Tag Archives: accounting

3 Of Seeking Alpha’s Best, Part II

Summary As a hedge fund manager, who do I think is worth following on SA? 3 (more) writers I take seriously and think you should too. This is the second in a continuing series. In Part I , I looked at three of Seeking Alpha’s best contributors. In this sequel, I offer three more worth following. They all happen to be hedge fund managers and friends of mine. Whitney Tilson Whitney Tilson founded and manages Kase Capital and he wrote The Art of Value Investing and More Mortgage Meltdown . He has been a valuable contributor to Seeking Alpha, especially on the short side. I want to highlight some of his short ideas that I found most compelling at the time. He has been one of the most consistent voices on the issue of World Acceptance (NASDAQ: WRLD ) since publishing his compelling investment thesis, World Acceptance: A Battleground Stock I’m Short . One of the next up was K12 (NYSE: LRN ). Shorting can be a painful waiting game, but he did not have to wait long on An Analysis Of K12 And Why It Is My Largest Short Position . For more on LRN, he also published this slide presentation. Whitney is probably best known on Seeking Alpha for the quality (and quantity) of his devastating work on Lumber Liquidators (NYSE: LL ), starting with My Analysis Of Lumber Liquidators’ Updated Guidance . Here was my reaction to the 60 Minutes episode on LL: Whitney, Well done and congratulations! It was a terrific and compelling piece. The LL founder was evasive and deceptive. I replayed his comments several times. He knew . This is an important and favorable development for short sellers. Shorting and exposing truth is not a conflict of interest – it is a confluence of interest. Ethics involves not lying/cheating/stealing; we cannot rely on the cheap substitute of listening only to people with nothing at stake. Modern investment management has often tried to rely on both thinking substitutes and ethics substitutes. Thinking substitutes such as diversification and volatility minimizing have fared poorly but have not yet been abandoned. Ethics substitutes (“listen to me because I promise that I have at no time and in no place ever even thought about doing with my own money what I now tell you to do with yours”) have fared just as badly but are still in daily use. Your 60 Minutes segment is a big step towards real morality in business and investing. Sure, you are invested in the outcome, but you are invested because your view – and the evidence you lay out – supports that outcome. That is a bigger deal than whatever ultimately happens to LL. Finally, it serves the interest of free enterprise and free trade to have markets self-policed. Pieces such as this can protect markets from inevitable calls to have endless central planning and control. The best way to counteract the self-interest of cheaters is with the interest of short-sellers. While the government may have the resources, it never seems to have the speed to act when it counts. You have both and did something about it. Chris DeMuth Jr. InterOil (NYSE: IOC ) is one that we have both followed for a long time. I wrote about our IOC short on my blog and in InterOil Increases Production… Whitney’s thinking was helpful to the short thesis, including his article Why There’s More Downside To Come For InterOil . When he wrote The Beginning Of The End Of The 3D Printing Bubble… …it was, in fact, the beginning of the end of the 3D printing bubble. Unilife (NASDAQ: UNIS ) has been a favorite topic of mine on my blog here and here , as well as in an article on my favorite pairs trade. While I do my own work, Whitney’s contribution to the topic further solidified my thinking on this company. Ben Axler Ben Axler founded Spruce Point Capital, a long/short hedge fund. He has exposed over $1.0 billion of alleged listed frauds on NASDAQ and the NYSE. Want a great short idea? Read about Caesarstone Sdot-Yam (NASDAQ: CSTE ) in Ben’s article: Caesarstone: A Counter To The Bull Thesis On Quartz Countertops Suggests 40-75% Downside . It has declined by over 20% since publication, but remains expensive and risky. Value investors, skeptics, and debunkers should follow him here on Seeking Alpha and here on Twitter. You can also learn more about his hedge fund and other investment ideas on Spruce Point’s site . He was kind enough to join us for our last biannual ideas dinner in New York City last month where he gave us a devastating preview of what would happen to CSTE. His update is available here: Downgrading Caesarstone On Concerns About Its Capital Expenditure Accounting And Management’s History At Tefron . Andrew Walker A portfolio manager at Rangeley Capital, Andrew is a long-time friend. We have collaborated on investment ideas that we’ve posted on Seeking Alpha as far back as our early work on ALJ Regional Holdings ( OTCPK:ALJJ ), which I wrote about here . If you have an hour to learn about investing in small caps, you should listen to this interview. Additionally, I describe our work together here . Next year, we will launch our new Special Opportunities strategy that will focus on small-cap equity opportunities including special situations. Andrew has been chosen as the portfolio manager to run that new endeavor. He is exactly who I always wanted to run such a strategy. I will follow the example of Charlie Munger, who says that: Berkshire (NYSE: BRK.A ) (NYSE: BRK.B ) is run with decentralization almost to the point of abdication. While I plan to do the same at Rangeley, this requires the perfect people to manage specific businesses. Happily, I have the right people. Meanwhile, if you would like to hear more of Andrew’s investment ideas, he and I will both be speaking at an upcoming conference focusing on microcap investing. Conclusion These are the types of people I rely upon. Charlie Munger said that: The highest form that civilization can reach is a seamless web of deserved trust – not much procedure, just totally reliable people correctly trusting one another. This is what my web of deserved trust looks like. Who is in yours? Who should I add to mine? I intend to keep this series going, so please let me know if there is anyone who writes on Seeking Alpha who should be included in a future edition. I am always in search for idea candidates for Rangeley Capital as well as candidates for both new submissions and new members for Sifting the World . Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

