Few Friends for New Trends

For readers who made it through my quarterly management commentary, it should come as no surprise that wage pressure is a growing concern for many businesses. An increase in operating costs, particularly employee related, is a relatively new business trend I noticed earlier in the year. As the trend became clearer in Q2 2017, I began documenting and sharing my observations with readers.

In addition to providing numerous company-specific examples, I continue to collect a growing list of anecdotal evidence from readers and personal experience. For example, after being shocked and awed by our homeowner’s insurance renewal a few days ago, I called our insurance agent to ask for an explanation. The representative blamed higher premiums on the rising cost of home repairs and construction. I informed the agent that she must be mistaken, as the Federal Reserve has been very clear on this subject — inflation is not a problem, and in fact, is inadequate. She laughed and said, “Yeah, yeah, I know, I know, you don’t have to tell me about rising expenses.”

I also noticed more anecdotal evidence of rising wages last week. After our three-year-old dishwasher decided to break down a day before Thanksgiving (I thought quality was improving Mr. Hedonic Adjustment!), I went to the local hardware store to search for a part. While walking into the store, I was greeted by a sign advertising $15/hour positions. That’s pretty good, I thought! But the need for labor didn’t end there.

As I drove home contemplating working for a local hardware store, I drove by a Walgreens with its sign advertising “flu shots” and “hiring”. Shortly thereafter, I found myself stuck behind a school bus with a “drivers wanted” sign taped to its back window. If this wasn’t enough to convince me to write another post on the tight labor market and rising wages, a commercial advertising employment opportunities (included signing bonus!) at a waste management company came on the radio.

In summary, thanks to our broken dishwasher, I was introduced to four job leads all within fifteen minutes. I can’t wait for the refrigerator to break!

And finally, I ended my week with an interesting conversation with an owner of a large lawn service company. He was lamenting on how difficult it was finding workers. In fact, he said his company doesn’t want or need new business, but desperately needs employees. I told him I’d be happy to help as I enjoy mowing the lawn, but wouldn’t be available during allergy season! Given his capacity constraints, I also mentioned raising prices may make more sense than chasing a dwindling pool of available workers. He seemed to like this idea better than putting me on one of his crews!

While signs of rising wages and costs are becoming more apparent, inflation doesn’t appear to be a very popular topic for most investors — including the bulls and the bears. While the bulls love rising asset prices, they’re not particularly fond of inflation spilling over into the real world. In my opinion, rising inflation would be devastating for the bulls, as it would undermine one of their key assumptions used to justify current asset prices. Specifically, the assumption interest rates will remain abnormally low indefinitely.

Bears, on the other hand, aren’t especially open-minded to rising costs and wages either, as it conflicts with certain bearish views on the economy. Many bears believe the economy is weak, saddled with debt, and incapable of generating wage and cost pressures. While I agree the tremendous amount of debt accumulated over the years will have serious consequences, I do not believe the economy is currently weak or incapable of generating higher prices.

And then there’s the policy makers. Despite their own Beige Book stating otherwise, most Federal Reserve members continue to believe wage growth and inflation is too low. In fact, while watching Bloomberg TV last week the following headline appeared, “Yellen Says It’s Dangerous to Allow Inflation to Drift Lower”. Out of curiosity I read the article (link) and discovered Janet Yellen is in fact concerned “raising rates too quickly risked stranding inflation below the U.S. central bank’s 2% target and there’d been ‘some hint’ that expectations for future price increases may be drifting lower.”

While I don’t know the precise rate of inflation, based on the last two quarters of corporate operating results, I’m very confident trends in cost and price are not “drifting lower”. My view on inflation is focused more on trend than a specific rate. Is inflation running at 1%, 2%, 3%, or 4%? I don’t know exactly, but the trend, in my opinion, is very clear – it’s higher. How long and how far this trend goes remains to be seen. However, to say inflation is currently drifting lower conflicts with what many businesses are reporting and openly discussing.

Although many investors and policy makers remain in a deflationary mindset, several investors I know and respect recently contacted me to provide support of my bottom-up views. In effect, they reassured me while my views were in the minority, I was not crazy or alone.

A former fund manager who continues to monitor the markets closely sent me the following chart on the number of times “wage pressure” was mentioned on conference calls. I’m not certain of the sample size, but the trend certainly confirms what I’ve been noticing over the past two quarters.

Another knowledgeable investor sent me an article from The Economist titled, “Blue-Collar Wages Are Surging. Can it last?” As the title implies, the article discusses the generous wage gains blue-collar workers are currently enjoying, further supporting my belief wage pressures are building in many areas of the economy.

In the current job market, finding an MBA to enthusiastically recommend stock buybacks and acquisitions isn’t difficult — they’re a dime a dozen. However, try hiring a skilled worker to wire your house, drive your goods cross country, or nurse your patients back to health. It’s much more challenging.

A shortage of skilled labor would help explain why certain blue-collar wages are growing at a healthy 3-5% rate (per The Economist article). Interestingly, The Economist’s blue-collar estimate is similar to the Atlanta Fed’s 3-4% estimate of median wage growth (link). I found the rate and trend of the Atlanta Fed’s wage growth tracker (chart below) to be informative and similar to my bottom-up view.

In my opinion, current trends in wages should be concerning for investors extrapolating the past to support future asset price assumptions. For example, how would investors respond to an employment report confirming mid-single-digit wage inflation? Where would the 10-year Treasury and stock market trade with wages expanding 3% to 5% a year? I’m not certain, but I believe some very confident and important inflation, interest rate, and valuation assumptions would need to be adjusted.

This isn’t the first time my bottom-up macro views have conflicted with the top-down consensus. Furthermore, business trends have and can reverse, especially in an economy overly dependent on asset inflation (all bets are off assuming a sharp decline in financial markets). That said, based on my current observations and analysis, I believe the deflationary scare popularized throughout the current market cycle is coming to an end.

Will incoming wage data and shifting trends in inflation eventually force bond and equity investors to reconsider their valuation assumptions and long-held beliefs? Current bottom-up analysis suggests it’s possible, but only time will tell if new trends in cost and price will persist or be acknowledged.

What’s Happenin’ Q3 2017

During periods of inflated asset prices, patience is an essential tool for absolute return investors. In addition to avoiding eventual losses associated with overpaying, patience allows absolute return investors to act decisively when valuations revert and opportunities return. While patience may be required during certain periods of the market cycle, inactivity in the portfolio should not be confused with inactivity in the investment process. In other words, patient positioning is not a ticket to the beach or golf course! This is especially true for flexible and opportunistic strategies.

To my surprise, over my career I’ve found I’m often busiest when cash levels are highest and discounts to value are in short supply. During periods of patient positioning, I spend considerable time remaining current on my possible buy list and searching for new buy ideas. Furthermore, it’s a great time to update business valuations and improve the quality of opportunity sets. Instead of resting during periods of excessive overvaluation, absolute return investors should be preparing for the eventual transition from patient to aggressive positioning.

Being prepared takes considerable time and effort, but the rewards can be tremendous. Knowing an opportunity set well allows absolute return investors to act decisively and confidently when the bids disappear and the market cycle ends. During periods of market dislocations, market participants frequently panic, causing extraordinary volatility and uncertainty. During such chaotic periods, concentrating and following through on discipline becomes increasingly difficult. Knowing exactly what you’d like to own beforehand (and at what price) can be very beneficial once the market cycle concludes. Investors without a thoughtful and detailed strategy may find it difficult to act decisively and with reason. Instead of acting opportunistically, unprepared investors may freeze and miss the bounty the end of the cycle often brings.

During the current period of patient investing, I’m spending my days staying on top of my possible buy list and preparing for future investment opportunities. It’s a very labor intensive process. In fact, I just completed one of the busiest earnings seasons in recent memory. Over the past three weeks I reviewed and analyzed the quarterly reports and conference calls of the majority of stocks on my 300-name possible buy list.

