Sunday, June 30, 2013

5 Years After Great Recession, What's Next?

As I have mentioned in other recent posts, this summer season feels like the calm before the coming storm.

I am not predicting a September/October market crash, nor am I saying the market will shoot higher while we climb a wall or worry. I cannot predict Mr. Market. But this season is a milestone because five years ago this time we were getting close to the start of the Great Recession. The last five years covered the full force of the Great Recession as well as a seemingly miraculous recovery.

It is often said the true measure of an investor or money manager is how he does through at least one full boom and bust economic cycle. No great investor has been called great without showing that he has weathered several such cycles. Think of the likes of Benjemin Graham, Warren Buffett, Walter Schloss, Seth Kalman, John Neff, John Templeton, and on and on.

Furthermore, many investing sources will give you the past 1, 5, 10 year period performance of any mutual fund or hedge fund. So I have collected the a list of some prominent equity funds, as shown below:

Fund Manager(s) Last 5 YR Annualized Return
Bruce Fund Bruces8.6%
Yacktman Fund Yacktmans 14.0%
Davis New York Venture A Davis/Feinberg 2.7%
Fairholme Berkowitz 5.2%
Pabrai Investment Fund 2 Pabrai 3.0%
FPA Crescent Romick/Rodriguez 6.5%
Legg Mason Cap Mgmt Value C Miller/Peters 1.0%
Hussman Strategic Growth Hussman -4.0%
T2/Kase QualifiedTilson/Tongue -2.9%
S&P 500 Total Return (Jan 2013) 3.1%
Returns include fees. Period is Jan 2008 to Jan 2013, or if not possible then a close period to it.

The list includes hedge funds, mutual funds, US equity funds and international equity funds. So, the list isn't meant to be a direct comparison but as a gauge of how various funds and their manager's strategies have fared.

The fund managers in the table are some of the most prominent fund managers in the US. They are all probably in their 40s and 50s. These are going to be our thought leaders in the coming five years. It will be very interesting to see five years from now how these funds and their managers fare!

In the last fives years we have learned a lot about ourselves and our world. One of the biggest is that our world is not going to grow as much as we would like. In the past the typical investor like myself were too optimistic about the long term stock market growth. We thought 10% to 12% is achievable. That I feel is one of the biggest reasons for two horrific market corrections in the last 15 years. Investors were sold on the idea that we can achieve high growth, if we just knew where to go. So first it was high-tech in late 1990's and when that failed, well, we'll just go to housing.

Now I, and a lot of other retail investors, are much more jaded and are much more wary of equities. I am more resigned to the overall market achieving 7% long term, rather than the 10% to 12% I expected before. This, coupled with the fact that we had a run up in stocks in the last 4 years, leads me to think we should expect much lower than 7% in the coming 5 years.

The rise of formerly developing countries like China is creating ever greater demand for commodities. I am talking about better foods, like meat, oil, water, etc. This fact by itself isn't really surprising, but its consequences can be surprising. For example, higher oil prices and innovations have caused the US to produce more oil than any other time in recent memory. And as the US produces ever more oil, the US will be able to reduce its trade deficit and the dollar will get stronger.

Next Five Years

The US Fed actions of the last five years have shown that the US dollar is a debased currency. But the Euro isn't much better with all the problems in the EU countries. Meanwhile, developing countries like China also have fundamental problems. I feel the conventional thinking is that China is a country with a tremendous amount of "animal spirits". And the country has a command economy that can direct whatever necessary for the greater good. However, I feel the conventional thinking doesn't give enough weigh to the roadblocks to China's success. China does not have long history of rule of law, nor does it have a long history with a large vibrant middle class. These and various other negatives, which developed countries do not have, can lead to corruption, discontent and distrust of the local financial system. This can have a dramatic effect on Chinese household asset allocation.

The average Chinese cannot cannot rely on the equity markets for returns because the Chinese equity markets have not proven themselves to be good allocators of capital. China's GDP grew at around 9% annually in the period from 2000 to 2013. Yet the Shanghai Composite Index has only returned about 2.1% annually over that time! Yes there are many elite and powerful people in china who have become extremely wealthy through equities, but these are mostly through connections which are closed to the average household.

In addition, the Chinese get low rates on deposits. So recent articles have pointed to a "shadow banking" sector whereby the average person can deposit money for loans to corporations through less regulated banks or institutions. The Chinese are starved for yield to combat their inflation.

It is quite interesting that the last few years of easy money all over the world has not resulted in excessive inflation. Wages are kept low and companies are achieving record margins. Money is growing faster for shareholders than wage earners. Maybe that's why inflation for everyday items are low. But we may soon see inflation of financial assets, such as bonds and equities. But it has to be quality financial assets.

According to this report, the world owns $198 trillion USD in financial assets in 2010. One third of this amount ($67 trillion) is equities. The report expects the world's financial assets to reach $371 trillion in 2020. That is a reasonable 6.5% annual increase. But the report stresses that developing countries do not invest in equities nearly as much as developed countries. This is a case of distrust of the equity markets and less sophisticated equity markets in those developing countries. But I think good equity markets are necessary for an advanced economy.

Now is only 7 years to 2020 and how is it playing out for China? Well, either the article is off the mark, or the China market is going to explode, or the Chinese will have to invest in bonds or other alternatives, or they will have to move money overseas. I feel the latter will be a big factor; that is, they will invest more and more in real estate overseas, as well as equities and bonds overseas. If they are restricted from moving money overseas, they will face lower returns. You can see this in the low returns of the stock market, bank deposits and the high price of real estate in China. And when they move money overseas, they want more to preserve capital rather than generate cash flow.

And China isn't the only developing country with growth and reform issues, as we have seen from protests in Turkey and Brazil.

So my conclusion here is that the coming five to ten years will see a resurgence of asset values in developed areas of the world; i.e., North America, Japan and Europe. And based on this I think the CAPE (10 year PE) of the US markets can remain above average for the next five years. But considering the fundamentals of the US, I don't see the market going 20% higher in the next year or two. But, I also don't see a prolonged correction in the near future.

Thursday, June 13, 2013

Why I'll Pass on the Pfizer-Zoetis Exchange

I am an Pfizer (PFE) shareholder and the company is making an interesting tender offer of its animal meds division call Zoetis (ZTS).

Zoetis up until a year ago was a wholly owned division of PFE. Then it IPO'ed this year. PFE tendered 20% of its shares in ZTS, so it still owns 80%. Then PFE realized that the market was strong and this is the time to unload all of its remaining stake in ZTS. It is doing this via a exchange offering to PFE shareholders.

The exchange offering expires June 19. It gives the PFE shareholder the right to get ZTS at roughly a 7% discount to the ZTS market price. To get the ZTS shares, however he must exchange his PFE shares. This is a non-cash exchange. So the discount gets reflected in the exchange ratio between ZTS and PFE. Suppose the market price of ZTS and PFE are equal, then the PFE shareholder can get 107 shares of ZTS for each 100 PFE shares tendered.

The market price for the exchange is considered to be the average of the two stock's trading price in the three days before and including June 19.

The Pfizer shareholder has the right to get up to 0.9898 ZTS shares for each PFE shares owned. The number of shares that Pfizer will actually exchange may be different from what the shareholder asked for because ZTS is a much smaller company than PFE. If PFE shareholders oversubscribe (i.e., there wouldn't be enough ZTS shares to go around) the ZTS shares will be distributed proportionally to the number of PFE shares tendered.

So, the amount of benefit to a PFE shareholder is dependent on how much other PFE shareholders tender. If plotted on a graph this would be a straight-line relationship. I didn't bother plotting a graph but instead calculated the benefit at the endpoints if I tender to exchange $100 worth of PFE shares. The endpoints are the least and most favourable cases.

In the least favourable case, we all subscribe all our shares. The market cap of PFE and ZTS are $204.8B and $15.6B, respectively. And PFE is putting up 80% of ZTS shares. So the ratio is $204.8:$12.4, or $100:$6.05. Then to get $6.05 worth in ZTS shares I must exchange about $6.05 &divide 1.0752 = $5.63 worth of PFE. And in the end for each $100 PFE I had before exchange, I would have $94.37 worth of PFE and $6.05 of ZTS, for a $0.42 gain in the least favourable case.

In the most favourable case, few people beside myself subscribe. Then for each $100 of PFE I would get about $100 * 0.9898 * 1.0752 = $106.42 worth of ZTS. And in the end for each $100 PFE I had before exchange, I would have $1.02 worth of PFE and $106.42 ZTS, for a $7.44 gain in the most favourable case.

So, it is a guessing game between PFE shareholders; the payoff is a possible 7.44% gain. The more people exchange thinking they can get the 7% the more likely they will end up closer to 1%. The more people give up and think it isn't worth the trouble, the more likely that those who do exchange will get 7%. This is a arbitrage situation. I am sure someone in some hedge fund must be dreaming of a way to make a small gain. But one major downside is the transaction cost of executing such a trade. I don't want to do such a thing because of the small gains involved. The other reason for exchanging could be because I want to own ZTS long term. But again, I don't want to because Zoetis trades at a PE of more than 30. I wouldn't own such a stock with such a tiny discount.

So I will keep my PFE shares. Tell me what you think.

Disclaimer: please look at the disclaimer section on the right column. If in doubt about what to do, please consult a qualified financial advisor.

Wednesday, June 12, 2013

Now Is Always the Most Difficult Time to Invest

I have heard that saying somewhere. A few weeks ago, I wrote an open-ended post that reflected this uncertainty. I wasn't sure of whether to load up more aggressively or lighten up on stocks. I used to think that this kind of strategy is somewhat like trying to time the market. And I know I cannot and should not try to do that.

But recently, upon reading Benjamin Graham's books again. I realize his conservative strategy is really centered on the allocation between bonds, which reflects a pessimistic view, and stocks, which reflects a bullish view. Graham says that one should allocate between 25% to 75% stocks, with the remainder in bonds. In bullish times, when stocks are undervalued, he would allocate closer to 75% stocks. In times when stocks are more speculative, he would allocate closer to 25% stocks. This has the effect of moderating the big returns in bull markets and mitigating the huge drops during bear markets. The net result of this is better return in the long term which is over cycles of bull and bear markets.

