Investing Archives - Page 3 of 10 - the patient investor

April 16, 2018

Red flags for Blue Sky

More good work by Elizabeth Knight at The Age. Here she interviews Chad Slater from Morphic Asset Management on red flags at fund manager Blue Sky Alternative Investments (BLA).

“It doesn’t actually come as surprise to me that Blue Sky (BLA) has been singled out as a short. I have been contacted on a number of occasions over the last two years as to my thoughts on BLA’s business model from a short-sellers’ perspective. Many of the issues raised by Glaucus were raised in those phone calls as a concern previously.”

These include, firstly, “a business with internally valued assets”.

“Businesses with assets that are ‘marked to market’ by company paid affiliates (auditors etc) are vulnerable to manipulation as the incentives are there for management in bonus payments, to hire someone to tell them what they want to hear. Now clearly not all companies will do this, but it is a murky area. Definitely a flag.”

Flag number two, he says, is when the CEO and founder suddenly leaves and cashes out a large portion of his wealth.

Another thing Slater says to watch for is “a very young senior team that has a background in management consulting rather than industry”.

Lastly a company that has grown very rapidly from a small base is another flag, he says.

While the last point is not necessarily a red flag, the first three are clear warning signs. Especially “a very young senior team that has a background in management consulting rather than industry.” I have witnessed the dangers of that first hand. Academic brilliance is no substitute for experience.

April 16, 2018April 16, 2018

Avoiding the hubris trap

Great example of how even the most professional management teams can fall into the hubris trap.

Michael Chaney describes to The Age how Wesfarmers burnt a billion dollars on the highly successful Bunnings hardware chain’s expansion into the UK market:

S&P 500

Bunnings Warehouse by Bidgee – Own work, CC BY-SA 3.0, Link

Chaney was the chairman that signed off and despite everything contends he had never seen a more thorough investment analysis than had been undertaken on Bunnings UK.

They had a base case set of projections and a downside case and it all looked very positive at the time according to Chaney.

But a couple of fundamental mistakes were made subsequently after acquisition of Homebase home improvement network of stores including the removal of 150 senior managers.

“One was moving out the senior management and replacing it with our Australian experts and the second was getting rid of a lot of the products and the franchises because they didn’t suit the Bunnings model,” says Chaney.

By way of example the Australian interlopers jettisoned Laura Ashley from the home decorator product line up – and British women voted with their purses.

It was the success of the Australian model and its management that blinded the higher ups inside Wesfarmers to the fact that these guys didn’t know better what the UK customers wanted. Wesfarmers got caught in the hubris trap.

Some years earlier hardware giant Lowes fell into a similar trap in the US. Number-crunchers at head office worked out that they could save a bundle by replacing senior salespeople with more junior, inexperienced staff. The knowledge base of experienced floor staff was decimated. Customer service and sales plummeted. As one manager described it: “we became find-it-yourself instead of do-it-yourself.” Fortunately Lowes were able to correct their mistake and should have learned a valuable lesson but it seems they did not.

Investors should always be on the lookout for the hubris trap. The more successful the company, the more vulnerable they are. Expanding operations away from the home country or state is often a high risk venture, where management may be blind to cultural differences, regulatory pitfalls and an array of new competitors. Expanding into new product lines or services that are outside management’s traditional core expertise may also present traps for the unwary.

Ask Woolworths (Australia) about their Masters hardware venture, Commonwealth Bank about their expansion into financial advice, NAB about their expansion into UK markets, Centro Properties (now Vicinity) and Westfield about their foray into US shopping centers,….. I could go on. It’s a long list.

April 16, 2018June 11, 2019

Investing in a Volatile Market

The S&P 500 again respected primary support at 2550. Twiggs Volatility Index is retreating but a trough that forms above 1.0% would warn that market risk remains elevated.

S&P 500

I explained recently to my clients that the odds are at least 2 to 1 that the S&P 500 will recover and go on to make new highs later in the year.

But there is still a significant risk (one-third to one quarter) that tensions will continue to escalate and the S&P 500 breaks primary support to commence a primary down-trend.

If you are risk-averse, as my clients tend to be, it makes sense to adjust your portfolio allocation to cope with either scenario. What I call “having one foot each side of the fence” or “having a bet each way” in racing parlance.

Typical Portfolio Allocation

Gen Stocks are what I call “generational stocks” such as Apple (AAPL), Google (GOOGL), Amazon (AMZN), etc. ASX Income are stocks that yield strong dividends and franking credits.

If you have 50% of your investment portfolio in cash and short-to-medium-term interest-bearing securities (I collectively refer to this as “cash investments”) and 50% in equities, you are well-positioned to take advantage of either scenario.

If the market does fall — the less-likely scenario — you are well-positioned to convert some of your cash investments to take advantage of lower prices when the dust has settled after the crash. If the market rises, as expected, then you have enough exposure to benefit from the continued bull market. In that case, your only downside is the difference in yields between cash and equities.

Bear in mind that:

This only addresses clients’ equity portfolios and does not take account of their other assets;
The allocation is generic and does not take account of your personal circumstances; and
The allocation is addressed at Australian investors.

