Pizza! Pizza!

I rarely watch CNBC. That wasn’t always the case. I watched it in the early 90s when Neil Cavuto was the network’s rising star. He was very good and had some interesting guests. Things have changed a lot since then. Of course Neil is no longer with CNBC and the guests are, well, let’s just say a lot of them are a little too promotional for me. When I do watch CNBC it’s usually in a common area, like a gym. Today was one of those days as I watched from a treadmill.

The segment I was watching started by saying stocks were trading at 25x earnings. I thought, “Wow, they must be using GAAP earnings, not adjusted non-GAAP.” And they were, which immediately got my attention and increased my respect for the host and the network (even better if they used GAAP cyclically adjusted P/E, but I’ll take what I can get). Had something changed while I was away? Unfortunately nothing has changed. It was just a teaser before the good stuff began.

The host went on to say while stocks look expensive based on GAAP earnings, if you look at it from projected (non-GAAP) earnings, stocks are “only” trading at 17x earnings. The host then opined that above average valuations may be irrelevant given low bond yields. This was the setup before turning to the guest. As 9 out of 10 portfolio managers that appear on CNBC do (I have no data supporting this), the guest began to tell investors that there is no alternative (T.I.N.A.) to stocks. I immediately grabbed the remote and searched frantically for Bloomberg TV, which isn’t much better, but I like their scrolling headlines.

Is this the best the investment management industry has to offer? There is no alternative? And I thought “The New Economy” rational in 1999 was looney. Will T.I.N.A. be in the new fiduciary duty rules? Always act as a fiduciary…unless of course there’s no alternative, then do whatever you want with other peoples’ money. In my opinion, T.I.N.A. is just one more excuse, or easy to understand one-liner, to help sell and justify overpaying near the peak of a cycle. There may not be an alternative for central banks (to keep the game going) and relative return investors (to keep playing the game), but absolute return investors have a choice.

The logic behind T.I.N.A. goes like this. Because rates are so low and are expected to stay low indefinitely (so they say), it’s acceptable to alter valuation variables to make stocks appear more attractive. A high quality stock is essentially a perpetual bond with a variable coupon. How you value a perpetual bond is simple. It’s cash flow divided by discount rate (CF/k). Forgive me if this is review for many of you, but we have a few readers who majored in psychology (they probably tend to be better investors than finance majors).

Let’s assume you have $100 in annual cash flow and you demand 10% return on investment. Let’s also assume the cash flow is stable indefinitely. In this case, the value of this perpetual stream of cash flow is $1,000. With interest rates so low, the theory is an investor should reduce the discount rate, or required rate of return. If the investor lowers the required rate of return to 5% from 10%, the value of the same stream of cash flow jumps to from $1,000 to $2,000. This is what has happened to stocks this cycle. We’ve had huge multiple expansion, which is another way of saying investors are requiring less return to assume the same risk. They are doing this because apparently “they have no alternative”.

Here’s the problem with lowering investment standards, and in this case, lowering the required rate of return assumption. When valuing risk assets, the discount rate is used to measure risk or the uncertainty of an investment’s future cash flow. As I illustrated in previous posts, risks to company cash flows are alive and well. After Q2 we’ll have had five consecutive quarters of negative earnings growth. If risks to cash flows haven’t been reduced, why should an investor demand a lower return on investment? Businesses are not risk-free and shouldn’t be valued as such. Furthermore, I don’t believe artificially suppressed risk-free rates should be the starting point or foundation of a business valuation.

To think about this in simple terms, pretend you own a pizza shop (during asset bubbles I often imagine making pizzas instead of fighting the Fed). You buy the pizza shop for $200,000 and it generates $50,000 a year in cash flow. So you’re receiving a 25% return on your investment assuming cash flows remain stable. But stable cash flows is a dangerous assumption when running a business and that’s why you’re requiring a much higher return on capital than a risk-free rate (also known as a risk premium). Do you care about risk-free interest rates? Maybe if you borrowed to buy the pizza shop or if your lease is tied to interest rates in some way, but for the most part you’re much more concerned about operating risks.

Cheese prices are volatile and a major cost. Minimum wage is increasing. Oh no, the health inspector just shut you down for a week. Papa John’s and Little Caesars are both opening next door – pizza price wars! Pizza ovens burn a lot of natural gas. Your delivery guy just ran over a $5,000 poodle. Your building was just bought by a private equity firm that overpaid and they are raising your rent 20%. The kid running the cash register is missing and so is the cash. All of a sudden the positive $50,000 cash flow you were valuing is now negative -$50,000. Is your business still worth $200,000?

In effect, are risk-free rates relevant to your pizza shop valuation? I don’t think so. In my opinion, operating risks of a business are the most important risks to cash flows and it is the risk to cash flows that should determine an investor’s required rate of return, not risk-free rates. I prefer using a required rate of return that consists of what I’d lend to a business and then apply an equity risk premium on top of that (combined it’s typically 10-15% discount rate). Granted this valuation technique remains subjective, but it makes much more sense to me.

