Market Musings Blog

How Value Investing Works, Part I

Posted on 09.27.16 by Michelle Rand in Investment

This post is dedicated to a couple clients – you know who you are! – who requested a sort of primer on value investing. Sorry it’s so tardy, but you know, better late than never.

In an era when indexing has captivated the investing public, it seems anachronistic to be writing about actually thinking about what to invest in. After all, indexing is the ultimate ‘black hole’ for knowledge. You don’t need to know a thing, think a thing, evaluate a number, understand a financial statement, or talk to management – all you do is buy the index, which is a bunch of stocks that are the largest companies around. Are these companies in the index because they are good companies? Not always. JC Penney, a stalwart of the S&P for decades, was kicked out in 2013, in favor of a slightly larger company. It was kicked out because it ran into trouble, but it has started to recover, and now it’s actually larger than the smallest S&P companies so in a twist of irony, it might get let back in. What does all this have to do with whether JC Penney will make money for you? Absolutely nothing.

But JC Penney does offer an interesting illustration of value investing. JC Penney is Value Investing: Graduate Course, prerequisite Value Investing For Dummies. In other words, JC Penney is a tough call. It’s easy to say that banks are cheap value stocks right now, with bank bashing happening all over the place, Deutsche Bank in dire straits, and Wells Fargo in front of Congress every two minutes. This scrutiny has shoved bank prices down down down, while their earnings are really not bad thank you very much. Dividends are pretty fancy too. When stock prices fall because of a perceived problem, but fundamentals remain …. well, at least okay if not sterling, then you probably have a good value on your hands.

JC Penney is worse off than 99% of banks out there. Fundamentals are really not very good at all. In fact, Penney was given up for nearly dead, especially by the ratings agencies for its bonds which had them rated a whisker above D for DEFAULT. Penney has lost money, scads of it, for a few years now. It’s had at least a couple CEOs in just a few years. But, and here’s where thinking comes in, it has found religion, and is scrambling to improve, and it has taken tacks that are worthwhile given the retailing environment. It has begun to pay down debt, and earned an upgrade from one ratings agency at least. It is losing less money. Cash flow has been positive for some time. Its results whomped Sears, Nordstrom, Macy’s, and others in the last couple quarters. It is actually growing.

The stock, however, is in the $9 – $10 area. Ok, it’s recovered from the bottom, and it’s probably outrun the improvement that’s becoming evident – we call that ‘overextended’. No doubt one would rather pay $8 than $10. Question is, will you get a chance at $8 before it goes to $12?

Value managers try not to forecast, mostly because no one is any good at it over time. So our job is to determine if paying $10 for Penney brings us enough value to make the price worth it, today. Not two years from now, because we can’t know that. But we do know that if we pay a cheap enough price for an asset – and that’s what Penney is, an asset – it will be a lot easier to make money than if we pay a lot for an asset.

Next time, we’ll get into numbers a bit, to show what ‘cheap’ really means. Stay tuned!

The Fed’s Method

Posted on 07.15.16 by Michelle Rand in Interest Rates, Investment

For years, we have observed that the vaunted Fed has, at serious inflection points, done nothing more than followed the market. The evidence we’ve collected shows our hunch is on the mark, and that the market generally ‘knows’ ahead of the Fed where rates ought to be, even in the shortest maturities. Of course, there’s something to the ‘jawboning’ theory – the Fed talks a lot before changing rates so the market has a chance to adjust. Still, take a look at the chart below:

FedGraph

In the critical 2007/08 time frame, a wide gap appears between policy rates and the market. During this time, officials felt that the economy would withstand the decline in real estate prices, and they stubbornly refused to make an adjustment despite falling rates in the bill market which were all but screaming ‘warning!’ Then, as it began to dawn on officials that things could get ugly, policy rates were lowered, but not quickly enough.

In this era of sharp criticism aimed toward the Fed, we note that its meddling in matters of the economy have not always worked. As interest rates head to negative territory all over the world, the US is likely not far behind, and this tidal wave will drown Fed policy. Managing bond portfolios is best done with ears tuned to the market itself, rather than the Fed’s words. The yield curve and yield differentials are excellent communicators; ofttimes, the Fed is just noise.

The Conventional Wisdom About Brexit is Wrong

Posted on 06.26.16 by Michelle Rand in Foreign Investing

The media is full of disaster mongering now that Brexit has passed, In fact, even some Brits have been horrified by their own behavior in the referendum and are wishing they could take it back.