Although the equity allocation is split equally between Australian and International (mainly US) stocks this does not infer that I rate them as equal market risk. Australian equities includes an allocation to Cyclicals which, in the present situation, could best be described as “counter-cyclical” as this largely consists of gold stocks which tend to rise as the market falls. My “Trump Insurance as I called it in an earlier newsletter.

J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to your sleeping point.”

~ Burton Malkiel

March 5, 2018March 5, 2018

Warren Buffett: Bonds and portfolio risk

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

~ Warren Buffett, letter to the shareholders of Berkshire Hathaway – February 24, 2018

February 4, 2018February 5, 2018

Black Monday, October 1987

Cross-posted from Goldstocksforex.com:

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.

December 17, 2017December 19, 2017

PEMAX second highest peak in 100 years

I published a chart of PEMAX for the last 30 years on Saturday. PEMAX eliminates the distortion caused by cyclical earnings fluctuations, using the highest earnings to-date rather than current earnings. The idea being that cyclical declines in earnings reflect a fall in capacity utilization rather than a long-term drop in earnings potential.

Since then I have obtained long-term data dating back to 1900 for the S&P 500 and its predecessors, from multpl.com.

PEMAX for November 2017 is 24.34, suggesting that stocks are over-valued.

S&P 500 PEMAX

Outside of the Dotcom bubble, at 32.88, the current value is higher than at any other time in the past century. PEMAX at 24.34 is higher than the peak of 20.19 prior to the 1929 Black Tuesday crash, and higher than the 19.8 peak before Black Monday in 1987.

This does not mean that a crash is imminent but it does warn that investors are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

Robert Shiller’s CAPE ratio

Here is Robert Shiller’s CAPE ratio for comparison. CAPE attempts to eliminate distortion from cyclical earnings fluctuations by comparing current index values to the 10-year average of inflation-adjusted earnings.

Shiller CAPE 10 Ratio

While this works reasonably well most of the time, average earnings may be distorted by the severity of losses in the prior 10 years.

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

~ Warren Buffett

October 4, 2017October 5, 2017

Structural Trends and Affected Industries

Discussion of major structural trends in the global economy and the impact they have on specific sectors or industries. A full list of identified trends is available at Structural Trends. I will focus each month on changes to existing trends, the latest statistics, and their impact on sectors or industries.

Cyber Security

Rapid growth of the Internet and online services has spawned a whole new array of threats to governments, corporations and private individuals. Data breaches and identity theft are growing.

The type of cyber attacks has evolved from early blunt instrument, denial-of-service attacks — where co-opted servers are used to overload the target with bogus traffic — or destructive viruses, to more sophisticated penetration of security networks using phishing, worms and trojans.

Opportunity

Growth of cyber attacks and data breaches has established a niche for specialized security software and consultancies to protect client networks from external threats. First Trust have a Cybersecurity ETF (CIBR) that illustrates sector performance. Their top 10 holdings are not a comprehensive list of companies in the industry but offer a good start.

Threats

All industries are vulnerable but Trend Micro identifies the most targeted industries as:

Health Care
Education
Government
Retail
Financial

Serious security breaches are capable of destroying shareholder value as with the September 2017 Equifax (EFX) announcement of a major data breach. The credit reporting specialist recorded a 37% fall in stock value.

But at this stage security breaches are considered unlikely to blight an entire industry.

Social Media

Social media giant Facebook (FB) dominates social networks with three of the top five networks ranked by number of users: Facebook, WhatsApp and Facebook Messenger. The other two are Youtube (Google) and China’s WeChat (Tencent).

Social media is dominated by mobile users. Approximately 90% of active users connect via mobile, according to We Are Social global stats for January 2017, and mobile social network users grew 30% over the previous 12 months.

Opportunity

Social media growth is expected to continue over the next three years but is then expected to slow as saturation increases. Mobile usage growth has already slowed to 5% (Asia-Pacific: 4%) and should act as a constraint on long-term social media growth.

Threats

Proliferation of fake news and misinformation threatens the industry. The motto of early Internet adopters was “Information is free” according to Mike Elgan at Computerworld, but it has now become “Information is fake”.

He explains:

The rise of false information online is caused by five factors:

1. The Internet allows anyone anywhere to publish anything everywhere.

2. Digital content is easy to counterfeit or modify.

3. Many people have powerful incentives to spread false information.

4. It’s easier for social network algorithms to favor emotionally reactive content than true content.

5. The public increasingly relies upon digital internet content for “knowledge.”

Facebook, Twitter and Google claim that they’re taking active measures against the rise of fake information. But previous efforts have failed.

Reaction from major advertisers and governments is likely to impose greater responsibility on online media to restrict publication of misleading information on their platforms, or face onerous penalties.

Online Retail

E-Commerce retail sales are growing rapidly and now exceed 9% of total retail sales or $110 billion on a quarterly basis.

US online retail giant Amazon has announced plans to open its first major Australian warehouse in suburban Melbourne, according to ABC News.

Australian Retailers Association, Russell Zimmerman, played down the threat (to Wesfarmers and Woolworths) saying traders had been planning for Amazon’s arrival.

