Market turn approaching?

This may be premature but I’ve noticed that our portfolios have been outperforming for the past three days.   That may not sound like much but I believe its an indication that the breadth of the market is improving and that the major indices are masking underlying strength.

When underlying market strength is weak, the major indexes that you can own via ETF’s or Index mutual funds tend to do relatively well.  However, when underlying strength is weak there is a strong tendency for individual equities and small caps to outperform.  This could be the case now, time will tell.   It has been 10 months since we last outperformed so the tide may be turning.

We continue to hold Appliance Recycling Centers of America ARCI Green Plains Renewable Energy GPRE and have a small position in Perma Fix Environmental Solutions PESI.

Severe sell off in solar play First Solar FSLR a former high flying darling of the solar energy industry.   FSLR came out with a statement that 2012 earnings will be roughly half of analysts expectations.   We have no position in FSLR but I must say the price is getting interesting.

FSLR share price is $33.90

The balance sheet is solid: Book value is $46 which includes $8 in cash and the equivalent of approximately $7 in debt.

But the market cap is now below revenues, which indicates very good value.

Its probably too early to buy as the stock needs to stabilize and the source of the earnings weakness must be determined.  Stating again for the umpteenth time:  Europe is the primary source of Alt Energy revenues and Europe is cutting back severely through austerity programs to curb their debt.  Alt Energy will be sacrificed in the meantime as for most countries its a discretionary expense.




Should a Socially Responsible Investor Invest Heavily In Bonds Now?

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.

Socially Responsible Investing and the Margin of Safety

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 InflationDeflation and market peformanceSource: 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  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

**Bullard, James of the St. Louis Federal Reserve.  “Seven faces of The Peril” July 2010


Alternative factors to consider in evaluating Socially Responsible Investment performance

As an investment manager with Rocky Mountain Humane Investing (  the most common question we hear from potential clients is “and advisor told me that socially responsible investing isn’t profitable” versus unscreened portfolio management.   In general the advisor providing the dogmatic opinion does not offer any foundation for their opinion but this is their chance to influence the potential client especially if they cannot offer an SRI option for the investor.   Unless you have a few arrows of your own in your quiver you may be quite likely shrug your shoulders and resign yourself to an unscreened portfolio versus a clean portfolio.

Probably due to the fact that I’m over 50 now with a repellent view of hyperbole and unsubstantiated opinions I have been uncomfortable with opposite view as well: socially responsible investing improves rate of return.  It has been my view based upon empirical experience of managing SRI portfolios for 20 years that SRI is not a significant determinant of investment performance.   SRI is a highly subjective practice where investors can have divergent opinions on industries and companies.   There is not unified screening standard amongst the SRI industry, each firm or fund makes their own decisions on screening criteria.  While some funds screen for only 3 or 4 issues there are other funds that screen over a dozen.

Practitioners of SRI may draw attention that investors always assume a given level of risk with any equity investment but that the risk premium associated with SRI is less.    Case in point the risks associated with Tobacco, Asbestos or BP and the Gulf oil disaster.  However in my 20 years involved with socially responsible investing, screening stringency is often a matter of interpretation as BP was considered Best of the Lot for many years for funds that desired petrochemical exposure.

Let’s take a look at some of the academic studies that have touched upon the issue of the factors of SRI performance:

  • Moskowitz Award winner, John Guerard, Jr., director of quantitative research at Vantage Global Advisors, examined the returns of Vantage’s 1,300 stock unscreened stock universe  and a 950 screened universe (The screens eliminated companies that failed to pass alcohol, gambling, tobacco, environmental, military, and nuclear power). He found “that there is no significant difference between the average monthly returns of the screened and unscreened universes during the 1987-1994 period.  The “unscreened 1,300 stock universe produced a 1.068 percent average monthly return during the January 1987-December 1994 period, such that a $1.00 investment grew to $2.77. A corresponding investment in the socially-screened universe would have grown to $2.74, representing a 1.057 percent average monthly return. There is no statistically significant difference in the respective returns series, and more important, there is no economically meaningful difference in the return differential.”

Guerard’s conclusions are reinforced by other works:

  • “Socially Responsible Investment: Is it profitable” Dhrymes, Columbia University July 1997 June 1998.Dyrymes concluded that: “that by and large the Concerns and Strengths of the KLD index of social responsibility are not consistently significant in determining annual rates of return.”

  • Socially Responsible Investment Screening Strong Empirical Evidence For Actively Managed Value Portfolios.  June 2001, revised December 2001 Stone, Guerard, Gultekin, Adams.“No Significant Cost” means no statistically significant difference in risk adjusted return”. In addition, they surmise that “the conclusion of no significant cost/benefit is not just a long term average.  It has remarkable short term consistency!”