For those who continue to insist the risk-free rate should be the foundation of business valuation (academic version and often used by those with perfect SAT scores), the math still doesn’t work. If one were to use a low discount rate based on low risk-free rates, they must also assume risk-free rates stay depressed indefinitely. If we assume interest rates stay depressed indefinitely, shouldn’t we also assume growth rates remain depressed? Isn’t subpar growth in domestic and global economies the reason risk-free rates are low? You can’t have it both ways — if you use a lower required rate of return due to abnormally low risk-free rates, you can’t also assume normal growth rates. In theory, the lower growth rate would offset the valuation benefit from the lower discount rate (CF/k-g).

We’ll get back to actual businesses and operating results tomorrow, but I thought it was important to touch on why lowering valuation standards doesn’t make sense to me. I believe T.I.N.A. is just another end of the cycle excuse to overpay, or one more version of this time is different. When has lowering your standards ever worked in life? Why do it with your money, or even worse, someone else’s money. No more CNBC for me! However, a pizza sounds good.

What’s the Deal With Japan? (Seinfeld tone)

A friend of mine just emailed me a headline “BOJ Officials Said to Be Leaning More Toward Easing”. The helicopter money drops are coming — get out your fishing nets!

Here’s what I don’t understand about Japan. They’re scared to death of deflation, but it’s one of the most expensive places in the world to live. How does that make sense? In 2013, CNN Money ranked Tokyo and Osaka, Japan as the two most expensive cities in the world. Does Japan really need higher prices to prosper or are they looking for a free ride (fund unmanageable debt with unimaginable monetary policy)?

“If You Think Nobody Cares About You, Try Missing a Couple Payments”

The quote above is from one of my favorite comedians, Steven Wright. I’m not sure if he’s still performing, but he’s the dry humor guy with an extremely slow and unique delivery. He’s hilarious and his jokes are very clever. One of his jokes goes something like, “If you’re driving in space traveling at the speed of light and you turn your headlights on, does anything happen?” I remember this joke because when I first heard it instead of making me laugh, it made my head hurt! That’s exactly how I feel about financial markets these days and the global central bankers propping them up.

Over the weekend I thought some more about earnings season. Although it’s happened for several quarters now, I continue to be surprised stocks are holding up as well as they have. I’ll admit this market cycle has lasted longer than I expected. Given how expensive stocks have become, I believed once earnings began to decline, stocks that were priced for perfection would abruptly reverse once investors realized fundamentals were anything but perfect. After four consecutive quarters of earnings declines (soon to be five), that has not been the case.

While earnings season remains young, so far I’m not seeing sufficient evidence that would suggest a reinvigorated corporate earnings cycle. In fact according to FactSet, earnings for Q2 are expected to decline -5.5%. FactSet states, “If the index reports a decrease in earnings for the quarter, it will mark the first time the index has seen five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.” The earnings cycle ended long ago, but the market cycle (second longest in history) marches on.

Why has there been such a large disconnect between fundamentals and valuations this cycle? We all know. It’s no secret global central banks have hijacked the financial markets with eight years of emergency monetary policies. Whether central banker policy is meant to create asset inflation, fund fiscal deficits, raise capital gains taxes, make 1-2x government debt to GDP affordable, or simply keep it together until the next policy maker comes into office, is all up for debate. What we do know is central banks have set interest rates and bond prices. This is undeniable. As a result, they have also interfered with the pricing mechanism of all asset prices. What asset class is not dependent on interest rates or their cost of capital? If the cost of capital of all asset classes is manipulated and untrue, isn’t information derived from asset prices misleading? I think so.

I have a love-hate relationship with the Federal Reserve and central banks. I despise their interventionist policies. I believe capitalism and free markets are wonderful concepts if allowed to function properly. Current monetary policies and the temporary suspension of free markets truly make me sad. Over the past twenty years I’ve witnessed some very serious monetary policy errors along with three Fed-induced asset bubbles. While I was also upset about monetary policies during the tech and housing bubbles, I acknowledge I benefited from these imprudent policies as the asset bubbles eventually popped, creating massive dislocations between price and value (opportunity). Given my current positioning, I again expect to benefit once the Fed’s third bubble in only 17 years pops.

While I’m looking forward to future opportunities, for now it’s steady as she goes for rising asset prices. According to a July 21 Bloomberg article, the S&P 500 enjoyed its fourth weekly gain last week. Although companies continue to beat their spoon-fed earnings estimates, I believe actual operating results have been insufficient to drive stock prices higher. In my opinion, stock prices continue their march higher because of relentless global central bank policy, not fundamentals.

The Bloomberg article points to the catalyst of the current rally, “Expectations for lower rates or additional bond buying had sparked a three-week rally in global equities that added more than $4.5 trillion in value.” So much for the negative impact of Brexit. Not only did the unexpected Brexit not harm investors, it provided them with a $4.5 trillion bonus for misjudging its likelihood! In effect, Brexit provided central bankers with cover to keep policies extremely easy. So now not only do we have the central banker “put” on risk assets, investors now also receive free call options! Simply amazing. I miss free markets and I miss investing.

I don’t know what to call allocating capital in these markets, but I’m reluctant to call it investing. That’s a shame given the extraordinary amount of human capital being consumed by the investment management industry. If central banks fix asset prices how is this investing? If this isn’t investing, what is it? And if we all know prices are fixed and artificial, why are so many playing along? Where are the bond vigilantes for goodness sake? If you’re not going to be a bond vigilante now, when?