I’ll Take VNQ Over The Federal Reserve: Benefit From Low Rates

Summary The Vanguard REIT Index ETF is holding a diversified portfolio of REITs that can benefit from low rates. Wage growth is a bullish factor for domestic demand. Inventories at high levels relative to sales are bearish, but goods are frequently imported rather than built domestically. If the Federal Reserve follows the mandate to maintain high employment, they will need to keep rates low. The Vanguard REIT Index ETF (NYSEARCA: VNQ ) has been one of my core portfolio holdings and I don’t foresee it going anywhere. The fund offers investors a very reasonable expense ratio of .12%, a dividend yield running a hair under 4%, and a large degree of diversification throughout the industry as demonstrated in its sector allocations: Weak Bond Yields The yield on the 10-year treasury has dipped under 2% and I don’t expect it to end the year much higher. Our economy is depending on very low interest rates, which can be a boon for the equity REITs as it offers them access to lower cost debt financing for properties. Why Treasury Yields are Limited The Federal Reserve is largely incapable of pushing rates up. It might be technically possible for them to have some influence in pushing the rates higher, but it would be a disastrous scenario. The Federal Reserve is facing a dual mandate for low and steady inflation combined with high employment. If domestic interest rates are increased, it would encourage further capital flows into the country as globally investors would seek the security of buying treasuries. The predictable impact would be a stronger dollar that encouraged companies to ship more jobs abroad and a decline in domestic asset prices due to the “cheaper” goods being imported. Essentially, when interest rates are rising, it will need to be across the globe. Raising interest rates in only one developed country is asking for problems when the tools of production can be operated on a global scale. I understand investors are clamoring for respectable low-risk yields, but increasing rates is not practical. If Those Yields Stay Low If the bond yields are remaining low, investors are going to be searching for yield in other places. With that dividend yield around 4%, VNQ is one viable option for providing some yield to the portfolio. It isn’t just demand for the shares of the REIT, though. The REIT industry has another tailwind that makes it more favorable. Wage Growth is Bullish Some major employers like Wal-Mart (NYSE: WMT ), Target (NYSE: TGT ) and McDonald’s (NYSE: MCD ) have announced very substantial increases in their base wages. This is finally showing that domestic companies are finding value in their own employees. When capital is not flowing to labor, there is less demand in the society for physical goods. As corporate earnings were climbing in previous quarters, there wasn’t enough capital flowing back to “Main Street.” A growth in wages here should help combat weakness in sales for the corporate sector. This growth in wages is a favorable sign that major employers are seeing value from labor. Many investors may scoff that the jobs provided by these employers are creating “low wage” or “low class” jobs. That makes the increase in wages even more important. In a recovery in which too many of the new jobs were failing to provide material levels of income for workers, there is finally an increase near the bottom of the pyramid. Increasing Inventories to Sales is Bearish The following chart compares inventory levels with sales: (click to enlarge) We are seeing a growth in inventory levels, which is a dangerous macroeconomic sign, as higher inventory levels encourage companies to cut production. If the physical production is reduced, there is less demand for workers. That could bring us back towards higher levels of unemployment and weaker wage growth at the bottom of the pyramid. It also indicates that earnings could take a substantial hit. Weaker Earnings Projections Should Force Rates Down For the investors that are not familiar with the accounting for inventory costs, it is important to state that higher levels of production generally stretch fixed costs across more units of production. When companies have to cut production due to inventory levels becoming too high, it results in higher costs of production. Those higher costs can effectively be wrapped into the “inventory” line item and the expense won’t pass through the income statement until the inventory is sold. When the inventory is sold, the higher costs of production flow through the income statement as “cost of goods sold.” The REIT Impact If increasing inventories results in a large reduction in labor in the United States, it would be a problem for REITs as it would signal deteriorating fundamentals. On the other hand, a great deal of inventory comes from imports and a reduction in imports would not have the same dramatic impact. According to ABC news , in the 1960s only 8% of American purchases were made overseas. Now that value is greater than 60%. Whether we talk about residential REITs, office REITs, or retail REITs, a lack of domestic employment would be a bearish sign that would indicate a reduction in the consumption of goods. For residential REITs, the impact would be a drop in the amount of demand for apartments as unemployed workers are not a solid renting demographic. For the office REITs, there is a lack of demand for office space if the companies renting that space find their sales diminishing and must cut their costs. The retail REITs face a similar problem to the office REITs as they depend on consumers buying products from their tenants. Why I’m Still Holding onto VNQ The potential for weakening levels of employment as evidenced by factors like the increase in inventories relative to sales is a material concern. Despite that concern, I choose to remain long VNQ. The increasing inventories are a concern, but imports still fund a substantial portion of inventory. If rates were rising and forcing the dollar to appreciate even further, it would be a serious risk factor for the REITs, but it would also be a challenge directly to the mandate of full employment. So long as the Federal Reserve is following that part of their mandate, they will be forced to keep the rates low. That provides support to share prices as investors seek yield and it provides support to the underlying business by keeping the cost of debt capital lower. Because the REITs can benefit from a low cost of capital and the impact of higher wages, they are in position to gain twice. On the other hand, if I’m wrong and the Federal Reserve does opt to start jacking up short-term rates, then I’ll be eating some nasty losses on my portfolio value. I can’t be certain that I’m right, but I’m confident enough that I am holding VNQ and the Schwab U.S. REIT ETF (NYSEARCA: SCHH ) in my portfolio .

