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Value Investing In Cyclical Stocks

Cyclical stocks tend to be reliable profit generators in a value investor’s portfolio. Cycles exaggerate the valuations because they cause uncertainty in the market. So arguably, value investing should work very well. In practice, it can be hard to identify the right investment candidates and pick the right time to invest. We all know that value investing involves buying stocks at prices depressed below the intrinsic value. Cheaper the stock, better the purchase, as theoretically, the potential returns (normalizing the price to value) are higher and the inherent risk of capital loss is lower (the stock is already at distressed levels, where investors have given up). Most cycles in essential commodities are predictable. Phase 1 – Growth and Investment: The business in an industry goes through a period of growth, managers become more confident and hire more employees, invest in assets and new projects and build new plants and increase capacity. There are new entrants in the industry as it grows with above-average profits. The analysts build Discounted Cash Flow and other models that assume good earnings growth for the near future and a possible terminal growth rate thereafter (which is almost always a positive number). This results in higher multiples being assigned to the stocks in the industry than the historical average. Wall Street firms do a lot of business with these growing companies flush with profits, and are therefore inclined to look upon them in a kind light. Investors pile in. Phase 2 – Peaking: All the capacity expansion via new capital investments and new entrants in the industry finally reaches a point where it starts to exceed market demand. The profit margins get squeezed as the marginal unit of production starts to sell at cost or below cost. The high-cost and smaller economies producers start to exit the market. A few players may merge to improve their economies of scale or add in new line of businesses to support the company until the cycle in this line of business recovers. Wall Street starts getting disappointed many quarters running, as the earnings come in lower than expected. Phase 3 – Decline and Disinvestment: Supply now starts to exceed the demand. Product price falls. Weaker and high-cost producers are unable to stay in business, and make an exit. Larger and lower-cost producers may choose to exacerbate the situation by making counterintuitive moves, such as increasing production, to drive the prices further down and hasten the exit of weaker competitors – as long as they are able to at least break even. Predatory pricing is generally illegal in most developed economies, but increasing production is not, and can easily be blamed to an error in judgment. Analysts don’t understand what is going on, and if they do understand the competitive games being played, they do not talk about it. Investors start to lose interest and move on to greener pastures. Businesses disappear, jobs are lost, capital projects are cancelled or postponed, assets are scrapped, and eventually, the supply starts to decrease. Phase 4 – Trough: Supply has finally dipped below the demand. The surviving businesses have started to gain their pricing power back and have begun to enjoy improved profit margins. They have also emerged from the cycle with a bigger market share as a large number of competitors closed shop. At this point, Wall Street has likely lost all interest in these companies, and analysts have dropped coverage of their stock. In Phases 3 and 4, the stock is likely to be undervalued. The cheapest and safest time to invest is in Phase 4. However, timing the bottom of a cycle is difficult and almost impossible. The best a value investor can do then is decide to invest some time after the decline has started and has gone to some depths, and then choose the stocks of the companies that are more likely than others to survive and come out with an increased market share. Which Kind of Industries Does Cyclical Investing Work In? In industries with low-to-zero cost of entry, such as software or internet, cycles do not exist, or if they do, they are short-lived. Some barriers to entry for new competitors can be established by increasing the switching costs for existing customers – it is difficult for the whole enterprises to switch over to Macintosh when all their business systems are written for Windows. However, these switching costs are not insurmountable. The story is very different in industries where a significant capital investment is required to enter an industry or a market. For example, airlines, mining, shipping, automotive production, most manufacturing, real estate development, etc. In these industries, capital projects may also have multi-year lead times before they start contributing to the business. Therefore, a project started today (such as a new ship ordered to be built when the market was doing very well) could take years to complete. When it is complete, though, the company may be adding new capacity in an environment of glut. Therefore, the cycle of boom and bust may be quite drawn-out in these industries. To invest profitably in these cycles, 3 things are required: Pick an industry that is not going to disappear anytime soon or be substituted out with something completely new. Pick companies that are strong enough to outlast the down cycle, or at least, are stronger than most of their competitors. Wait. Understand that these industries are going to go through structural changes and countless investor confidence ups and downs before the winners and losers are determined. Track if your pick continues to be a strong contender as a winner, but otherwise, mostly wait. Finding Values in Phase 3 and Phase 4 Stocks Finding good value stocks in Phase 3 and Phase 4 of the cycle can actually be very hard. As value investors, we are trained to look for the following: Low P/E ratio stocks – These are the companies whose earnings have been decimated. If anything, a great value stock here might actually sport a sky-high P/E ratio. The trailing 12-month or 5-year values are no longer typical, and the future earnings estimates are worthless. Low P/B ratio stocks – Since we are looking at asset heavy industries, it is worth pointing out that the valuation of the assets on the books typically get written down when the industry is in stress like this. Profitability ratios like ROI, ROA, etc. are all atypical and therefore useless. Therefore, cyclical investing for a value investor is much more of an art than science. Things like the strength of the balance sheet , economies of scale, management experience and skill, customer relationships, their ability to raise funds, cash and debt levels in the business, etc. become much more important. We still need to consider the valuation, and the valuation comes from asking the question: What is this business worth to a sophisticated buyer (competitor, private equity, etc.)? Sophisticated buyers are the ones who are buying for long-term strategic advantage. Now consider the plight of a retail investor who has no time to analyze these companies, and more than likely there is no longer any Wall Street coverage on these stocks (or if there is, it is much reduced from its heyday). These stocks will be volatile, and if you think you are getting a great value, it should not be a surprise that the stock is an even greater value a few weeks or months down the line. For most cyclical investments like this, I generally ease into my full allocation by starting small and then adding more and more over time when the cost can be improved. Sometimes, the extent of the future declines may surprise, but the declines themselves are to be expected. It takes time to hit Phase 4 and then turn around.

Don’t Forget About Time

Mutual Fund and ETF investors need to match their time horizons to the assets they hold. Hedge Fund and Venture Capital investors give their managers the time to invest in distressed assets. Retail investors’ time horizons are shorter and more volatility sensitive than they realize. Can you teach me ’bout tomorrow And all the pain and sorrow running free ‘Cause tomorrow’s just another day And I don’t believe in time – Hootie & The Blowfish – Time Just a few days after writing our last letter about the warning sign that the high-yield market was flashing, Third Avenue went and closed an open-ended mutual fund to redemptions because it, essentially, couldn’t find reasonable bids for its bonds. In the aftermath, some commentators have noted that this fund was an exception, because its portfolio was particularly risky, made up of really low quality bonds, and that it wasn’t symptomatic of larger issues in high-yield. I kinda agree and disagree. The issue was clearly that what they owned was a bunch of dreck, bottom of the barrel-type stuff, in a structure that really shouldn’t own such things. They forgot one of the key risk-factors in managing money – time. The issue of time is often recast as one of a liquidity mismatch – owning assets that are less liquid than the liquidity terms offered to the investors in the structure. Mutual funds offer daily liquidity, which is great for assets like stocks and government bonds that have deep and liquid markets. Low quality junk bonds aren’t quite as good a fit – a much better fit would be closed-end funds, where there are no redemptions, or in a private equity type fund of the sort that Oaktree and others run. But owning them in a regular retail mutual fund? Not a good idea. Is this going to be a systemic problem? Probably not. It appears that a lot of the mutual funds that own high-yield bonds only have portions of their funds in them, or, even better, are closed-end. Interestingly, many closed-end funds run by decent managers are trading for extremely deep discounts to NAV currently, and probably are good buys here. Our fund has been buying a few of these in the past week. Closed-end funds don’t have to worry about this liquidity element of time. However, another asset that is often confused with closed-end funds definitely does – ETFs. Time the past has come and gone The future’s far away And now only lasts for one second, one second – Hootie & The Blowfish – Time ETFs have been hailed as the savior of retail investors. Some claim ETFs eliminate the risks in investing alongside other investors whose time horizons may not match your own. In the case of Third Avenue, this issue was made clear by the fact that those who sold early realized a much better return than those who sold later, because Third Avenue was able to sell its better quality bonds to redeem them. But ETFs suffer from the same problem. They have investors who can not only redeem daily, they can redeem at any time throughout the day as well. Amazingly, the Wall Street Journal published an article on the front of its Business and Finance section yesterday that is 100% wrong. Very wrong. Incredibly, I can’t believe this got published wrong. In it, Jason Zweig, who writes their weekly Money Beat column, states that ETF managers don’t have to sell their holdings to meet redemptions. Instead, they give a prorata share of those holdings to ETF dealers called authorized participants (APs) who in return gives the ETF back some of its shares. This part is correct. But what Zweig misses completely, and I really don’t know how he does, is that the APs then turn around and sell those securities. APs are not in the business of just holding onto whatever the ETF manager gives them. Zweig says “The ETF doesn’t have to fan the flames of a fire sale by dumping its holdings into a falling market.” Well, actually, it