Absolute return investors need not worry. They aren’t required to play the game. The best game to play now, in my opinion, is patience, discipline, and preparedness. When policies fail, free markets and investing will return, along with another round of wonderful opportunities. Until then, let ‘er rip Yellen, Draghi and Abe. The crazier heights policies and prices reach, the more opportunities in the future for those of us not playing along. A final quote from Steven Wright to sum up the current investment environment and market cycle, “The early bird gets the worm, but the second mouse gets the cheese.”

Examples Please

As an absolute return investor, it’s very important to limit mistakes. One mistake that can be made when valuing a business is taking overly optimistic management projections as fact. This goes beyond the second half story we touched on yesterday. Sales and profit margin goals can go out several years. As an analyst hungry for ideas, it can be tempting to plug aggressive assumptions in a valuation model in an attempt to manufacture investment opportunity.

In a corporate world addicted to the use of non-GAAP adjusted earnings and pro-forma earnings going out to 2017, 2018, and beyond, it’s becoming increasingly important to determine if projections are achievable. Making this task more difficult is the fact that there are a lot of good salespeople in corporate America, and on Wall Street for that matter. Many of these great salespeople make their way up to the top of the management structure and become CEOs. Charismatic CEOs are likable, great story tellers, and easy to believe.

How can absolute return investors combat this? Time is my favorite weapon. The longer a business has been in existence, the more actual results are available that can be compared to previous management predictions. Does management have a history of telling the truth and providing realistic guidance? This is one of the reasons why I like established companies, many of which have been around for several decades. Following businesses over many years also helps an investor properly read the person distributing the spin. Over time I’ve learned which CEOs tend to tread conservatively and which CEOs have won academy awards for their role in giving financial projections.

Some CEOs are just born this way. You can’t stop them. They can’t help it and they just love to sell. This is fine from a business perspective as it probably means they’re good at selling their products or services. However, from an investment perspective it’s the analyst’s job to be aware of the CEO’s powers and adjust their valuation variables accordingly.

Another defense against financial spin is asking for examples. I’ve found superheros of spin do not like giving detailed examples — it’s their kryptonite. It interrupts their script and it’s just not exciting theater. They might have one or two examples prepared, but if you keep digging, don’t be surprised if the charismatic CEO hands the question over to the boring CFO. For example, when a business has a 15% margin goal by 2020, ask specifically why they’re confident margins so far out into the future can be predicted accurately. And don’t take generalizations for an answer. The great spinners will go on and on without talking specifics. If they say synergies, ask for specifics. If they then say back office consolidation, ask for more specifics. Don’t be surprised if it ends there, but then you’ll have your answer. If detailed and quantifiable examples cannot be given, I believe it’s better to rely on proven operating metrics such as historical (over a cycle) profit margins and cash flows.

The above also applies to the asset management industry. For those of you that are fund shareholders and interview fund managers, I suggest doing the same. Grill your portfolio managers on their holdings and you’ll soon learn how involved the managers are in running the portfolio. Ask for specifics rather than accepting broad generalizations like “we’re focused on quality stocks” and “we’re defensively positioned”. Given how expensive quality is trading today,I’d have a field day with that one. In any event, as holding stocks and bonds become more and more difficult to justify, I suspect Wall Street’s spin levels will increase along with asset prices.

I didn’t intend to talk about corporate spin again today after touching on the second half recovery story yesterday. However, after reviewing today’s earnings reports, I found a couple good examples of what I was discussing yesterday. This reminded me of the importance of asking management for examples so I thought I’d discuss.

Yesterday I talked about the second half story and when it isn’t achievable management will often guide earnings lower. Shortly after, the company will then beat the lowered guidance and the stock will go up. I know this doesn’t sound logical, but it happens frequently in today’s warped markets. It happened today with Werner Enterprises (WERN). Werner is a trucking company with a nice balance sheet that I’d actually consider owning at the right price. On June 20 they reduced earnings guidance to $0.21 to $0.25 for the second quarter. Analysts at the time were expecting EPS to reach $0.40, so this was a big disappointment. Today Werner announced actual EPS of $0.25 which was at the high end of guidance and beat analysts’ lowered earnings estimate.

When Werner preannounced its poor results after the market closed on June 20, its stock was at $24.68 and fell to $22.31 the following day. Today its stock spiked higher on its “good” earnings report and ended the day at $25.26. So Werner’s stock was up today above where it was before they preannounced poor results. All of this because it won the “beat the earnings estimate” game even though the estimate they beat was lowered significantly a month ago. And to be clear, it wasn’t a good quarter. Results were poor due to soft freight demand (sales down -7% and earnings down -43%). The company acknowledges this in their earnings release, “Second quarter 2016 freight demand was significantly softer than freight demand in the second quarters of the prior two years.” Sounds like bad news doesn’t it? Not in this market — Werner’s stock increased 5% today.

Watsco (WSO), a leading distributor of HVAC equipment, also provided a good example of the second half story. Although Watsco actually lost the earnings estimate game along with reporting weak Q2 results (small declines in revenue and earnings), management offset this bad news by making positive comments about performance in July. Despite weak results, investors looked to the future (the second half) and drove Watsco’s stock up $2.

There were several more earnings reports Friday that I’d like to discuss, but I went on longer than normal today so I’ll stop here. Overall I thought earnings today were a little weaker than earlier this week; however, I thought investor responses have been much more positive than I’d expect given results. We have a long way to go in earnings season, but so far it’s been mixed at best.

Second Half Hockey Stick Dream

I just counted. I’ve been through 90 quarterly earnings seasons. What do half of these quarters have in common? The second half of the year will be stronger than the first half! I love this story — it never gets old. Tell it to me again. And again. And again. By now I know this story is usually fiction, but the sell-side analysts seem to play along year after year. I’m not sure why, but I have theories that range from analyst turnover to it’s easier to fill in an earnings model by simply cutting and pasting company guidance.

Very rarely does a company in the first half of the year say the second half will stink. They almost always say the future will be brighter. It encourages confidence and optimism – not to mention a higher stock price! What’s the downside? If management is wrong they’ll simply call their favorite sell side analysts and encourage them to gradually reduce their estimates. The company will then beat the “new and improved” lowered guidance and the stock will go up again. Do you see how this works? My favorite part comes after the company beats lowered guidance and the analyst who was played like a fiddle says on the call, “great quarter guys!” I’m sorry for making fun of the second half rebound story and everyone who plays along year after year, but it’s just too easy.

Given the popularity of the second half story, I was surprised by Graco’s (GGG) guidance today. Graco manufactures equipment that pumps and dispenses fluids. They have a very broad product line and have three divisions:  Industrial, Process, and Contractor. When I think of them I usually think of paint sprayers, but they manufacture a lot more. As a business, I like Graco and consider them a high quality cyclical company. As many companies I follow with industrial exposure are reporting, Graco experienced a slow top-line quarter (3% organic sales growth). Graco also lowered its expectations slightly for the year. Management stated, “Modest first half organic growth has resulted in a reduction in our full-year outlook for 2016. We have revised our low-to-mid single-digit growth expectation down to a new outlook of low single-digit growth.”

I shouldn’t have been surprised by Graco’s quarter or outlook as it coincides with what I’m seeing in the sectors where they’re seeing softness. What surprised me is they didn’t provide second half guidance showing a rebound. This was Graco’s response to a question regarding their industrial business and their second half outlook (minute 32 on today’s call). Management stated, “I don’t want to make it sound like today we’re giving up hope, but I want to be realistic. And we don’t want to sit here and tell you everything is going to be rosy in the second half.” “…and we don’t know what’s going to happen globally and the geopolitical environment in the second half so we definitely as a group we haven’t given up on the second half, but what we’re trying to do is communicate that from a realistic viewpoint we ought to think about the second half on industrial more like the first half than on some hockey stick that is based upon a dream. [emphasis mine]”

Thank you Graco for your honesty. They don’t know so they’re not going to predict a “rosy hockey stick second half”. Instead, management is going to use a “realistic viewpoint” that isn’t based “upon a dream”. How refreshing and good for Graco! Their business is naturally cyclical and it’s ok not to know, especially in a challenging operating environment. This goes back to my belief that equity risk premiums are too low and should not be abolished by another crowded “this time is different” theme. Risks to companies’ cash flows have not diminished. They are alive and well, no matter how many times we’re told the second half is going to be better.


You’re Fired! (May) You’re Hired! (June)

A couple weeks ago the Department of Labor reported 287,000 jobs were created in June. A robust report. However, a month prior, the Department of Labor reported only 11,000 jobs were created in May. A very weak report. Is the labor market weak or strong and why the huge dispersion between months? I believe it has more to do with the government’s calculation methodology than reality.

From what I observe with the businesses I follow, barring a sudden shift in demand for products or services, companies don’t significantly alter labor plans from month to month. Labor decisions aren’t made lightly as turnover and misjudging the need for labor can be very expensive. Before hiring or firing, companies want to be certain changes in demand trends are sustainable. For example, when demand plummeted in the second half of 2008, many companies I follow waited before announcing layoffs to make sure the decline in demand wasn’t just a blip. It took some companies a couple quarters to finally face the facts and bring costs, along with labor, in line with new demand.

I continue to find it amusing that investors pay so much attention to the monthly job reports. We know government estimates on jobs can be lumpy and we know they’ll be revised (often sharply). There are also seasonal adjustments and the birth death model (estimate of job creation from business startups) that significantly influence the government data. As I commented in a previous post, if you want a clear picture of what’s going on with the real economy, consider getting your data points from actual businesses, not the government.

Fortunately we received a timely economic and employment data point yesterday when Cintas Corp. (CTAS), a market leading uniform company, reported earnings and provided insightful commentary on its conference call. Approximately 50 minutes into the conference call an analyst asked a question regarding employment trends. Management’s response was very interesting and confirms what I’m seeing with many of the companies I follow – growth remains uneven and slow, but is also not getting significantly worse. It’s more of the same — a similar environment to what I’ve been documenting since mid-2014, when the economy and profit trends were considerably stronger.

The analyst initially asked management about the negative impact from the oil and gas industry. As I mentioned in a previous post, I believe the earnings drag from the energy industry will continue, but companies have had time to adjust and comparisons should become easier. Cintas confirmed this by saying, “Well, we — from an oil, gas and mining standpoint, we have seen continued deterioration, but I would say today, that rate of deterioration is slowing, certainly relative to 90 days ago.”

Management went on to discuss the economy more broadly, “…let’s call it [the] economic picture, I would say that it’s still a challenging environment. There’s not a lot of momentum to it. But I would call it stable. We haven’t seen a lot of change today compared to a quarter ago. And so, I would say we are continuing to operate like we have been.  I would say as we look into fiscal 2017, if I were to make a comment about the economy that maybe did feel a little bit different, I would say today compared to — let’s call it six months ago, it does feel like there is a bit more uncertainty [emphasis mine]…We’ve seen the European issues; we’ve seen changes from the Department of Labor in terms of minimum wage and overtime that can have a pausing effect on our customers. We’ve got the election coming up. It does feel like there is a little bit more uncertainty than there was six months ago.”

So there you have it from the uniform maker’s mouth. Makes sense. I suspect May and June employment reports are inaccurate and the truth is probably closer to the average of the two months. Management’s comments were also helpful in confirming my macro views. Cintas sells to 900,000 businesses. I believe that makes them qualified to talk about the economy and employment trends. I’d much rather hear Cintas’ opinions on the economy and employment than those of a highly paid economist analyzing stale government data.

It’s very early in small cap earnings season, but so far it looks as expected and similar to what we covered in a previous post. Most companies are easily beating estimates, but overall organic top line growth remains challenging. This earnings season I’ll continue to point out data points I find interesting and any new developments that may appear. While fundamentals and valuations are currently not the main drivers of asset prices, I continue to believe it’s important to stay informed from a bottom-up perspective.

Brown & Brown is no Eddie Haskell

Like most analysts and portfolio managers, I read and listen to a lot of quarterly conference calls. Over the years these calls seem to get more and more promotional. Somewhere along the line conference calls went from being managed by boring CFOs to the more exciting CEOs and PR departments. While some calls now resemble infomercials, other calls continue to provide very valuable information on the business, industry, and economy. Sometimes I’ll listen to calls, while other times I’ll read the transcripts. When I’m concerned about excessive spin, I’ll usually listen to the call as I like to hear management’s tone. Is the tone genuine or am I being sold? You know the “being sold” tone – that Eddie Haskell tone. When I hear the Eddie Haskell tone (usually from the CEO) I immediately raise my required rate of return and lower my valuation!

A company I’ve owned in the past and continue to follow is Brown & Brown, Inc (BRO). Brown & Brown is a market leading insurance broker that has a long operating history (founded in 1939) and generates strong free cash flow. It’s a high quality business, in my opinion. Their conference calls are light on spin and heavy on good data points and interesting information. Their CEO, Powell Brown, is no Eddie Haskell. While Mr. Brown does a good job in his prepared remarks, he typically shines in the Q&A session as most good communicators and CEOs do. I always learn something about the business or the operating environment during Brown & Brown conference calls.

Today’s call wasn’t too dissimilar from recent calls. Organic growth remains in the low single digits range at 2.6%. Management again pointed out that there remains excess capital in the insurance industry, which is putting pressure on rates. While organic growth is positive, there are some inconsistencies between locations and industries. Management also pointed out its customers were hiring at a moderate pace. All in all it was a solid earnings quarter, with top line results not too different than what one would expect in this economy (my estimate of nominal GDP is similar to BRO’s organic growth).

I thought today’s conference call was good, particularly the Q&A session. A topic that I found interesting was addressed about 52 minutes into the call when Mr. Brown discussed valuations of potential mergers and acquisitions. Valuations have been rising and are on the expensive side. This isn’t new news as it’s occurring in several industries as many mature businesses are starving for growth (a sizable acquisition can give management an entire year of sales growth and time to figure out how to make it “work” from a non-GAAP adjusted earnings perspective). I’m typically not a big fan of constant acquisitions as acquirers often overpay or fail to add value; however, over the years I think Brown & Brown has done a good job on average. In any event, what I thought was interesting on today’s call was Mr. Brown’s comments regarding who was partially responsible for driving up M&A valuations. None other than one of the better performing asset classes this cycle – private equity.

Specifically, Powell states there was “a lot of activity in the PE [private equity] space and there continues to be more money it seems…or they want to put more money to work.” This is important. As some of you know, large pension plans such as Calpers, have recently fired hedge fund managers and increased allocations to alternatives, such as private equity funds. As plans attempt to shift the good ol’ efficient frontier upward by allocating more assets to what has worked, those entities receiving inflows, such as the private equity funds, must find a home for this new capital.

Mr. Brown is pointing out that some of this capital has found its way into the insurance broker industry and has driven up prices of mergers and acquisitions. Funny how performance chasing works — new flows and excess capital drives up prices and reduces future returns (see bond market), defeating the purpose of the asset allocation shift. Asset allocators should take note and may want to make that efficient frontier adjustment with a pencil.

