earnings have been growing nicely but have been largely ignored this year. We’re using an earnings estimate of $90 for the S&P 500 in 2011 which makes the market 12x times 2011 earnings. Historically the S&P has been nominally valued at 15.3x earnings with comparable interest rates and inflation, and up to 17x. There is significant upside potential looming and with negativity growing rapidly the bottom in the current correction may be soon. My best guess is the “real” rally would likely be in the 4th quarter but the risk at present is not great by my estimation.
“In speculation, interestingly enough, contrary-mindedness is often a virtue. A layman might suppose that profits lie with the majority. Because the mass of people have the weight of the money, he might imagine that the crowd would tend to be on the winning side of things. Not for long, in my experience. If the majority confidently knows something, that one thing is probably already reflected in the structure of prices, and the market is vulnerable to a surprise. Markets are moved by the unexpected and the unexpected is what the crowd isn’t anticipating. The financial future may be imagined, but it can never be positively known. What people know is the past and present, and they often project the familiar out into the unknown, with unsatisfying results”
— Jim Grant, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer
