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2015 Third Quarter Commentary

October 12, 2015

For printable version which includes all graphs and tables, please click here.

 

 

Bargains galore? Not so much, yet.

 

Who would have thought that cash yielding 0% would have outperformed U.S. stocks and corporate bonds for the first nine months of 2015? During the third quarter, many U.S. stock indices finally had their first official correction (defined as a 10% decline from top to bottom) in almost four years, an event that usually occurs every 12-15 months. So during the third quarter, we began to hear from clients, “I’ll bet you are starting to see some real bargains now that we have had a correction.” Our answer was generally, “Not so much yet, especially in new areas.” Since 2013, we have been saying that the overall U.S. stock market has been highly valued. Only recently have we seen the overall market go from highly overvalued to just plain overvalued (see accompanying chart).  We prefer to see positive stock returns stemming from broadly rising profitability. However, over the last four years, a large majority of stock returns have come from valuation expansion that we believe is largely fueled by 0% interest rates. Going into 2015, our list of approximately 600 companies that we have thoroughly researched had approximately 55% of the list selling not just above our buy price, but actually above our sell price. That is what has led us to be net sellers of stocks over the last several years and has accounted for our higher than normal cash position. Therefore, we had a relatively long way to go before we would see a plethora of bargain stock opportunities.

 

We are, however, beginning to be encouraged.  Very recently we have begun to see certain stocks in under-represented industries start to reflect some attractive valuation characteristics. Even certain high-quality companies have started to show up on the ever-increasing new low lists. As you can see from the accompanying chart, there are many more stocks today selling closer to their 52 week lows than nearer their 52 week highs. As a recent example, in the 9/30/15 Wall Street Journal, there were only 3 stocks on the 52 week new high list and 507 stocks on the 52 week new low list for the previous trading session.  As you might also expect, many of the stocks hitting their recent low prices are in the natural resource industries, which for the most part, have been in a four-year bear market. However, when you start seeing high quality companies like Abbott Labs, United Technologies, Caterpillar, Zimmer Biomet, Tenet Healthcare, Baxter International, and many others hitting new lows, we become encouraged. That means the undervaluation is starting to broaden and is not just tied to the price of commodities.

 

We have done further work on our clients’ existing equity portfolios, and we see significant opportunity overall in the securities we hold. Our calculation of Price to our estimate of Intrinsic Value for the overall portfolio is now approximately 56%, which is a very low measure (arguing for higher potential future returns). This is somewhat unusual, particularly given that the overall U.S. stock market valuation has only recently dropped from very high valuations to just plain high valuations. Remember, that at any given point in time, our portfolios generally contain some stocks that are selling at deep discounts and some that are selling very near their intrinsic values. We liken it to a garden. Some investments are in the early planting stage while others are near the harvesting stage. Currently, there are a number of stocks in the planting stage that have some of the largest upside potential (300, 400, and even more than 500%) that we have seen in our careers, regardless of overall market valuation.

 

A fair number of our current holdings are selling at prices below their March 2009 bear market low prices in a market where the average stock has roughly tripled in price since then. We would also argue that the fundamentals for many of these holdings are far better than the fundamentals during those dark days of March 2009. For example, did you know that current copper prices are approximately 80% above their levels in the trough of the ’08-’09 financial crisis? Gold prices today are roughly 60% higher than then, and many of the stocks in those industries are selling well below their trough prices six years ago when it almost looked as if the world was coming to an end.

 

Oil and Gas Fundamentals – An Optimistic Assessment in a World of Pain

 

There is no question that oil and gas prices have been in a bear market recently, which has impacted our portfolio returns negatively. If you look at the chart below, you will see that oil prices are relatively cyclical and that plummeting oil prices are quite common occurring, on average, every four years or so. In the last 30 years, there have been nine times when oil prices have seen a precipitous drop followed by a price improvement of, on average, more than 60% within one year from the trough. The average price decline has been slightly more than 50% and the decline in the current down cycle is approximately 60%. Painful, no doubt.

 

What is typical of commodities is that oftentimes a slight imbalance between supply and demand leads to extraordinary price reaction. It is important that we distinguish that what happens in commodities at the margin has a huge impact on the price of the commodity, but not necessarily on the value of the commodity. There is a distinct difference. Remember, price is what you pay, and value is what you get. In the current downturn, oversupply due to OPEC’s surprise announcement last fall that they would increase production in order to garner market share has amounted to approximately 2-3 million barrels per day excess supply on a worldwide daily demand factor of approximately 94 million barrels per day. Therefore, a 2-3% oversupply has led to a 60% price decline, a wide discrepancy indeed.