Mr. Brown continues, “And so like I said, remember, we just sell and service insurance at Brown & Brown and those guys are doing their financial modeling relative to shorter-term things that include a flip with a terminal value. What we look at is does it make sense financially? And the answer is a number of the ones that we have seen don’t make sense financially.” I don’t know exactly what the private equity firms are paying, but if I had to pick who knows more about the business and the appropriate price to pay for an acquisition, Brown & Brown or the private equity firms, I’ll take the market leading operator that was founded in 1939.

In conclusion, beware when private equity is deeply involved in an industry. It usually means there is either too much capital or about to be too much capital chasing too few sales, profits, or in this case M&A deals. I remember in 2014 when energy was booming there were several management comments regarding private equity firm activity in the energy service and E&P sectors. In hindsight, it was a good data point that we were approaching the peak of the cycle.

Smoke ’em if You Got ’em!

Have you ever bought a mutual fund or ETF and received a prospectus in the mail? Some of them are over 100 pages. One of the reasons they’re so thick is the requirement by mutual funds to disclose the strategy’s risks. The government requires it. They want to make sure investors know the risks they’re taking before investing. How many people actually read the prospectus is beside the point. My point is the government wants investors to be careful and know they may lose money. Seems simple enough.

Out of curiosity, I pulled up a prospectus of a popular bond fund today. The fund’s risks include: principal risk, interest rate risk, call risk, credit risk, high yield risk, market risk, insurer risk, liquidity risk, derivatives risk, equity risk, mortgage risk, asset back security risk, foreign investment risk, emerging market risk, sovereign debt risk, currency risk, leveraging risk, managing risk, and short sale risk. Now you know why prospectuses are so long!

With interest rates at record lows and negative rates becoming more common globally, what is the biggest risk fixed “income” investors face today? I’ll give you a hint, it’s not on the list above. In my opinion, the biggest risk to bond investors, and all investors in all asset classes, is central banks and the possibility that their eight years of “emergency” policies fail. Among other things, the failure of these policies could create inflation, deflation, a currency crisis, a sovereign credit crisis, a fiscal deficit funding crisis, an inequality crisis, and a major reset in interest rates and asset prices. Don’t kid yourself (and I doubt many of you are), but interest rates and asset prices are not where they are because of fundamentals. Without the faith and confidence in central bankers, everything changes, everything.

How would bond investors respond tomorrow if central banks announced they were no longer able to buy bonds? Instead of buying, what if central banks had to sell the bonds they bought during their QE operations? In other words, what if the currency markets, or inflation, or a sudden shift in crowd psychology (i.e. zero to negative rates were perceived to be bad) forced central bankers’ hands and they went from the market’s unlimited bid to the world’s largest seller? Bond investors would lose trillions. Why isn’t the largest risk to investors, central banker policy failure, listed in the bond prospectus I referenced above? In my opinion, it should be listed, it should be mentioned first, and it should be in bold. Furthermore, it should be listed in all prospectuses, including equity funds.

What I find particularly interesting about all of this is how the government has a conflicting role in disclosing and encouraging investment risks. On the one hand, you have one government agency warning investors of the risks of investing – they’re trying to protect investors. On the other hand, you have another arm of the government, the Federal Reserve, actively encouraging investors to take risk. Eight years of ZIRP and negative real rates have screamed take equity risk, duration risk, liquidity risk, leverage risk, credit risk, market risk, and anything is better than cash risk!

The Federal Reserve is on record stating monetary policy has been successful in raising asset prices and that it has helped stimulate the economy. From Ben Bernanke’s op-ed article on November 5, 2010, “The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011…this approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth.” Later in the article Bernanke again discussed the wonders of asset inflation, “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion [emphasis mine].”

So what is it Mr. Government? Do you want to protect investors from the risks listed in the prospectus, or do you want investors to take risk in order to drive up asset prices? It’s like the Surgeon General requiring cigarette manufactures to place warning labels on their packaging, while encouraging smoking by giving out free cigarettes! The Federal Reserve is running a smoke ‘em if you got ‘em monetary policy. Although the risks of the Fed’s policies are not being fully disclosed, investors should be aware that these policies can be very hazardous to their financial health.

As it relates to investing, identifying and fully understanding all of the risks of an investment is an important part of the research process. It is also critical to the valuation process as the measurement of risk goes directly into determining an investor’s hurdle rate or required rate of return. An accurate required rate of return is essential in properly valuing many assets including corporate debt and equities (especially when using DCF valuation methodology). In conclusion, absolute return investors should not rely on government warnings when it comes to understanding the most important risks associated with an investment. Read the risks. Read the disclosures. But also do your own work, think for yourself, and just because the risk isn’t listed doesn’t mean it isn’t there.

Thou Shalt Not Overpay With Other Peoples’ Money

Funds: How Much Cash Is Too Much?

There’s good reason for funds to have extra cash—as a cushion—but not two-thirds of their assets or more.

Barron’s recently published an article with the title and subtitle above. The article mentions several funds with very high cash levels and implies these funds are invested as if the world is coming to an end – doomsday funds so to speak. Instead of investing for Armageddon, is it possible these funds are simply staying true to their investment disciplines and objectives? If the funds’ objectives are to generate absolute returns, high cash levels during periods of record high valuations is not only possible, but should be expected. Moreover, in my opinion, today’s overvaluation is much broader than the bubbles of 1999-2000 and 2006-2007. This cycle’s broadness of overvaluation has significantly reduced the number of qualifying investments, increasing the need for cash above that of past cycle peaks.