I want to follow this strategy because I don't have a crystal ball as to the direction of the market, especially now. In fact I don't even know whether stocks are overpriced or not. But if I am forced to take a position, I'd say we are most likely in an overpriced market right now.

I am not a financial guru on market valuation, so I look to others for guidance. The mutual fund filings are a good source of information. But the funds must be balanced funds that hold both stocks and bonds. My only fund holding is the Bruce Fund. I have a lot of respect for this fund because of its staying power over 30 years. They say past performance is not guarantee of future gains. But I believe the Bruce fund has the best idea of how to handle the current market. So I look back over the last 15 years when the annual reports are available on the SEC website. The following chart shows their bond and cash allocations over that period. The remainder of their fund was invested in securities, including common, warrants and preferred shares. The chart shows the bond position from the safe portion (cash) to the riskier portion (corporate bonds).

One can see how the Bruces correctly called the recession of 2000 and 2008. The fund's cash and the safer government bond positions were high in the periods before 2000 and 2006-2007. I believe this is the key to the Bruce Fund's outstanding return. But most important goal of this exercise is to figure out what to do now. It is appears that the Bruce Fund is in a holding pattern for the last 4 years. The fund is cautious but not so much like the periods before the last two recessions.

Warren Buffett is another great investor who likes to keep a cash hoard as insurance for a rainy day. His cash position is substantial but difficult to interpret as he has a big conglomerate and insurance business to run. Seth Klarman of the hedge fund Baupost is another defensive investor and he has recently said he keeps more than 30% cash.

But there there is also some compelling arguments to the opposite view that this is the time to allocate more to stocks. The current overall investor sentiment just isn't strong. The current market is full of investors running scared. Since 2009 investors have been consistently moving money from equities to bonds. Furthermore, the consumer confidence index is at 70, which is still below the normal 100 of the pre-recession days. These are contrarian indicators that makes it hard for me to imagine a bubble and the inevitable crash.

Another compelling data point is the graph I posted earlier. The graph shows the 10-year cyclical adjusted PE , the 10-year treasury yield and the inflation rate. A high inflation rate forces a high interest rate. But today we have the enviable position an of big government stimulus without high inflation and without high interest rate. And, for this reason, Fran├žois Rochon of the Canadian Giverny Fund then concludes: "We believe that equities will be the best asset class in the coming years for the simple reason that it seems to be the most undervalued."

So there you have it, both sides of a compelling argument. Never is the adage that now is the most difficult time to invest been so true.

Friday, June 7, 2013

McRae Industries Reports Third Quarter Earnings up 46%

McRae Industries (MCRAA) reported revenues up 22% and earnings up 46% from the same quarter a year ago. Operating margins were the same as a year ago, but SG&A expense was 18.6% of revenue this quarter versus 21.4% a year ago. This made the difference in the tremendous improvement in earnings.

The company earned $1.3M in the quarter. In each of the first and second quarter the company earned $1.9M. I consider the drop in earnings acceptable. From what I hear about earnings this year, companies that sell domestically have outpaced the market as a whole. That would explain McRae's outstanding results this year. Consumer sales now account for about 2/3 of sales. McRae's biggest product is women's cowboy boots. And the recession's effects must have depressed earnings last few years. But this year they appear to be back in a big way. The earnings for the first 3 quarters are $5.1M. Projected over the year that is $6.9M. The company market cap is approximately $54M, for a PE of 7.8!

Granted women can be fickle and earnings could go south very quickly. But with the end of the recession (hopefully) and consumer confidence back I think the upside is much greater than the downside. Furthermore, the balance sheet offers protection for the investor. The following chart shows their balance sheet numbers:

The company is a netnet and it is earning good money, money which goes straight into making a bigger and bigger netnet! My intrinsic value on this stock is $32. It trades at $22.35 today.

How McRae Reports EPS

The company's financial statements are straightforward, except for the EPS calculations which has myself and otcadventures stumped. But today I finally solved the mystery by speaking with Marvin Kiser, the CFO. Marvin explained to me that the formula for the EPS calculation came from the SEC and was blessed by their auditor. So they just go with it.

The cause of the EPS anomaly comes from the treatment of the class A and class B shares. The class B shares are the big voting shares, and they are like preferred shares and they mostly lies in the hand of the insiders. Class A is what us common folk own. There are about 5 class A shares for each class B share.

The reported basic and diluted class A EPS is:

Now if you think like me, the reported EPS just makes no sense. Is the dividend somewhere in the income statement as an expense? No it isn't. So, it appears the reported EPS is double counting the dividend amount, which was $0.09 last quarter. Go figure!

From now on, I will ignore the company's reported EPS and use my own EPS, as I have given above as the net income divided by total class A shares. But it isn't a big deal, as the EPS has no real bearing on the shareholder's bottom line. What really matters to the shareholder is his dividend and his share of the equity.

McRae Industries is one of my largest positions.