does. APs are in the business of arbitraging, for very small amounts of money, the differences between the price at which the ETF trades and the underlying value of its assets. That is why ETFs have to publish their holdings daily. It is why ETFs that invest in less liquid assets will trade with a higher bid-ask spread. Its why – oh man, its why a lot of things. But one thing ETFs are not are closed-end funds with an unlimited time horizon. They are a fund with an even shorter redemption time period than regular mutual funds. And yet, the Wall Street Journal has it completely backwards. Amazing. Time why you punish me Like a wave bashing into the shore You wash away my dreams – Hootie & The Blowfish – Time But there is a more subtle, and more pernicious, aspect of the time factor in investing. That is the mismatch between investor expectations and time-horizons for returns on the underlying investments. Different investors have different time horizons of course, but I’ve found in the more than 20 years I’ve been investing that what people say their time horizon is and what it really is are very different things. For all of its smug insularity and inability to hire women or minorities , one thing venture capital has gotten right is matching the duration of its investors with the duration of its investments. Investors in venture capital funds are conditioned to expect the investments to both take a long time to payoff and often not work out. It is a lesson that most retail investors miss. Instead, retail investors say they are “long-term” investors, when in reality they are generally uninterested investors. Until, suddenly, they are very interested – at which point they usually panic. This panic creates a selloff that punishes those investors who thought they had a lot of time to let their investments grow and generate the returns they expected, at least on a marked-to-market basis. This sell-off then triggers fear of further losses in investors who thought they owned “safe” assets, or “liquid” assets, so they sell too, which leads to a downward spiral. This is the contagion effect we’ve discussed here previously. It’s being exacerbated by the destruction occurring in many retail investors portfolios, because they, despite all the clear warning signs, chased yield instead of total return in recent years. In a world of low interest rates, they looked at the yields being paid by MLPs, private REITs, BDCs, and other yield vehicles and decided that getting a high current income was so important that they invested in companies or funds they didn’t really understand. They were happy, so long as prices were going up and they were getting paid. But now that prices are going down, often dramatically, they are realizing that there is no such thing as return without risk, that their tolerance for volatility is lower than they thought, and that their time horizon for their investments is shorter than they thought. Not a good combination. Time why you walk away Like a friend with somewhere to go You left me crying – Hootie & The Blowfish – Time In my experience, mutual fund boards are no different in their short-termism than retail investors, and in some ways are worse. They get regular reports showing how the funds under their purview have performed on monthly, quarterly, yearly and 3-5 year time horizons. Usually there is a 10 year comparison as well, but it is routinely ignored as not relevant, as most investors ignore it too. These fund boards will harshly question any manager that dares to deviate from their benchmark, even for good reasons, and even if it is just to hold more cash during times of market excess. A mutual fund manager may well believe that the bonds or stocks it holds are overvalued, but be unable to do anything about it since they are, for the most part, supposed to be fully invested at all times. This means that even if the manager fully believes that the most prudent course of action would be to sell and hold cash, he or she generally won’t, because making a market bet is a quick way to find yourself looking for another job. Therefore, when markets do selloff, mutual funds are generally not a good source of buying support – they have to sell something to buy something. Twenty or thirty years ago, fund managers had a lot more flexibility to use their judgment about markets and fund positioning, but today much of that flexibility is gone. Similarly, another source of market buying during times of panic used to be the investment banks and bond dealers, but Dodd-Frank has killed that off. Today, dealers are just middle-men – they are not allowed to position securities on their books. When I interviewed at Goldman Sachs after business school, the interview took place on the equity trading floor, where I was surrounded by hundreds of traders and salesmen. Today, Goldman has less than 10 traders making markets in U.S. stocks. Think they are making a big two-way market anymore? I don’t think so either. Time without courage And time without fear Is just wasted, wasted Wasted time – Hootie & The Blowfish – Time One of them main advantages of hedge funds is that their investors, for the most part, understand that in order to make money you need to be willing to tolerate some volatility and wait out the markets recurring cycles. (Full disclosure: I manage a hedge fund, and am biased toward the structure). Another advantage is that, because their managers are granted flexibility to go both long and short, and to hold cash, they can take advantage of these market dislocations to buy good assets at distressed prices. They can cover shorts, sell one asset to buy another, or use leverage to buy when others panic. Granted, some managers will get their markets wrong, and fail spectacularly, but that doesn’t mean that overall the industry is flawed. It’s simply