For the past 18 years I’ve been running an absolute return portfolio with cash levels ranging from fully invested to over 80%. During this time, I’ve been asked every question imaginable as it relates to cash. I think the biggest misconception about portfolio managers who are willing to hold cash is that they are market timers. Although I can’t speak for other managers, I am not a market timer. In fact, I believe I’m an awful market timer. I have no idea where the stock market is headed. Although I believe stocks are overvalued (especially small caps) and they “should” decline, if I had to guess near-term I’d say they could go either way.

Stocks could go up. Policy makers appear determined to keep the game going by providing more and more stimulus and investors appear more than willing to play along. While valuation metrics are at nosebleed levels, one thing I learned in the late-90’s tech bubble is valuation isn’t a good predictor of stock prices in the near-term. Once prices and valuations are detached from intrinsic values, they can go anywhere they want and they can go there quickly. Given poor earnings and fundamentals haven’t mattered over the past several quarters, it’s possible they’ll continue to be ignored and multiples and overvaluation could continue to expand. Although the current market cycle is one of the longest in history and I believe we are in the later stages, the exact timing of this cycle’s demise is unknowable. The bull market could continue.

Stocks could go down. Let’s face it, we’ve never seen this type of investment environment before – global central bankers gone wild. We have no idea how these monetary experiments will end exactly or when they end. If central bankers can no longer maintain the perception that their balance sheets and bids are unlimited, investor demand for bonds yielding practically nothing (or worse!) would evaporate. We could wake up one morning and see the long bond down four or five dollars along with currencies in turmoil. A bond or currency collapse would most likely be blamed on failed central bank policies; therefore, more policy response would be perceived as a negative. At that point the central bankers’ “put” finally expires with no one left to bailout the markets. Stocks would crash.

So there you have it. I can see stocks continue to go up and I could see them crash. Real helpful I know and proves I have no idea where stocks are headed. Being 100% cash in my absolute return portfolio has nothing to do with my opinion on the stock market and everything to do with investment discipline and principle. On principle it’s pretty simple. While I’m no longer managing a public mutual fund, I strongly believe investment managers should never knowingly overpay for any asset with other peoples’ money. It’s a serious investment sin. In fact, it’s the first of my investment ten commandments – Thou Shalt Not Overpay. In other words, holding cash is a result of having a conscience and understanding overpaying is not only a poor investment decision, it’s just wrong.

Investment discipline is also a major factor in determining cash levels. None of the successful investors I’m aware of just wing it – they all follow strict investment disciplines, or a set of investment rules. As an absolute return investor, my discipline is founded on my desire to make money. It is driven by the fundamental analysis and valuation work I perform on hundreds of small cap stocks (it’s a bottom-up process). My discipline attempts to avoid overpaying and limit mistakes. To do this it’s essential to only take risk when getting appropriately paid relative to risk assumed.

Disciplined absolute return investors do not need to continuously hit home runs to achieve their investment objectives. By maintaining a high batting average and limiting mistakes (over a market cycle), absolute return investors can generate attractive returns while taking significantly less risk than relative return investors. As a reminder, relative return investors usually remain fully invested even in periods of inflated prices, elevated risks, and limited opportunities. Currently I do not believe most stocks, or bonds for that matter, will provide investors with sufficient returns relative to risk assumed. Prices and valuations are at record highs, overvaluation is very broad, risks appear unappreciated (VIX below 13), interest rates are artificial, and profit margins are extended.

It is during periods like we are in today that investors make their biggest mistakes; when conventional wisdom and crowd psychology suggests prices can only go up and there is “something different this time” (late 90s it was the new economy/productivity miracle, 2007 it was home prices never fall, and now it’s faith in global central bankers). This is when following discipline is most important and when I’m most thankful to be an absolute return investor. I’d be very uncomfortable if I was forced to be fully invested in this environment. Imagine being a bond manager right now with a fully invested mandate — yikes!

In my opinion, absolute return investors must have the willingness and ability to be patient, especially during prolonged periods of overvaluation and asset bubbles. In order to maintain a patient positioning, safe and liquid assets, such as cash are essential. I do not believe cash should be used in an attempt to time markets. Instead, cash levels should be determined on principle and by following a strict and thoughtful investment discipline. Cash provides investors with an alternative to owning overvalued assets. This makes a lot of sense to me as I’d rather hold cash than an overvalued asset. Wouldn’t you?

The Small Cap Police

Today I was going to write about passive investing, but there was just too much for one post, so I decided I’ll try to touch on the topic once a week until all aspects are completely covered.

In 1996, I joined the Evergreen Funds in Purchase, NY and started working solely on small cap stocks. It was a great experience and I pinched myself every day heading into work. I was only 25 years old and was working on a 4-5 star small cap fund. In 1996-1997 small cap businesses were performing very well as the profit cycle was peaking. It was tough to make mistakes as rising profits were elevating the small cap market to record highs. I thought I was the next Warren Buffett, but in reality I was just in the right place at the right time. Nevertheless, I learned a lot during the mid-90s and look back on those years as a time when the foundation of the absolute return strategy I developed was formed.