 

Price influences behavior. If you look at the next chart, you will see a huge reduction in the drilling rig count- the measure of active oil and gas drilling rigs. Almost daily, oil and gas companies around the globe are announcing capital spending budget reductions and employee layoffs. This has only begun to have an effect on the supply of oil. In the U.S., oil output peaked in April of this year and has just barely begun to drop. Meanwhile, The International Energy Agency (IEA) has projected that petroleum demand will rise in 2015 at the fastest pace in five years. According to the U.S. Department of Transportation, Americans drove 1.82 trillion miles in the first seven months of this year, a record. As is said, nothing cures low prices like low prices. We are hopeful that probably by early next year, we should begin to see supply and demand come back into balance and be reflected in higher oil and gas prices. Many of the stocks of companies that should benefit from these events should be great performers.

 

The Fed – The Bad, The Good, and The Ugly  

 

Much like in 2004 when we sensed that aggressive Fed policy was leading to excessive speculation in the housing market, we again are concerned at where the current unprecedented Fed behavior will lead. Back in ’04, we knew something was awry, though we did not fully grasp the levels of risk and speculation that were being exercised. Usually when large amounts of leverage are involved, it is a question of “when,” not “if,” serious financial problems follow. We believed at that time the bubble in the housing market was mostly created by unnecessarily aggressive Fed actions during a strong economic recovery. It made no sense to us that the Fed was cutting interest rates unnecessarily. Basically, the “Bad” Fed took interest rates too low for too long which led to excessive speculation in asset prices, particularly manifested by sub-prime lending in the housing market.

 

Once the housing bubble burst, which ultimately led to the financial crisis of ’08-’09, the “Good” Fed showed up. We have to give them credit. In hindsight, the “Good” Fed took an aggressive stance to rebuild the balance sheets of the financial industry to get it back on its feet. This approach worked almost to perfection. However, we cannot give them too much credit for effectively dealing with this problem since it had been caused by their excessively accommodative policy in the first place.

 

Now, let’s lay out the current case for the “Ugly” Fed. For the life of us, we do not understand the Fed’s rationale for not beginning to raise interest rates six years into an economic recovery. Balance sheets have had the opportunity to be repaired (although many companies and governments have not remained disciplined, as discussed later). Until just recently, the good news was that stock prices and per capita household net worth in the U.S. were both at record levels. Unemployment has plummeted to 5.1%, a level typical of an economic boom. Yet the “Ugly” Fed has resisted raising overnight interest rates, which have been stuck at 0% for almost seven years. Could they not just start with a lofty goal of raising overnight rates to 0.25%? We believe this aggressive Fed policy is neither prudent nor necessary and has actually been detrimental to economic growth. We believe what the market really wants is confidence that our economy is off life support.

 

We are reminded of a story about a man lost in the hot desert for days. He happens upon a small shack and opens the door to find protection from the sun. When he looks inside, he finds a jar of water sitting next to a pump. On the jar of water is a sign that reads, “The contents of this jar are exactly sufficient to prime this well pump.” The thirsty man has a decision to make. He can take the myopic view and drink the water in the jar or he can take the long-term view and use the contents of the jar to prime the pump to have bountiful water to drink. We argue that the Fed has taken the myopic choice by not raising rates to a historically normal interest rate, which the Taylor Rule (a monetary policy rule that stipulates interest rates based on inflation, output, and unemployment) would suggest should currently be somewhere around 3.5%. It probably goes without saying that raising rates by the Fed takes more political courage than cutting rates. This short-term choice by the “Ugly” Fed will have its costs due to the predictable misallocation of resources by borrowers, savers, and investors.

 

What do we mean by this term of a “predictable misallocation of resources?” Due to low borrowing costs, the world has re-levered because debt is both cheap and available. As quoted in a recent McKinsey and Company study, world Debt/GDP ratios have risen from 246% in 2000 to 269% in 2007 to currently 286%. U.S. corporate debt has risen from $5.2 trillion in 2007 immediately prior to the financial crisis to $8.1 trillion today. Almost all of that corporate debt growth is due to the financing of mergers, acquisitions, and stock buybacks rather than companies actually growing their businesses. It is not just the quantity of corporate debt that is a concern. The poor quality of corporate debt is troubling. According to activist investor, Carl Icahn, U.S. junk bonds and leveraged loans have grown from $1 trillion in 2007 to $2.2 trillion in 2015. Also, according to well-known former hedge fund manager, Stanley Druckenmiller, covenant- lite loans, which signify loose credit, have risen from $100 billion in 2007 to $500 billion outstanding now. When credit is this cheap and this available for this long, the quality of borrowers predictably deteriorates.

 

We believe that the risk of the “Ugly” Fed raising rates too late is now much greater than the risk of them raising rates too early. In our opinion, the “Ugly” Fed has opted to take the short- term approach of keeping rates low for longer rather than begin to bring interest rates back to more normal levels, given current economic activity. We argue that moderately higher and more normal interest rates, while maybe more painful short-term, would be the proper tonic for getting our economy back to a higher and more normal growth rate. The sooner the “Ugly” Fed lets interest rates rise to their natural level set by the markets rather than central bank decree, the sooner our economy can return to strong, genuine, and organic growth.

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