Based on my review, operating results for most businesses in Q3 2017 were very similar to Q2 2017, with organic growth remaining in the low single-digits. Given the time and effort I allocated to this earnings season, I was slightly disappointed with my conclusion. Nevertheless, the process and information I gathered was very valuable and has increased my confidence in my business valuations and cycle positioning. While the financial markets and business operating environment are relatively uneventful and frankly, uninteresting, I’m prepared and ready to reallocate capital at a moment’s notice.

Below is a summary of several business trends I noticed during Q3.

  1. Consumer companies, on average, reported soft to mixed operating results. Most volumes and comparisons remain low single-digit positive to negative. It’s been a year since I noticed the consumer slowdown (see Elevated Consumer Discretionary Risk); therefore, it shouldn’t be surprising that year over year comparisons are getting easier. Several companies reporting mid-single digit negative comps are now reporting low single digit negative to flat comps. Several companies blamed warm weather and hurricanes for weak results, but impact temporary. Although results remain sluggish for most, the operating environment and outlooks improved slightly for several companies. Easy comps, persistent asset inflation, and wage growth may be contributing. I plan to research new consumer ideas now that earnings season has concluded. I’m especially interested in beaten down retailers (see Retail Survivor) with strong balance sheets.
  2. Similar to Q2, I again noticed growing signs of cost pressures and pricing action in Q3. Wage pressures were mentioned frequently, while raw material costs were also noticeably higher for many industrial companies. To be clear, I don’t believe inflation is spiking higher, but the trend has definitely shifted, in my opinion. Specifically, the trend in inflation appears to have moved from fears of deflation (2015-2016), to slow to moderate inflation. I believe costs and pricing is something to pay very close attention to as it relates to profit margins and systematic risk (equity and bond markets have clearly not priced in the risk of inflation, in my opinion).
  3. Industrial businesses had another good quarter. Companies tied to construction and aerospace/defense reported healthy results. Exports healthy, on average. The rebound in energy spending also contributed to improved results, but year over year growth has slowed (rig count rebound stalling).
  4. Investment in domestic energy infrastructure was satisfactory in Q3, but growth is moderating (more from difficult comps than slowdown in industry). Credit has returned and terms are favorable (especially considering the bust was only 1-2 years ago). Energy production is growing again, but cap ex growth more disciplined versus 2014 peak. Assuming $50 oil and $3 gas holds, I suspect 2018 capital expenditures will be similar to cash flows – growing moderately from 2017 levels. We’ll know more when most 2018 budgets are released with Q4 2017 results. Hedging programs are active for 2018, therefore, many E&Ps have already locked in a large portion of 2018 prices which should provide some visibility/stability for cap ex next year. Labor and material costs clearly increasing for industry. Lastly, offshore remains weak, but some mentioned the sector may be in the process of bottoming.
  5. Auto manufacturing slightly down to stable. There doesn’t appear to be strong conviction on future trends. Hurricanes may have stemmed the slight decline temporarily.
  6. Agriculture remains weak, but stabilizing.
  7. Transportation capacity utilization and pricing appears to be improving modestly. Higher transportation costs mentioned on several calls.
  8. Financials are doing well on average. For now, loan losses are manageable. I continue to believe there is a growing risk insurance companies are underwriting too aggressively to maintain premium growth. And of course their investment portfolios are tied to the bond and equity markets to different degrees. As such, I have a low degree of valuation confidence when using book value for insurance/financials.
  9. Technology results were mixed depending on end customer. I tend to avoid using technology results to help me form my opinion on aggregate profits and economic activity. Technology operating results are often not a good indicator given choppiness of their forecasts and results – their cycles can be very short and abrupt. Results and outlooks can change weekly.
  10. Currency was not a major factor in Q3.
  11. Hurricane impact was mixed, but not meaningful and temporary for most. Some short-term sales and raw material cost/availability impact.

Looking forward, outlooks and commentary suggest the economic and profit cycle will continue into Q4 2017. Barring a sharp decline in asset prices (financial markets and economy appear to be one and the same currently), I’m expecting approximately 3% growth in Q4. Overall, I believe Q4 will be similar to slightly better than Q3, with easier comps in consumer and slightly tougher comps in certain industrials and energy. Business outlooks appear more confident this quarter versus Q3. Again, this assumes asset prices remain inflated, which appears to be the path market participants are committed to heading into year-end (performance panic season).

As always, if you’d like to read the management commentary and quarterly highlights that helped form my macro and profit cycle opinion, please request via email. Given its size (60 pages) it was again too lengthy to post.

Happy Thanksgiving!

Getting Old Is Not For Sissies

Considering I don’t own equities, it may come as a surprise that I believe the operating environment for most businesses is satisfactory. As I wrote last quarter, “Based on the operating results of my opportunity set, I continue to believe the U.S. economy is growing in the low single-digits.” I went on to note that I believe on a nominal basis, the mid-3% growth reported in Q1 and Q2 appear reasonable. Lastly, I stated real GDP of slightly below 2% was in-line with my bottom-up observations and analysis.

Although I don’t use government data to form my macro opinions, last week’s GDP report was similar to my “slightly below 2%” economic growth estimate. While Q3 GDP grew at 3%, after removing the impact from inventories and trade, final sales to domestic purchasers increased 1.8%.

Based on my initial review of third quarter corporate earnings, Q3 is shaping up to be similar to Q2, with low single-digit growth continuing. It’s not especially strong growth, but the economic expansion and profit cycle continues nonetheless.

Given my view on the economy and profit cycle, I’m not expecting stocks to decline near-term due to poor earnings. Nevertheless, in my opinion, the risk associated with equity overvaluation remains significant.

I continue to believe my opportunity set is the most expensive it’s ever been, with prices well above levels that can be justified using realistic assumptions. I do not know when or exactly how the current market cycle ends, but when it does, I expect my opportunity set to change considerably. Hence, my absolute return discipline and strategy remains the same – wait and wait some more. Zzzzzzz, I know — the boredom is excruciating.

While I’m not anticipating a near-term earnings catalyst to end the current market cycle, in the “they don’t ring a bell” department, catalysts are not always necessary. I remember the end of the tech bubble well. I came into work one day and everything changed — there was no warning. For no particular reason, internet stocks simply stopped going up, rolled over, and crashed. Few investors saw it coming and most were in shock. Many newly created millionaires (often through stock options) lost it all almost instantly.

Similar to March 2000, I believe one of the least appreciated risks facing investors today is one morning they’ll come into work and discover a stock market that no longer goes up. Despite the best efforts of dip buyers, financial television enthusiasts, and central bank talking heads, the stock market gets tired, rolls over, and dies of old age. And because this market lacks valuation support, stocks can decline considerably before genuine margins of safety reappear and protect investors on the downside.

Of course conventional wisdom suggests central banks will come to the rescue at the first sign of declining stock prices. However, what if central banks achieve their inflation goals, as I believe they already have, and find themselves behind the curve?

In recent posts and quarterly management commentary, I provide many examples illustrating the Federal Reserve’s inflationary “success”. Assuming the end of the current market cycle coincides with a period of accelerating inflation, will the bond and currency markets permit another round of open-ended QE? Maybe, maybe not, but the belief that central banks will always be capable of bailing out investors with an unlimited bid is flawed, in my opinion.

Based on my observations over the past two quarters, the trend in inflation (especially wages) is clearly higher. Even last week’s GDP report showed inflation is accelerating. For clues on inflation, or the QE assassinator, I plan to continue monitoring trends in company-specific costs, wages, and pricing. I’ll be watching the bond market closely as well. While equity investors appear unconcerned, the short-end of the curve appears to be sniffing out what I’ve been observing and documenting.

Going forward, I expect rising equity prices will be accompanied by rising inflation and interest rates – classic ailments of an aging market and economic cycle. In effect, I believe we’re entering the stage of the cycle when the equity and bond markets transition from being friends to adversaries. If I’m correct, relying on extraordinarily low interest rates to justify equity allocations may become increasingly precarious and uncomfortable.

Based on recent increases in equity prices, I question if the changing relationship between stocks and bonds is being adequately considered by investors. In fact, as I was watching Bloomberg TV yesterday, a CEO of a large asset management firm recommended buying stocks. He stated that while interest rates have increased, they remain low historically. Maybe so, but what is the trend in rates and inflation? And if his prediction of higher equity prices becomes true, what does that mean for the economy, inflation, and an already extremely tight labor market?

It sure is a fascinating market cycle. I’m very interested to see how it ends. While a market dying from old age and without warning wouldn’t surprise me, I suspect rising inflation, an uncooperative bond market, and an impotent Federal Reserve would surprise many. This isn’t a prediction, but one of the many possibilities to consider as the clock on today’s aging market cycle ticks.

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Until the cycle ends, I plan to continue documenting the growing number of inflationary signals I’m noticing. Feel free to email me examples. Below are some headlines I noticed this week. I also included a few management comments from my possible buy list names. I believe this is an important change in trend versus a year or two ago when inflationary trends were less certain and visible.

“Employment cost index advanced 0.7% after a 0.5% gain in the prior three months. Total compensation rose 2.5% over the past twelve months.”

“U.S. August S&P CoreLogic Home Prices rise 5.9%”

“Oil Extends Two-Year High as Investors Eye OPEC Extension”

“Rent is Eating Up a Record Share of Americans’ Disposable Income”

“Hot Labor Market Seen in Dallas Fed Manufacturing Markets”

“U.S. Companies Add Most Workers in Seven Months”

“Why the Biggest Metals Rally of the Year May Have More to Run”

“NJ Transit is Missing $2.4 Million in Fares From Worker Shortage”

“We have plans in place to respond to the approximate 8% per ton increase in manufacturing costs…increases were driven by increased labor, employee benefits and depreciation costs…” Oil-Dri conference call.

“So the whole impediment…is labor and I think you may have witnessed this in the new home construction site where the demand is very strong and basically labor constraints in general are inhibiting the natural growth that could take place.” Pool Corporation conference call.

“And all over the country, you hear how challenging it is with unemployment being so low to — you’re competing for talent. And so you’re having to pay in almost every position more than you did even a couple of years ago, and every year has gotten tougher as unemployment has continued to trickle down.” Texas Roadhouse conference call.

“$13 for two cups of frozen yogurt! Are you kidding me?” Guy in front of me at Yobe.

Chick-fil-wAges

My wife just emailed me the picture below. At first I thought she was sending it in support of my last article on inflation, but then I realized she was actually encouraging me to get a job!

I remember some long hours in the office when I was an analyst/portfolio manager. My boss would joke that he’d be happy to slide TV dinners under my door if I didn’t want to leave.

It’s interesting. As analysts and managers, sometimes we sit in our offices reading for hours and hours attempting to figure out our investment and economic worlds. Meanwhile, the answers are often not in the piles of data and research stacked on our desks, but right outside waiting for us to simply look up and acknowledge.

For example, during the housing bubble, all you needed to do in Florida was go for a short walk or drive and count the number of new condo buildings and neighborhoods being constructed. The unsustainable excesses in credit were right outside for all to see. It was not only obvious in hindsight, but in real time.

I believe the same can be said for the labor market today. As stated in my previous post, and based on my bottom-up research, I’m noticing growing signs of a tight labor market and rising wages. If government data isn’t picking this up — making it difficult for many investors and economists to identify — maybe it’s time to step out of the office (or immaculate Federal Reserve building) and go for a walk to observe.

While central banks may still have control of the bond and stock markets, the labor market appears to be functioning freely, with supply and demand pushing wages higher. As such, in my opinion, new labor laws requiring an increase in the minimum wage are unnecessary.

Locally, it’s clear the market price for entry-level employees is well over Florida’s $8.10 an hour requirement. Chick-fil-A isn’t alone. There are many companies being forced to pay higher wages to fill positions. Remember, just a few weeks ago Target (TGT) increased its minimum pay to $11 an hour. I suspect this move wasn’t out of generosity, but out of necessity.

So go for a walk or drive and see for yourself. Talk to mangers and business owners attempting to fill positions with qualified employees. When you return to the office and review macro statistics suggesting wage inflation remains subdued, ask yourself if the numbers agree with your observations and conversations.

Drivers of Higher Rates: Good and Bad Inflation

[Apologies to subscribers: Friday’s post was sent prematurely and did not have a link. Hopefully the link and edited version is sent successfully Saturday.]

The 5-year Treasury yield hit 2% this morning. It’s not much, but the short to middle of the curve is starting to look a little more interesting (relatively). As I wrote in “Patience – A Possible Win Win”, I believe “…as long as financial conditions remain stable and equity prices inflated, the Fed will most likely continue raising rates. In effect, until something in the financial markets ‘breaks’, the Fed’s tightening path appears to be on a set course.”

In other words, as the asset inflation fires rage in risk markets, the Fed has cover to raise rates. And who knows, they may actually feel responsible enough for their asset inflation inferno, and its potential risk to the economy, to at least begin building some fire lines.

While I believe rising asset prices have contributed to the recent increase in interest rates, I’m also continuing to detect signs of less investor-friendly forms of inflation. As I documented in past posts with examples, costs and wages are rising for many of the businesses I follow. While I prefer viewing inflation from a bottom-up perspective, my observations have recently been confirmed by unlikely top-down sources — the media and the Federal Reserve.

Below are a few headlines I noticed this week while watching Bloomberg TV and reading the financial news.

“Consumer Price Index Jumps 0.5% in September”

“Canada Annual Inflation Rises in September on Gasoline, Food costs”

“UK Inflation Hits 3% in September”

“Commodities Rally a Welcome Tailwind for Asia Open”

“China’s Factory Inflation Rebounded”

“New Zealand Inflation Quickens More Than Economists Forecast”

Even the Federal Reserve is beginning to take note of rising costs, or specifically, the tightening labor market (thanks to a reader and very knowledgeable investor for pointing this out).

Similar to the information I accumulate each quarter from small cap businesses, the Fed’s Beige Book gathers and summarizes economic information by interviewing “business contacts, economists, market experts, and other sources.” Below are the Fed’s comments on labor, which conform with many of the company-specific results and commentary I’ve recently discussed.

“Labor markets were widely described as tight. Many Districts noted that employers were having difficulty finding qualified workers, particularly in construction, transportation, skilled manufacturing, and some health care and service positions. These shortages were also restraining business growth.”

“Despite widespread labor tightness, the majority of Districts reported only modest to moderate wage pressures. However, some Districts reported stronger wage pressures in certain sectors, including transportation and construction. Growing use of sign-on bonuses, overtime, and other nonwage efforts to attract and retain workers were also reported.” [my emphasis]

Interesting, isn’t it? Consumer prices are up 2.2% year over year (over 2% goal), unemployment is near 4% (under full employment), and the Fed’s own Beige Book is reporting tightness in the labor markets, with shortages and the growing use of signing bonuses. Meanwhile, after a nine year bull market in risk assets and an economy displaying classic late-cycle signals, Fed policy remains in an emergency and very accommodating stance (negative real short-term rates and a severely bloated balance sheet). From a policy perspective, is it 2009 or 2017? Hard to say.

As I noted in a previous post, “Exactly when the current market cycle ends remains unclear, but in my opinion, the cozy relationship between short-term interest rates and equities is over. Going forward, higher stock prices will most likely lead to higher short-term rates.” And this is exactly what has happened. However, when I initially wrote this, I was focused mainly on asset inflation.

Going forward (barring a decline in asset prices), I suspect there will be a growing number of headlines related to other forms of inflation. In my opinion, given the widely-held belief that interest rates will stay low indefinitely, broadening inflation, from the perceived good to the bad, is something investors should monitor closely.

Sorry for the short post this week. As many of you can relate, I’m currently very busy plowing through earnings season. I’ll publish my own Beige Book in a couple weeks, summarizing the operating environment and economy through the eyes of business.

Have a great weekend…and I hope you’re enjoying these higher interest rates!

Fiduciary Hot Potato

The year-end rally appears unstoppable. As has been the case for much of the current market cycle, elevated valuations have been an ineffective deterrent for investors willing to pay higher and higher prices. After such a long and seemingly endless period of rising stock prices, wanting and expecting more comes easier than settling for less.

When overindulging in anything enjoyable, few people want to listen to the virtues of settling for less. No one likes to hear, “Hey buddy, you might want to put down that triple cheese burger, cigarette, beer, or grossly overvalued small cap stock.” I can relate. When I’m knocking down a large bowl of my favorite private label ice cream, the last thing I want to be lectured on is discipline and prudence!

After almost nine years of all gain and little pain in the financial markets, the topic and practice of risk aversion isn’t very popular. Nevertheless, considering the potential losses current valuations imply, I continue to believe risk is a very important message to communicate and consider. Fortunately, I’m not alone.

A fellow absolute return investor, Frank Martin, also continues to consider and write about risk. Last week he focused on tail risk. In his article, “The Tail Risks Optimizer’s Dilemma: Taleb Vs Spitznagel”, Frank writes about the leading experts on tail risk and their attempt to position for black swan events.

While I found his comparison of Taleb and Spitznagel very interesting, Frank’s discussion regarding the difficulty of applying their strategies caught my attention. His comments reminded me of the challenges encountered by many absolute return investors.

Frank writes, “In reality, most people are simply not hardwired to endure pain before gain, especially when the duration of the suffering and the magnitude of reward are uncertain. Moreover, most investors find it difficult to remain patient and circumspect as the gravy train to apparent riches pulls out from the station. The loneliness of watching the caboose get smaller as it fades into the distance is more than most can handle. Benjamin Graham quantified those who can stand such isolation at 1 out of 100.”

Frank goes on to discuss a very important topic that I believe is underreported and underappreciated by many investors. Specifically, business risk and its influence on investing and decision making. As many of you know, Jeremy Grantham is well known for his comments on career risk, or how portfolio managers’ fear of “being wrong on their own” influences decision making. But what about business risk?

Business risk differs from career risk as it’s sourced from the asset management firm, not the portfolio manager. Just as a portfolio manager can invest too differently and risk his or her career, if an asset management firm thinks and positions itself too independently, it can risk losing assets and revenues.

Frank explains, “The human aversion to pain and desire to join others aboard the train affects clients and investment firms alike. Managers, however, are assumed to be more aware of systemic risks than their clients, or else there would be no reason to employ them. Investment institutions are often risking their own economic survival if they try to optimize their clients’ portfolios for adversity and get off the train before their peers. The optimal scenario would constitute institutions that are unconditionally client-centric and clients who understand and appreciate that value proposition. In a battle between human nature and nirvana, the state of the world would suggest that the former will invariably dominate. Consequently, many firms fail to properly prepare clients and their portfolios are left to suffer the vicissitudes of the market.” [my emphasis]

I love that paragraph. It touches on a very important and relevant topic for the asset management industry. Specifically, the possible conflict between business risk and “properly preparing clients and their portfolios”.

Imagine for a moment you’re a board member of an asset management firm. You have a duty to the owners to maximize the value of their business. Asset managers are not charities – they have some of the same desires and objectives as most businesses, such as growing assets, revenues, and profits.

Now imagine you’re in a board meeting. As you sit in the meeting, a discussion of current market conditions, asset valuations, and risk begins. A board member throws up a chart of historical equity valuations, clearly illustrating current prices suggest significant losses to client capital are possible, and if history is an accurate guide, probable.

What do you do? Recommend reducing risk, increasing cash, or returning client capital? This option would most likely cause assets to leave the firm and revenues to fall. Or do you stay invested and point to investment mandates requiring the firm to stay fully committed to risk assets? This option would most likely increase the odds of retaining assets and allow the firm to benefit from further increases in asset prices.

The conflict between business risk and doing what is right for the client (also known as fiduciary duty) is complicated further by investment mandates. Investment mandates often require asset managers to invest in a certain manner, regardless of price, valuation, and risk. I’ve often wondered if strict investment mandates and fiduciary duty can coexist.

For example, during periods of broadly inflated asset prices and elevated risk, can an asset manager with a fully invested mandate act as a fiduciary? In other words, can certain investment mandates nullify an asset manager’s fiduciary duty? If so, do advisers and consultants that request mandates also assume a greater fiduciary responsibility? In summary, where does fiduciary duty reside, where should it reside, and how do investment mandates interfere with its implementation and allocation?

These are very important questions for most relative return managers and their clients. Absolute return managers, on the other hand, typically have more flexible investment mandates that are less likely to conflict with their fiduciary obligations. However, higher flexibility and fiduciary responsibility do not come without a price. To comply with their fiduciary duty, absolute return managers may be required to assume above average levels of career and business risk, especially during periods of excessive asset inflation and overvaluation. As an unemployed absolute return manager, I can certainly relate! 🙂

To conclude, business risk, fiduciary duty, and investment mandates are interconnected and have complex relationships. I believe it’s important to recognize these relationships and understand how they influence investment decisions and the allocation of fiduciary responsibility. Fortunately, given where we are in the market cycle, it is not too late to add flexibility to investment mandates and increase the level of business risk asset management firms are willing to assume. Such modifications, in my opinion, would better enable asset managers to perform their fiduciary roles and as Frank Martin wrote, “properly prepare clients and their portfolios”.

Have a great weekend!

Q&A

As Q3 earnings season approaches, there is a drought of company-specific news and events to analyze. Regardless of the lack of fundamental data points, investors appear committed to positioning themselves for another end of the year entitlement rally. I continue to have no opinion on the market’s near-term direction, but a year-end performance panic wouldn’t surprise me. During the current market cycle the S&P 500 has increased seven of the past eight Q4’s, averaging slightly over a 6% gain. This cycle’s only negative Q4 was in 2012 with the S&P 500 declining -1%.

While equity investors enjoy daily record highs in the popular benchmarks, I continue to patiently wait in low yielding cash and cash equivalents (granted, yields are thankfully moving higher). As an investor uninterested in owning equities, it’s a rather uneventful and boring period of the market cycle. While I acknowledge stocks could go higher, I remain committed to a process and discipline that requires an adequate absolute return relative to risk assumed.

Considering the lack of information coming from companies and the markets, I thought today would be a good time to share some questions I recently received from readers and my responses. I selected questions I receive frequently, are useful in helping understand my absolute return process, and address the current environment. As always, feel free to email me with any questions and comments.

Q: See anything or any sector that is somewhat interesting?

A: Since energy has rebounded, I’m not finding much. Actually almost bored to tears. Considered buying S&P 500 call options to cause the market to crash! Seriously…extremely boring market.

Everyone KNOWS markets are going to rally into year-end. And they certainly could…year-end performance panic has happened seven out of the past eight Q4s during this market cycle.  Only down Q4 was 2012 with -1% decline. You have to wonder if this concerns central bankers – the environment they helped create. While a stock market that never goes down may be what they want, the complete lack of volatility and pureness in asset prices must be concerning.

Q:   In regards to your most recent blog on inflation, other than government data, have you come across data points that suggest inflation isn’t going to increase?  Also, suppose you knew inflation would increase with 100% certainty, how would that change the way you invest?  What companies would you gravitate towards?  What securities would you gravitate towards?

A: Yes, there have been some areas where price is not increasing or even decreasing. Often these areas are found where there is too much capital/over supply (energy bust 2014-2015 good example). Food was also a good example, until KR reported this quarter that trend has reversed. While there will always be cycles within certain industries causing inflation to fluctuate, I’m currently noticing more signs of rising costs than declining. I suspect this will continue in Q3, especially with higher energy prices vs. Q2. We’ll see…still need more data points to come to a conclusion.

I currently have a very patient position (liquid and waiting) and I’m not making investment decisions based on my inflation views (volatility in cost and price should be included in your required rate of return and normalized cash flow assumption). My main issue remains valuations. Small cap valuations are high regardless of my view on inflation.

That said, I think it’s important when valuing individual businesses to understand how margins are or have been impacted by inflation or deflation. For example, many companies dependent on natural gas have benefited from abundant supply. A chemical company would be a good example. Or how about PZZA and cheese prices? In effect, when normalizing margins I believe it’s important to normalize input costs as well. I believe extrapolating low input costs (including labor) indefinitely carries risks and assumes margins will remain elevated indefinitely.

Hope this helps. Looking forward to Q3 earnings season and more information.

Q: How did you form your investment philosophy?  Did you try other forms like GARP or relative valuation before?  How do you think about position sizing?  And selling?

A:  Great questions. The process question can be found by reading through my blog as I touch on it in several posts. I particularly recommend the post “What’s Important to You”.  I plan to do a post on my sell discipline soon…that would be a 1000+ word email, so I’ll let you know when I post.  Position size has to do with risk/return and quality (degree of operating and financial risk)…that’s a good post topic as well I’d like to address. Really enjoyed the article on cheese you sent…7% margins seem reasonable for a monopoly! MSFT’s much higher!!!

Q:  If you are right and there is an unexpected bout of cost-push or other consumer price inflation in our near-term future, I think the game is over. After all, what options does the Fed have if inflation becomes the problem, not disinflation? I can’t think of the Fed being in a more difficult position: stagflation.

A: We’ll see what Q3 earnings season says about inflation. I’m not sold on the inflation accelerating idea yet, but definitely noticing more signs. I need more data to conclude. Also, for what it’s worth, so far I’m not seeing a noticeable earnings catalyst on the upside or downside in Q3. I think the greatest threat to stocks near-term won’t be earnings, but that stocks simply quit going up for no specific reason (old age and fatigue). And on the potential for more upside we have the good ol’ year-end performance panic by the “pros”.

Will be interesting next several months. I think as long as stocks go higher, rates continue to increase…a nice game of chicken could be forming between the stock and bond market! 2yr yielding approx 1.5%…I view gradually increasing rates as a raise so in an indirect way I’m benefiting from expensive equities getting more expensive. Asset prices and the economy are one trade, it seems. As long as asset prices remain inflated, I think the Fed will have to keep raising rates…especially if my theory on rising costs receives more supporting data in Q3.

Q: Do you know of good, niche conferences for small caps or small and mid-caps?

A: I do not go to conferences. I did earlier in my career, but as my possible buy list has grown I’ve found calling companies to be the only way I can keep up vs. visiting companies or conferences. That said, if an industry were to get extremely depressed, I’d be interested in attending. Great way to see a lot of companies in one industry at once.

Q: If you think about it, that’s the mechanism that would catch the majority of people off sides, just enough growth to give confidence that the market has more room to run and suck everyone back in before an unexpected pop in inflation and rates.

A:  I agree…how fitting would it be for this nontraditional cycle to end in a traditional manner! We’ll learn more once Q3 earnings are released…right now I’m just noticing a change in trend. Degree and consistency is still uncertain, in my opinion. That said, my water utility bill just went up 8% and my favorite “cheap” taco joint just raised their chicken soft tacos by 7%!!! So maybe I’m biased.

Q: Would you consider investing in overseas market or build your competency in these regions?

A: While I think there may be more value in international stocks vs. US equities, it is outside of my expertise. My focus is on domestic US small cap stocks. I believe staying focused on a relatively fixed opportunity set over many years provides me with a competitive advantage. In addition to having a better understanding of their businesses and appropriate valuations, I believe my familiarity will allow me to act more decisively when opportunities return.

Hopefully specializing on the same stocks for decades pays dividends when this cycle ends! Currently my beliefs on my opportunity set being grossly overvalued has only forced me to recommend returning capital and being unemployed 🙂Really looking forward to this cycle ending…just wish I knew when.

Q:  I would like to know if you could share with me some books that really changed your view about finance.

A: I don’t have a lot of book suggestions. I spend most of my time reading about individual businesses. In fact, that would be my recommendation…read as many 10-ks as you can on different companies and as you read them try to determine how you think they should be valued. The best investment process is one you develop and believe in, in my opinion. I wrote a post “What’s Important to You”…you might want to check it out.

Q: In your opinion, do you foresee a specific catalyst responsible for the coming downturn in the cycle? Could it be the Fed and their quantitative tightening and balance sheet reduction programs? What are your thoughts on the argument that we need to adjust to a new low interest environment (has the game actually changed)?

A:  Sometimes cycles end with a catalyst (2007-2008 Bear Stearns/Lehman) while other cycles they just die from old age/no catalyst (March 2000). It’s tough to say. If I had to guess, one day you’ll come into work and everything will change. What that catalyst will be for certain is unknowable, in my opinion. It’s such a unique cycle as we’ve never seen central banks act in this manner before…no real history to guide us.

Ideally this cycle ends due to the loss in faith of central bankers. If this is the case, I believe the decline will be more enduring and create more opportunity. In other words, the decline won’t be rescued by central banks as they’ll be viewed as the problem, not the solution. Furthermore, without central bank interference, I believe free markets and capitalism will be more effective and productive in properly allocating capital (what I once did for a living). But all of this is really out of my expertise. All I really know is prices within my opportunity set are expensive relative to risk assumed and if I were to get invested today I’d most likely lose money and would not be in a position to generate attractive absolute returns.

As far as rates staying low indefinitely…it’s possible. But if that’s the case, growth rates would also most likely remain depressed. Risk assets are pricing in strong growth (highest valuations in history do not go well with no growth). I’m optimistic the interest rate and market cycles have not become extinct…if so, how boring and how sad – investing as we know it will have died. In any event, fortunately your questions will be answered over time…I wonder the same things and can’t wait to know the answers. I suspect when your questions are answered, our opportunity sets will look much different…thankfully!

Q: I don’t understand what you meant by profit cycle. Are you saying that all businesses and sectors have their own profit cycles that you can reasonably assume to repeat cyclically? Also you said that you want to know everything about the business that determines normalized margins which determines normalized FCF. By normalized, do you mean factoring in where the business is in its current profit cycle?

A: Yes, I’m talking about the profit cycle of business, industry, and aggregate profits. Think of an energy service company like HP. During the peak they make about $6/share in earnings. During the trough they make $0.  If you value their business using peak earnings you’ll get a very high valuation, while if you value using trough you’ll get a very low valuation. I prefer normalizing, or using what I believe annual free cash flow will be on average over a cycle. While I’m simplifying here to make a point, in HP’s case that would be closer to $3/share. In my opinion, normalizing provides me with a more accurate valuation as I have a more accurate estimate of what cash flows will be over an entire profit cycle, not just one point in time. Hope this helps. Thanks for the email and question.

Q: You wrote, “A central bank’s balance sheet is entirely different. In theory, a central bank’s balance sheet can expand indefinitely as there is no limit to the amount of money it can create to purchase assets.” My understanding is that every dollar the central bank creates actually gets its value by stealing value from existing dollars, IE inflation. If my understanding is correct, if the central bank were to continue creating infinitely more money, would that money not become infinitely less valuable through inflation?

A: Great question. You are correct. While central banks have an unlimited ability to create money, doing so should devalue the currency. However, as all of the major central banks have QE’d together, or have taken turns monetizing debt, the major currencies have not devalued meaningfully relative to one another. Furthermore, today’s inflation to date has flowed mostly into stocks, bonds and real estate. In other words, instead of our dollars buying significantly less goods and services, they buy less assets; hence, the term asset inflation.

So yes, our dollars are worth less today, but the inflation has been focused in asset prices. I don’t know how this cycle ends, but I suspect it will be related to the failure of central bank policy. I don’t believe money creation creates value as it does not require effort or sacrifice – it just doesn’t pass the common sense test, in my opinion.

What a great time to be studying economics! I bet they don’t have many books discussing global QE! I think there will be plenty written after this cycle ends.

Q: A question I do have is for normalizing cash flows do you use Ben Graham’s time frame in Security analysis of 7 years? He mentions this is not too long to include things that no longer affect the business but its a long enough period to get the normalized earnings over a cycle. What would your take be on that?

A: Great question on time period. I customize per business valuation. Some cycles are longer than others. For example an energy service company may have a much shorter cycle than a grocer. Not a great example but you get the point. I’d say most cycles are 3-10 years. And of course this cycle longer than most!

Q: I was wondering if you wouldn’t mind saying how old you were when you were in the CFA program? Also, if you would recommend going through the program in today’s environment?

A: I was 22 when I took the CFA and finished when I was 25 (definitely recommend taking before staring a family!). I think it’s a good program and glad I went through it…I found about 1/2 of the information useful which is pretty good. Tough call on going through the program today. If asset prices never go down again and markets remain overly influenced by central banks, I’d say no…find something more productive to do with your life (if you go into carpentry let me know…need a new chimney and we can’t find anyone…labor market very tight here!). However, if history repeats, central banks lose control, and free markets return, I think studying investing makes a lot of sense…assuming that’s your passion. For what it’s worth, I think free markets will return. I just no idea when or how high asset prices go before the cycle ends.

Q: Based on Graham’s book we have created a spreadsheet to analyze companies based on Graham’s principles plus a few criteria of our own. Could you take a couple of minutes to see if you have any major updates you would add to the attached spreadsheet?

A: When viewing historical results I always like to include the good and the bad. A fixed time frame, such as 5-years in spreadsheet doesn’t always include the peak and the trough. I prefer customizing to include an industry trough or recession. This way you won’t be blindsided when the next trough occurs. Maybe throw in 08-09 in your analysis, or a cash flow estimate you expect during the next recession.

Q: By the way: I’ve read your blog posts, but also a couple of interviews. Maybe it’s just my failing memory, but did you ever go into your “sell discipline”?

A: Good question on the sell discipline. I don’t think I’ve written about it on the blog, but it’s a good topic and I’m glad you brought it up. I’ll put it on the list of topics I want to discuss.

Thankfully, most of my sells were a result of the stock price reaching or exceeding my valuation. So that’s the most common and preferred reason I sell. However, things do go wrong. When I can no longer value a business with a high degree of confidence I often sell. By this I mean when I’m forced to speculate versus invest. This could be due a large portion of revenues becoming uncertain (usually permanent loss such as lost contract or law suit) or normalized margin assumptions become too difficult to predict.

I also sell when my financial risk limits are exceeded (3-5x discretionary cash flow). This happened to an energy stock in 2014. They took on too much debt and leverage exceeded 3x cash flow. In this case my sell discipline protected capital as I sold around $20 and stock eventually declined to $3 (due to balance sheet and declining cash flow). But I’ve had the reverse happen too, when I’ve sold due to financial risk and the stock rebounds or is taken over. Regardless, I don’t want to own a business if they can’t pay their debt off in 3-5 years internally. Most small cap maturity walls are around 3-5 years out.

Finally, there are also times when I get the valuation wrong and my new valuation drops below the stock price. This happens less frequently, but it happens. When my valuation is in decline it means I got something wrong. If my new valuation remains above the stock price I’ll continue to hold the stock, but I won’t add to it until my valuation stabilizes.

Wow, didn’t mean to, but it appears I just wrote a post on my sell discipline.

Q: With the money my tightfisted friend no doubt squirreled away during his Halcion years, and a track record that is more than credible, maybe you have thought about teaching at one of the better graduate business schools?

A: If I was as smart as you I’d love to teach. Keep in mind I’m a product of the Kentucky public school system and former hair mullet member…hardly professor material! 🙂

Q: When you are looking at DCF, outside of managers directly saying on an earnings call what their maintenance capex vs. growth capex looks like, how do you distinguish the two? Do you even try to distinguish the two if not specifically mentioned by managers?

A: Good question. There are times when management overdoses on cap ex and has depreciation expense above maintenance cap ex. If it’s a large number I may add back to free cash flow a few years, but typically won’t do it long-term…but this is rare. Normally I base free cash flow more on after tax EBIT than EBITDA minus maintenance cap ex.

I’ve found managements tend to have a way of underestimating maintenance cap ex, but they can often run lower cap ex if needed (often in times of distress – see energy 2014-2015). I like to think of it as distressed cap ex, or how much cap ex they could spend just to keep things afloat. But if you do this, I think it’s only fair to lower growth rate assumptions…there are no free lunches when cutting back on investment.

Pet peeve of mine is using EBITDA to value energy companies when majority of EBITDA is depletion. Rarely do energy companies fail to reinvest depletion…most spend more. If it’s an expense and shareholders will never see it, why capitalize it? I prefer replacement value of reserves (interesting topic I’ll address soon in blog). In any event great question. As always, there’s not always a strict rule of thumb when it comes to investing and valuation. I always like to customize valuations on each business to fit what makes most sense to me.

Q: Have you ever seen this chart before?

Chart

A: Excellent chart. Shows overvaluation broader this cycle. In my opinion, “the market isn’t as expensive as year 2000” argument has a lot of holes in it! Thanks for sending.

Q: Now I have also bought Foot Locker (FL) and Hibbett Sports. Both great balance sheets, for both the latest few quarters were not so great. But does this really justify a crash of more than 50% in half a year?

A: Interesting. I’ve been looking into retail and energy. Currently working on HP, but I plan to look for beaten down retailers with good balance sheets next. I missed DSW’s move, but just like energy…usually retail gives you plenty of second chances!

Q: I have allocated 20% of my portfolio to small caps as a way to diversify, am I putting my money at risk doing this when we make a downturn? I am wondering if I should shift those investments to my SP500 index funds?

A: Yes, small caps carry risk…always have, always will. Many don’t make money, but many do…often depends where we are in the profit cycle. Currently profits and margins are high on average…and so are prices (at record highs), but that doesn’t mean prices can’t go higher. The risk of small caps often varies with the price you pay. You or your adviser should determine your appropriate risk level…unfortunately I can’t do that for you as I can’t give investment advice or make specific recommendations on funds or stocks. Good luck…it’s an interesting cycle to say the least!

Q: You don’t really speak about shorting ever, have you ever shorted the market or individual stocks? Do you have any advice for those of us who never have?

A: I’m more comfortable waiting during periods of overvaluation and picking up the pieces once the cycle concludes. In other words, I like to profit after prices have declined vs. trying to make money on the way down. Historically I’ve been good at spotting overvaluation, but not so good at timing when bubbles pop. I have put options on the homebuilders that expired in 2006 worthless to prove it!

If I had to be long or short right now, I’d probably be short…and I’d probably be losing money too! Instead of being short and losing money, I prefer waiting in 1-1.5% risk-free yields. Patience is essential in my absolute return process and I view it as a competitive advantage – few are willing to practice near cycle peaks. We’ll see if patience pays this cycle. Historically it has, but there are no guarantees.

Q: Did you read Grantham’s latest piece?

A:    I haven’t read it…and not sure I want to! Who is left? Next thing you know Klarman is going to get fully invested by buying the FANG stocks!

I’m noticing some cost increases in pricing power in Q2 earnings. Inflation isn’t surging, but it’s noticeable. Not sure Fed or the markets are taking anything related to inflation seriously. While I’m not a big user of govt data, I think wage growth in today’s number makes sense…agrees with what I’m noticing. I might be getting desperate and looking for things that aren’t there, but I think labor market pretty tight…ex disciplined value investors!

Q: Speaking of late-cycle grasping at straws, did you see Ackman’s move on ADP?

A: I did not see that on ADP. I don’t follow them, but I can imagine it’s a target given its stable high quality business. I’m not a big fan of activists that buy small positions of a company and make big demands. When activists buy 5-10% positions and then want the company to leverage up the balance sheet…again not a big fan. If you want to buy 51% of the business go ahead…and take as much debt on as you’d like…or whatever other changes you want to make. But if you only own 5-10%, don’t destroy the balance sheet for the rest of us…maybe the majority of shareholders prefer financial strength over financial engineering.

For what it’s worth, I believe activism is one of the many reasons companies have taken on so much debt this cycle. Strong balance sheets are often targeted. ADP’s valuation already rich. Activists running out of companies to bully…or at least stable ones that aren’t already expensive.

Q:  Have you thought about putting together a newsletter with this type of bottom up earnings call transcript analysis in a more consumable format?

A: Yes, I’ve thought about doing something like that…bottom-up macro analysis. However, I continue to remain optimistic that this cycle will end and I’ll be able to manage money again. Time will tell. But I think there’s a market, or need for it. So much of the government data initially appears inaccurate, or the reality is eventually discovered many quarters later…how valuable is information that is eventually revised to look completely different a year from now???

Q: I was wondering if you had a collection of other interviews, previous shareholder letters, etc. that I could read as well.

A: I’ve done other interviews while managing, but most are relatively dated by now. I thought the one below was pretty good but I don’t have a subscription to Wall Street Transcript.

Wall Street Transcript Interview

Q: How is the labor market in Florida?

A: I was offered another job yesterday at my daughter’s softball practice…from a lawncare company. The guy said he couldn’t fill his crews and wanted to know if I wanted to do something to stay busy. If I wasn’t living the minivan dream I’d do it. Interesting times! I think there’s a lot of push and pull going on in labor. Pockets of inflation and deflation, but I’m beginning to lean more towards wage increases. Living in an area that thrives on asset inflation probably pollutes my views (every business here is somehow tied to stocks or real estate). And of course if asset prices ever reverted to fair value all bets are off.

Q: Response to an email discussing pros and cons of relative vs. absolute return investing.

A: I completely understand the dilemma. Be absolute return purist and clients may leave and blow themselves up elsewhere when the cycle ends…or sprinkle in some low tracking error strategies and participate enough to keep clients from bolting at the wrong time. It’s a tough balance and you’re certainly not alone.

It’s funny…I believe most RIAs used my fund not as a core strategy but as an absolute return sliver. I’d guess most RIAs have stock mkt exposure but want some absolute return exposure. Sounds like you are more absolute and want some relative return exposure. Makes sense.

I’m thrilled there are RIAs like you out there that continue to think as a fiduciary. The last thing I’d want to do as an advisor right now is lose 30-50% of my clients’ capital. It won’t be defendable, in my opinion. Not with today’s prices. And while I think those sort of declines aren’t certain, I believe they’re possible based on valuations…at least in the small caps I follow. I can’t really speak outside of my opportunity set, but looks like slim pickings out there for asset allocators. I wish you the best…sounds like you have a very good understanding of the environment.

Q: Did you read Montier interview in today’s Barrons?

A: That was great…thanks for sending! Also cool shirt. On another topic…was at my daughter’s softball practice today and was speaking w another parent who sells windows. He asked what I did for a living and I told him I’m unemployed. He said really, you want to sell or install windows? I said I have no experience in either. He said not a problem as they can’t find anyone with experience and are considering all applicants.

He also told me they just gave a $2/hour raise to all installers and delivery employees. Just out of the blue. Said they’re trying to get in front of any turnover. I know just one data point but wouldn’t it be interesting if labor costs go up +3-4%…and trending up so the term “transitory” couldn’t be used. So much riding on belief Fed will QE again on next decline in asset prices (a sharp decline won’t be allowed or will be temporary).

What if they can’t QE during the next decline…inflation wouldn’t allow it? I’d like to see higher rates. It would put valuation mean reversion and financial justice on the fast track! One can only dream…

Q: Just returned from a business trip to London – if inflation is moderating why was everything so expensive?

A: It’s a good point about London. Everyone talks about deflation in Japan but it’s one of the most expensive places to live in the world, especially cities like Tokyo. How does that make sense?

Would You Rather

Last week I reviewed the investment options in my kids’ 529 plan. Slim pickings was the easy conclusion. Similar to many 401k plans, 529 plans are typically filled with index or index hugging funds, with few if any absolute return options. Instead of investing in a stock or bond fund with impressive historical returns, I decided on the lowest return option – cash equivalents.

In addition to limited investment alternatives, low interest rates and high equity valuations make contributing to a 529 plan today unappealing to me. In my opinion, it’s a good example of how low interest rates and inadequate future returns can discourage saving.

I was fortunate to grow up during a period of high interest rates. I was also fortunate to have a grandfather who understood the power of compounding. When I was born, my grandfather bought high-yielding CDs and set them aside for my education. Thanks to his sacrifice, along with Paul Volcker’s prudent and persistent monetary policies, the CDs compounded nicely and eventually funded a large portion of my college education.

I attended Stetson University in Deland, Florida. My grandfather didn’t call it college, but jokingly referred to it as “fun in the sun”. While I studied and made good grades, he was right, I was also having fun. I thoroughly enjoyed college. The independence, hanging out with friends, and even learning – it was as good if not better than the brochure advertised.

In addition to learning and having fun, my friends and I participated in spirited intellectual discussion and debate. One of my favorite debate forums took place while playing the game Would You Rather. Topics varied considerably and included important questions such as, “For $10 million, would you rather have a giant beach ball or bowling ball permanently attached to your left hand?” Or my personal favorite, “If required to do so, would you rather have ‘Hot Shots’ or ‘Say It Aint So’ tattooed on your forehead?” That was a tough one!

I was reminded of the game Would You Rather last week as I was catching up on quarterly reports and conference calls. As readers may recall, last quarter I noted and documented several examples of companies reporting rising costs and pricing power. Early indications suggest this trend is continuing in the third quarter.

While several companies I follow are reporting higher costs, government inflation and wage data remains subdued. As the dispersion between rising costs and reported inflation becomes more apparent to me, I can’t help but ask, “Would you rather rely on economic data gathered from operating businesses or government agencies?”

Of course, most economists and policy makers rely on government data to form their macro opinions. As such, it’s not surprising many central bankers are currently more concerned about inflation being too low than they are about inflation accelerating. In fact, on Monday, Charles Evans of the Chicago Federal Reserve said he was nervous low inflation might be structural, not temporary.

After reading Mr. Evans’ comments, I immediately thought of a cure for his low inflation anxiety. Specifically, I suggest he start a business and attempt to hire 100 qualified and skilled employees, such as welders, truck drivers, nurses, installers, painters, electricians, machinists, and construction workers. And try offering these skilled workers and potential employees an industry wage to join your company. Good luck!

In addition to rising labor costs, there were other examples of rising costs in recent quarterly reports and conference calls. Kroger (KR) recently made a very interesting comment on food inflation. Management noted, “…we had overall product cost inflation for the first time since 2015.” And, “Cost inflation trends for the second quarter were consistent by department with grocery, liquor, produce and meat all positive for the quarter. Deli was deflationary and pharmacy continues to be inflationary.” Food was one of the few areas where I was noticing declining costs over the past several quarters. That trend appears to have reversed.

Casey’s General Stores (CASY) reported noticeable wage inflation in its recent quarter, stating, “…store level operating expenses for open stores…were up approximately 3.9% in the first quarter, which includes our decision back in December to keep our commitment to salary increases for our store managers, stemming from the proposed change by the Department of Labor to increase the minimum salary for exempt employees.”

Lowe’s (LOW) recently reported comp sales of 4.5% with 0.9% coming from higher transactions, while 3.6% from an increase in average ticket. Management noted “job and income gains should continue to drive disposable income growth, and favorable revolving credit usage continues to hover near the highest rates of the current economic expansion, supplementing the spending power generated by stronger incomes.” The company also expects home price appreciation, or asset inflation, to persist.

And finally, Target (TGT) announced early this week that it was raising its minimum wage to $11/hour next month and to $15/hour by 2020. Management believes the increase is necessary to help attract new employees and keep existing employees – another clear sign of wage inflation.

While I’m curious if upcoming inflation reports will eventually reflect the higher costs and pricing I’m noticing, my investment process does not rely on government data. Instead, I use the operating results of the hundreds of businesses I follow to form a bottom-up macro and profit cycle opinion.

As Q3 earnings season approaches, I plan to pay very close attention to information related to corporate costs and pricing. As several Fed members communicate their concerns regarding inadequate inflation, I believe costs and pricing power may actually be accelerating. If so, investors relying on historically low interest rates to justify current equity valuations may need to reconsider their inflation sources and assumptions. In fact, while it’s difficult to predict the exact catalyst that ends the current market cycle (and sometimes a catalyst isn’t needed), I would put an unexpected increase in inflation and interest rates near the top of my list.

Conversation With Preston and Stig

I recently had a conversation with Preston Pysh and Stig Brodersen of The Investors Podcast (link below). After doing a podcast with Jesse Felder a few months ago, I was somewhat hesitant to do another one as I wasn’t sure I’d have much new to say. However, Preston and Stig did a great job digging into my investment process and covering new ground.

One area I found particularly interesting was our discussion on valuing asset heavy companies. In fact, I planned to write a post on this subject last week, but Hurricane Irma had other plans…including a mandatory evacuation and tearing down our screened porch! Despite the minor damage and inconvenience, all is well and we’re grateful the storm weakened before hitting Florida. I’m hoping to get back into my routine this week and will be posting again soon.

Podcast:  Conversation With Preston and Stig

It’s Not You, It’s Me

As a portfolio manager, I’ve been hired and fired by clients many times. Similar to investors trading stocks and bonds, advisers and consultants trade portfolio managers – some are hired, some are fired, and many are analyzed. Advisers and consultants have processes and disciplines as well, with the manager selection process customized to meet their investment objective. During this process, managers are screened, interviewed, and ultimately selected. It’s not very different from an analyst or portfolio manager performing due diligence on a company. It’s a continuous process, with constant review and varying degrees of manager turnover.

Most portfolio managers, including myself, would prefer clients stick around for a complete market cycle. Of course not all capital is that sticky or patient. In reality, from what I’ve gathered over my career, the most popular time allotment granted to managers is approximately three years.

Depending on the market cycle and when a portfolio manager is hired, a three year evaluation period may be insufficient and possibly counterproductive. For example, imagine being an asset allocator in 1999 and you’re considering hiring or firing portfolio managers based on their 3-year performance. The data would suggest firing managers avoiding tech and hiring managers that were about to incur significant losses. Or how about 2005-2007? Judging 3-year performance over this period would encourage rewarding managers invested in financials and punishing disciplined managers refusing to overpay.

My 3-year relative return numbers have ranged from outstanding to horrific. Given the extreme equity valuations we’ve experienced over the past twenty years, my absolute return process and discipline has required very unique and contrarian positioning. As a result, significant swings in relative performance were common and expected. High tracking error and my willingness to look different often landed me in first or last place in the relative return derby. In fact, on more than one occasion I’ve been called Ricky Bobby, referring to the Ricky Bobby in Talladega Nights who eloquently said, “If you ain’t first, you’re last!”

When in last place, it wasn’t unusual for certain clients and assets to leave. While disappointing, I understood. Manager changes and shifts in asset allocations are a natural part of the investment management process.

Although manager turnover should be expected, I found the timing of certain inflows and outflows interesting. Assets would often flow into my strategy after periods of strong performance and leave after periods of weak performance. It was classic rearview mirror investing.  In hindsight, I was often fired when I should have been hired, and hired when I should have been fired.

Again, it’s similar to buying and selling individual securities. Have you ever been so frustrated with a stock that you sell it and it goes on to double or triple? Or how about buying a stock that never declines, only to watch it crash a few months later. Advisers and consultants battle the same tendencies and emotions as portfolio managers. Furthermore, they are just as susceptible to the dangers of extrapolation and career risk. Whether you’re an adviser, consultant, or portfolio manager, buying low and selling high sounds easy, but in most cases it is not.

In my attempt to buy low and sell high, I’ve often been required to invest in out of favor stocks and sectors, such as energy in 2009 and precious metal miners in 2014-2015. My absolute return portfolio’s energy weight peaked near 20% in early 2009, while the miner position ranged from 10-15% in 2014-2015. When taking such large positions in underperforming assets, effective client communication is essential.

Buying and holding the precious metal miners was particularly challenging and required frequent and thorough client communication. During this period I had many conference calls and meetings explaining the portfolio’s positioning and my decision to own the miners.

I remember one meeting in particular in 2015 with a large and sophisticated client. The lead consultant was very smart and was known to ask tough, but fair questions. Considering the miners were the largest weight in the portfolio and were performing poorly, I was certain we’d spend considerable time discussing the position. And we did.

I started the discussion by reviewing my valuation methodology and reasoning behind the precious metals position. I explained my belief that miners were a classic contrarian investment and were selling at significant discounts to their net asset values. I argued miners were an area value investors should be swarming over, not avoiding – especially in a market with limited volatility and opportunity. I called the miners a gift and was surprised more value investors weren’t interested. I suspected the position was simply too embarrassing to hold for most professional investors, carrying unbearable levels of perception and career risk. I explained this was why miners were so inexpensive relative to their difficult to replace long-lived assets.

I should have stopped there. Instead of wrapping up my argument based on facts and sentiment, I did something I rarely do. I pulled out an old Warren Buffett quote and said, “As Warren Buffett likes to say, be greedy when others are fearful and fearful when others are greedy.” Nice closing, I thought. How can anyone argue with that? But then came a quick and sharp response, “Well then, does Warren Buffett own the miners?” Oops. He did not and I knew he never would. I responded with the unfortunate truth, “Hell no, Warren Buffett would never own these things!”

I was lucky. Instead of getting fired on the spot, everyone laughed. Even better, the client stayed with us and eventually benefited from the strong rebound in the miners. Thankfully the consultant did not sell low and buy high as emotions and career risk would pressure most to do.

Interestingly, after performance improved, we eventually lost the account due to a firm-wide asset allocation decision. In the asset management business, when you’re fired due to an “asset allocation decision”, it’s the equivalent of “It’s not you, it’s me” in dating. In reality we all know it probably was you (or in this case me)! 🙂

In conclusion, asset managers are hired and fired regularly – turnover is a natural part of the investment management process. Ideally, portfolio managers are allowed a full cycle to achieve their investment objectives; however, as we know, evaluation periods are typically shorter than desired. Like stocks and bonds, managers can be traded too frequently, or at inopportune times. Short evaluation periods, extrapolation risk, and career risk, can all amplify the urge to flock into the best performing funds and managers. Asset allocators should be alert to groupthink, concentrated flows, and the risk of buying managers high and selling them low. Currently in the ninth year of one of the most expensive market cycles in history, I can’t help but wonder where today’s risk is most concentrated. Is it with portfolio managers who are being fired or hired?