In my opinion this report presents a balanced view in that they concluded that the during the time of the study 1984-1997 the stock market rewarded the growth oriented style and that the performance of SRI investments could become “brittle” if markets were to become risk averse and adopt a more Value oriented style……….a remarkably accurate presumption!

Could the performance of SRI funds which have exceeded or lagged their respective benchmarks be in part due to size (average capitalization from micro cap to large cap) and style (Value or Growth)?

Fama and French of Dartmouth University examined the annual rate of return and beta (volatility) of an unscreened universe of Growth vs. Value from 1928 to 2009 by dividing stocks into ten deciles (groups) based on book-to-market value, rebalanced annually and found that Value had the lower risk while Growth had the higher risk.  In addition, they found that the highest book –to-market stocks exceeded the return of the lowest book-to-market by 21% to 8% on average.   Stock valuation was as significant factor in the Fama and French study where the cheaper the equity valuation the better the return.

Market Cap size was important in the Fama and French study as well (1992).   Market cap size showed a significant edge to small and micro cap equities on a monthly basis.  *Monthly returns for the smallest 10% of equities were 1.47% versus 0.89% for the largest decile.

It is our contention that there are attributes that could account for performance to equities other than social profiles and that concurrently a portfolio of socially screened equities with the highest book-to-value ratios could exceed comparative benchmarks largely due to valuation metrics and capitalization size.   In a case of pure cherry picking the monthly rate of return smallest market cap and lowest book value to market price was 1.63% versus .93% monthly for largest market cap and highest book value to market price.

I tested this theory using data supplied by the Social Investment Forum and Russell Index regarding the 10 year average rate of return for socially responsible mutual funds versus their respective benchmarks trends do emerge.

Data as of June 30, 2010


  • Russell Mid Cap Value Index was the top 10 year performer +7.55%.
  • Russell Mid Cap Growth Index returned -1.99%.
  • Russell 2000 Value returned +7.48%
  • Russell 2000 Growth Index returned -.92%

Equity Large Cap performance (information provided by SIF)

  • 4 mutual funds show positive 10-year average annual rates of return:
    Calvert Social Investment Equity +0.14% (Growth)
    Neuberger Berman Socially Responsive +3.18% (Value)
    Walden Social Equity +1.46% (Value)

Parnassus Equity Income +4.65% (Value)

Equity Small Cap performance

  • 2 mutual funds from one mutual fund company showed a positive 10-year rate of return.
    Ariel Appreciation +6.16% (Value)

Ariel Fund +5.62% (Value)

Disclaimer: While the sample size of SRI fund performance is very small.  I gleaned data from only the profitable SRI funds for the last 10 years.   The SIF forum does not show fund performance information for funds that have closed, merged or liquidated.   It would be a safe presumption IMO that funds that no longer exist were weak performers since money will flock to where it’s treated best.   Plus, hedge fund performance data was not available on the SIF site.

The results do fall in line with substantial academic works (Fama and French, Lakonishok) and it is possible that SRI performance should be viewed thru the lens of Value/Growth and Market Cap size.

A logical question that must be asked upon reading this might be: “If small market cap and low valuations are the sweet spot for investing, then why are there so few funds or managers focusing on this strategy?”  Not to be obvious…………ok, well lets be obvious:  The small cap / low price to BV tends to be the focus of many private portfolio managers since our small size allows us the dexterity to invest in companies that are simply too small for billion dollar mutual funds.  Successful funds tend to outgrow the size/valuation strategy espoused by Graham as assets become larger and the investment selection becomes narrower.  But this topic should best be explored at a later date.

No holdings mentioned

Brad Pappas
President of Rocky Mountain Humane Investing
Allenspark, Colorado

Wednesday musings

Yesterdays rally confirmed our more constructive intermediate term outlook as the S&P 500 pushed above the 200 day moving average on a 90% up day. We have not seen a cluster of 90% up days since 2009 during the strongest points of the rally. Bears will comment that it was a fake rally due to high frequency trading, but as the coach of the New England Patriots Bill Belichick would drolly would say: “It is what it is”.

Yesterday while driving home I remembered a conversation from the mid 1990’s with a major SRI fund manager who insisted upon owning a major oil company despite their environmental screening policies. His rationale was that this particular company was the best of the lot, the most progressive within the space. Care to guess what that company was? Hint: my initials.

Being that I’m somewhat of a financial geek I get excited when our model identifies companies that are also identified as promising by other proven investment models. Case in point is IDT Corp. which also ranks very high on the esteemed

Piotroski model

as well as our own. We don’t own the stock for clients at present but will begin to look closely at it.

Also, will be breaking down a host of Green Tech firms looking for revenue acceleration. Stories about this morning about the promise of Green Tech but unless revenues start to move higher its only a trade and not an investment.

All the best,