The fund I worked on was called the Evergreen Small Cap Equity Income Fund. It was a very interesting fund – a small cap fund with a yield requirement. Imagine how well that strategy would be performing today given the panic for risk and yield! In any event, the yield was meant to help reduce downside and obviously produce income. It turned out to be a great risk-adjusted return strategy and was listed by Barron’s in their top 100 funds rankings in 1997 and 1998. In addition to helping us generate attractive risk-adjusted returns, focusing on stocks with dividends forced me to follow and analyze more mature businesses that generated free cash flow. This concept has followed me even today as the majority of the small cap businesses on my 300 name possible buy list are in fact mature businesses that generate abundant free cash flow over a profit cycle.

Another reason I’ve gravitated towards mature businesses is I believe they can be valued with a higher degree of confidence versus young and unproven businesses. If there is a long operating history to analyze, I can better determine how the business will perform throughout an industry and economic cycle. The more cycles the better. Also, the longer the history the better understanding one can have of the company’s normalized free cash flow. Extrapolating peak cash flows (what many investors are doing now in my opinion) is a very dangerous game. Conversely, extrapolating trough cash flows can lead to tremendous cost in the form of lost opportunities. Lastly, mature companies often are higher quality businesses. If a company has survived for decades and has flourished through multiple economic booms and busts, there is typically something high quality about the business.

So what does all of this have to do with passive investing? Absolutely nothing. What I want to discuss, but was sidetracked, is how the top holders of many of the mature companies I follow has changed considerably since the mid-90s. At that time I remember the top holders of high quality small cap companies were often large buy-side mutual funds such as Royce, Heartland, and Gabelli. Can you guess what the top holders of most small cap stocks are today? You guessed it, passive index funds such as Vanguard, Blackrock, and Dimensional Funds.

In my opinion, high quality small caps are the most expensive I’ve ever seen them. For the first time since 1993 I don’t own one stock – I am completely out of the market. Looking through my possible buy list there is very little I would consider to be a good investment or that will generate adequate absolute returns relative to risk assumed. In effect, by recently recommending returning capital to clients, I was recommending going 100% cash. And that’s where I am today.

When I look at some of the stocks I owned over that past 20 years that were trading at 10-15x earnings at the time of purchase and that are now trading at 20-35x earnings, I ask myself, “Who in the world is buying these things?” When I pull up the top holders to discover the culprits, I often see the most popular index funds and ETFs.

Mature small cap businesses that are growing 2-3% organically should not trade at aggressive growth-like valuations. The math simply doesn’t work for slow to no growth companies. Investors are getting a 3-4% earnings yield on earnings that are in many cases being generated off peak margins. As noted previously, extrapolating peak cash flows is a very dangerous game, but extrapolating peak cash flows AND requiring a meager low single digit earnings yield is, frankly, irresponsible (especially if you’re doing this with other peoples’ money). A rational investor or banker wouldn’t lend to these businesses long-term at 3%, but equity holders are supposed to be satisfied with these type of cap rates on uncertain perpetual cash flows?

Why are valuations of mature high quality small cap stocks so expensive? ZIRP, NIRP, and global QE along with the investment philosophy of the day T.I.N.A. (there is no alternative) are obviously to blame; however, I believe the shift to indexing and passive investing is also responsible. Index funds do not care about earnings yields, risk premiums, margins of safety, cash flows, and on and on. When an index fund receives an inflow it buys the stocks in the index regardless of fundamentals and price. I believe this sort of price indifference is one of the main reasons valuation multiples have expanded significantly this market cycle. I haven’t done the comparison, but if you pulled up a chart of index and ETF inflows I wouldn’t be surprised to see a high correlation to a chart of rising valuation multiples (especially price to sales and CAPE).

When I started this industry small caps were policed by the largest holders, which were often disciplined buy-side managers. These “small cap police” helped keep law and order in the price and valuations of the small cap stocks they owned or followed. Unlike index funds, the buy-side funds were price sensitive. Mature and boring small cap businesses would seldom trade at today’s valuations because the top holders were expected to sell and take profits if valuations increased to levels that couldn’t be justified with rational assumptions. While overvaluation and investors’ willingness to overpay (the #1 investment crime!) are present in every cycle, the major holders were at least cognizant of companies’ worth and were not indifferent to price. Where are the small cap police today? They’re no longer as important and are dropping off the list of top holders.

So without the small cap police what do we have? We have a market that is more price insensitive and dependent of flows. What happens when all of the index funds (the top holders) have outflows during the next bear market? Who will they sell to? They can’t sell to each other as they’ll all be selling at the same time to meet redemptions. Furthermore, since they’re fully invested they don’t have cash buffers and will have to liquidate holdings immediately, or that day. Just as they’re price insensitive on the upside, they’ll also be price insensitive on the downside.

I suspect most of the indexers who believe markets are efficient have never tried to liquidate a multi-million dollar small cap position in a market with few bids. I’ve seen it. It’s sloppy, illiquid, and very inefficient. I believe the great passive investing unwind could be one of next attractive buying opportunities for disciplined absolute return investors. I’m ready and looking forward to owning small cap stocks again.