The conventional wisdom is that Brexit will be a disaster for economies. Depending on whose publication you are reading, this ranges from Britain’s economy to the EU (those who remain), to the world (see The Economist), to corporations if one can stretch to believe a company can be an economy (in miniature I’m sure). But economists have a spectacular record – of incorrect calls. In fact, on big items like Brexit, it is a rare economist who gets it right. We were particularly annoyed to hear Alan Greenspan – who really ought to crawl in a hole and never come out – predict doom and gloom. Frankly, hearing him issue a negative prediction is almost enough on its own to make me believe the opposite.

It may be that economies hesitate for a bit while the effects of the vote sink in. But it’s going to be hard to tell whether any of those effects are due to Brexit, or something else. Let’s not forget that some were predicting a slowdown in Britain before Brexit. In the US, the labor market is flashing a warning, and spending at restaurants – which has been robust – is slowing. Our election environment is partially to blame for softness on these shores. In the EU, slow has been the operative word for years now.

So before believing the dire scenarios pumped by the media, engage in a bit of watchful waiting and remember that in fact, most of the world is not part of the EU, and many of those economies are performing at least as well as the EU.

Brexit? But I’m Not British!

Posted on 06.23.16 by Michelle Rand in Investment

Tonight Britain has passed a referendum calling for the country to leave the Eurozone. It looks like US markets will open down severely tomorrow. The British pound is down about 10% against the dollar, and Asian markets are sinking fast. So no question about it: we’re in for a roller coaster ride for a while.

Aside from short term market reactions, why should US citizens care about Brexit? We posit a few reasons:

  1. That the Brexit vote resulted in ‘leave’ and voter turnout was so strong, indicates that a revolution of sorts is under way. A rather large percentage of people are pretty tired of not feeling heard, all over the world. Policies will have to change, which will usher in even more uncertainty than we’ve already seen this decade.
  2. The success of Brexit may have an effect on our own fast-approaching election, or at least policies we pursue around immigration, trade, and so forth.
  3. After Brexit, it’s a certainty that we will see other European countries contriving their own versions of ‘exit’. How strange that a few years ago we all worried that Greece might be forced to leave (Grexit), and now we have a country that has chosen to leave.
  4. Well, ok, we can’t resist mentioning – if you ever wanted to visit England, now’s the time. It’s going to be cheaper!

Consequences of these shifting policies will reverberate to returns over time. We can’t possibly predict even the direction of the impact yet. For the time being, we view the ‘leave’ vote as a shot at buying assets at cheaper prices.

Finally, if you want to know why Brexit was entirely predictable, pick up a copy of The Revenge of Geography, by Robert D. Kaplan (reviewed on our Resources page here). Uncanny!

Whither Interest Rates?

Posted on 05.12.16 by Michelle Rand in Interest Rates, Investment

While pundits have claimed that there is just no more money to be made in bonds because rates are as low as they’ll go, rates keep dropping ever lower. Take the thirty year Treasury issue. In 2008, at the height of the Great Recession, the yield on this bond shattered US records by plunging to 2.50%. A rebound followed all the way up to 4.75%, only to see the bond revisit 2.50% again in mid 2012. Once again, there was a rebound, but weaker – to just shy of 4%. Then, in early 2015, the bond dropped all the way to 2.25%, breaking its old record. In fact, we saw the yield at 2.12% intraday back then. The ensuing rebound carried the yield to just 3.25%, well below the last high. Here’s what this progression looks like:

30Yr

The economic circumstances that have led to the decline in yields are too complicated for this post, but suffice to say, they haven’t changed. The primary factor has been rising indebtedness here, in Europe, in China, in the oil patch, in public budgets, everywhere really – and that’s become worse, not better.

A colleague asked the other day, where do you think rates go from here? There we were, on the day of his question, in the lull of slightly under 3% on the long bond, and I didn’t really know what to say. We’ve been bullish on bonds for what seems like forever. Was that still justified?

Standing back, now, and looking at this trend which clearly shows lower highs and lower lows, and considering the pending bankruptcy of Puerto Rico, the continuing saga of Greece, the problems in Illinois, Atlantic City, and Hartford, and the patches applied in several California municipalities which will, sooner or later, come loose again – nothing has changed. In fact, things are worse – China has learned our bad habits and estimates say its debt exceeds 300% of GDP now, up tremendously from a very reasonable rate just a few years ago. Worse, defaults are rising. We all know China can rock the rest of the world.

Combine this with the fact that many other slow growth countries are experiencing negative interest rates. For a mind bender, consider that in Norway, some mortgage holders are getting checks from their lenders – rather than paying the bank for the house, the bank is paying them to own the house.

Those negative interest rates make our positive rates look mighty attractive, even at 2%. If buyers continue crossing borders to suck up our Treasury issuance, that will pressure yields downward still more.

My bet, then, is we head lower yet. You may one day have a shot at refinancing your home loan at 2%.