part of being in the markets – not everyone can be right all the time, and those that fail to manage their leverage and risk exposures will be carried out of the arena accordingly. But the impression that hedge funds are all the same, that they all are rapid day traders (some are, some aren’t) misses the point that they are one of the few sources of buying support left in the markets today. They are, as a group, the only ones that have both the time and ability to step into falling markets and buy when others are panicking. ______________________________________________________________________________ This week’s Trading Rules: If you’re going to panic, panic early. Retail investors often panic later, and for longer, than market professionals expect, creating larger crashes than fundamentals dictate. Match your investment time horizons to those of your investors. “Forever” is not a choice. The Fed hiked rates by 25 basis points for the first time in 7 years, and after initially popping higher, stocks have begun to fall again. Retail investors have seen most of the asset classes they flooded into in recent years decimated in the past 6 months. Large cap stocks have massively outperformed small caps over the past 6 months, with the Russell 2000 Index falling 12.7% versus a 4.9% decline in the S&P 500. This is inflicting pain on active fund managers and forcing performance chasing in the few winning stocks. Time ain’t no friend of these markets. SPY Trading Levels: Support: 200, 195, then 188/189. Resistance: 204.5/205, 209/210, 213 Positions: Long and short U.S. stocks and options, long CEFs, long SPY Puts.

Book Review: Free Capital

Summary Guy Thomas profiles twelve private investors. The interviewees remain anonymous and speak frankly about their successes and failures. Free Capital is an inspirational and educational read. The Market Wizards of U.K. amateur investors. Actuary, private investor and honorary lecturer Guy Thomas put together a terrific read called Free Capital: How 12 Private Investors Made Millions in the Stock Market after a thorough process of selecting and interviewing over 20+ private investors. The book consists of interviews with twelve private investors. It could have been part of the Market Wizards series by Jack. D. Schwager and an appropriate subtitle would have been: Interviews with the U.K. best amateur investors . If you enjoyed the Market Wizard series you are almost certain to like this book. The final selection of interviewees is made up of investors employing a variety of styles. The author segments the styles as follows: Geographers: top-down investors. Start from a macro perspective and search companies that will benefit from that trend. Surveyors: bottom-up investors who look at individual company financials. Activists: Investors taking an active approach to their investments. Putting a large percentage of their portfolio in a name and developing a conversation with management. Eclectics: Go back and forth between styles or don’t fit the other styles. It even includes one day trader and varies from activists to buy and hold dividend investors. Every investor interviewed had been highly successful with many racking up the balance of their U.K. tax-free, limited contribution accounts, up to well over a million. A feat than can only be accomplished by highly skillful investors. Thomas was also careful to monitor results of the interviewees over a market cycle to ensure their strategies could withstand a bear market. What is the book about? First and foremost the book in an inspirational read. Although a few of the investors in the book are exceptionally intelligent, many appear to be just above average in intelligence and some had to deal with severe setbacks in life or very tough starting conditions. Most of the people profiled struggled to keep their pre-investment career on track. Yet, they were able to achieve tremendous success through investing. They accomplished this through a variety of strategies. An important takeaway is that when you study investing, stick to a strategy that suits you and keep at it ultimately you should be able to achieve financial freedom. For many in this book, becoming a private investor enabled them to get away from company politics. Why you shouldn’t read Free Capital First of all to enjoy this book it is required you are interested in the practice of active investing. If you a convinced passive investor you will not like this book very much. The interviewees are all U.K. based private investors. The author guards their real identity which allowed them to speak frankly. The book really stands out in its genre because the people profiled do not try to talk up their strategies, try to look smart or otherwise try to boost their own ego. However, if you are looking for sophisticated literature, you should read the papers authored by Thomas (highly recommended as well). Who should read Free Capital? Read Free Capital if you are looking for an inspirational read. Quite a bit of actionable advice is dished out by the various interviewees but there are no stock tips. Of course stock tips wouldn’t have a very long shelf life any way. The book is especially valuable if you are developing your style as a private investor. You may not yet realize that it is also possible to be an activist investor from your home office. Even though most people day trading end up broke, some prosper. Perhaps you are considering to become a full time investor because you hate your career but do not dare to take the plunge yet. These people did it but all took precautions. You may think you are handicapped because you don’t have a finance or business background but neither did these people and they destroyed their benchmarks. Free Capital is certainly one of the best investment books I read in 2015 and I highly recommended it.