But Amazon operates on a lower cost structure than traditional bricks-and-mortar retailers and their margins are bound to come under pressure.

Opportunity

Online retail is expected to grow significantly as a percentage of total retail sales over the next few decades.

Threats

Medium-term: Bricks-and-mortar retail margins are likely to shrink.
Medium-term: Shopping center vacancies are expected to rise.

Electric Motor Vehicles

Adoption of electric battery-powered vehicles is accelerating in Europe, with several countries targeting zero sales of internal combustion engines in the next decade.

Opportunities

Huge amounts of money are being poured into battery research and development but there are no clear winners as yet. The rewards will be massive.

Threats

Australia lags far behind in the adoption of electric vehicles but the long-term threat to automotive groups is diminishing revenue. Not only from new vehicle sales, with manufacturers like Tesla selling direct to the consumer, but also falling service revenue as electric vehicles have far lower service requirements.

Telecommunications

The telecommunications industry typically requires massive capital investment to deliver low marginal costs, whether that be for mobile phone calls or Internet connections. It is dominated by a few large players, whose size delivers cost advantages over competitors.

Australia

In Australia, the natural order has been disrupted by the government-funded National Broadband Network (NBN) which delivers fiber-to-the-home in some areas of the country and fiber-to-the-node to the rest where fixed line copper or co-axial cable (Foxtel) is used to bridge the last 500 meters to the home. The NBN supplies broadband Internet connections at the same basic cost to large and small telcos alike, allowing smaller players to undercut large competitors such as Telstra, who have traditionally dominated fixed line and broadband, eroding industry profit margins.

Broadband

Growth in numbers of broadband subscribers has slowed but download volumes are growing exponentially.

Already there are complaints of slow download speeds on NBN as telcos overload purchased bandwidth to compensate for narrow margins.

Telstra and Optus have announced plans to commence the roll-out of 5G mobile broadband in 2018. At 10 Gigabits per second, speeds are expected to be up to 100 times faster than the existing 4G network and 10 times quicker than the fastest NBN plans.

Mobile

Growth in the number of mobile handset subscribers (26.3 million) in Australia has slowed, to 3.4% for the six months to June 2017. But download volumes increased 44.5% for the year ended 30 June 2017.

Threat & Opportunity

The telecommunication industry faces a profit squeeze in the medium-term (say 3 to 5 years) as the NBN disrupts profit margins but the long-term future looks bright as data downloads in both broadband and mobile are expected to grow exponentially.

June 12, 2017

The Myth Of The “Passive Indexing” Revolution | RIA

From Lance Roberts at RIA:

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall the previously “passive indexer” becomes an “active panic seller.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

Source: The Myth Of The “Passive Indexing” Revolution | RIA

June 12, 2017

The dangers of passive investing

There is a lot to be said for passive investing.

Key Takeaways from Morningstar’s Active/Passive Barometer Report:

Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons.
Failure tended to be positively correlated with fees.
Fees matter. They are one of the only reliable predictors of success.

Prof. Burton Malkiel, author of A Random Walk Dow Wall Street, writes in the WSJ:

During 2016, two-thirds of active managers of large-capitalization U.S. stocks underperformed the S&P 500 large-capital index. When S&P measured performance over a longer period, the results got worse. More than 90% of active manager underperformed their benchmark indexes of a 15-year period.

…..In 2016 investors pulled $340 billion out of actively managed funds and invested more than $500 billion in index funds. The same trends continued in 2017, and index funds now account for about 35% of total equity fund investments.

Volatility is also near record lows as the market grows less reactive to short-term events.

CBOE Volatility Index (VIX)

Lower fees and lower volatility should both improve investment performance, so what could possibly go wrong?

Investors could stop thinking.

If passive funds are the investment of choice, then new money will unquestioningly flow to these funds. In turn the funds will purchase more of the stocks that make up the index.

Prices of investment-grade stocks that make up the major indices are being driven higher, without consideration as to whether earnings are growing apace.

And the higher index values climb, the more investment flows they will attract. Driving prices even higher in relation to earnings.

More adventurous (some would say foolhardy) investors may even start using leverage to enhance their returns, reasoning that low volatility reduces their risk.

The danger is that this becomes a self-reinforcing cycle, with higher prices attracting more investment. When that happens the market is in trouble. Headed for a blow-off.

Investing in passive funds doesn’t mean you can stop thinking.

Don’t lose sight of earnings.

When prices run ahead of earnings, don’t let your profits blind you to the risks.

And start thinking more about protecting your capital.

May 21, 2017

The Quants Run Wall Street Now | WSJ

From Gregory Zuckerman and Bradley Hope:

For decades, investors imagined a time when data-driven traders would dominate financial markets. That day has arrived.

…. quantitative hedge funds are now responsible for 27% of all U.S. stock trades by investors, up from 14% in 2013, according to the Tabb Group, a research and consulting firm in New York.

Quants now dominate the short-term trading market but active managers (homo sapiens) are still very dominant in the much larger long-term investment market. And this is unlikely to change any time soon.

Source: The Quants Run Wall Street Now – WSJ