REM: A Supplement To Give Your Portfolio More Yield

Summary REM has a high expense ratio, but it is superior to new investors picking mREITs simply on trailing dividend yield. The top holdings are fairly similar, but as we move down to the third holding we see some great diversification benefits. When REM “goes on sale” after a period of intense interest rate volatility, it is not really “on sale”. The mREITs within the portfolio suffer severe losses from volatility. Investors should use allocations like REM in a conservative manner to boost the total income on the portfolio. One option many yield starved investors might miss out on is the iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ). The ETF isn’t perfect, but it does quite a few things right and in my opinion it may be a substantially superior option to investors picking their own mortgage REITs if they do not understand the mortgage REIT business. An enormous portion of my coverage on Seeking Alpha is in the mortgage REIT sector and I’ve seen quite a few investors lose large chunks of money to being heavily invested in individual mREITs without understanding the accounting implications of management’s decisions. If an investor is willing to put in the time to learn the mREITs, I find that superior to the ETF option. If that seems like too much work, REM is an option with a massive 14.4% dividend yield. Expense Ratio The expense ratio on REM is .48%. Largest Holdings (click to enlarge) The holdings are not ideal in my opinion, but they aren’t bad. For the expense ratio, I would expect more investigation of which small cap mREITs are going to be underpriced and which mREITs will excel in the opposite scenarios. Annaly Capital Management (NYSE: NLY ) is a fairly huge Agency mREIT and their portfolio is fairly similar to the second holding, American Capital Agency Corp. (NASDAQ: AGNC ). The biggest difference in these two mREITs at the present time is the structure of their swap portfolios. NLY is hedging farther out on the yield curve and AGNC is using hedges with shorter durations but a higher notional value. If you want to learn more about either, I’ve covered both quite a few times. The nice thing about this portfolio is that it uses Starwood Property Trust (NYSE: STWD ) as the third holding. Starwood Property Trust is a huge REIT with vastly different risk factors from the simple Agency RMBS portfolios of NLY and AGNC. You can see my introduction to STWD . Overall, the portfolio of mREITs will be prone to one major weakness which is volatility in the interest rate environment. Some of these mREITs will benefit more from low rates and some from high rates, but very few mREITs are designed to benefit from volatility in the interest rate environment. If we go into a sustained period of fairly stable interest rates, it would be very bullish for the sector. Dividend Difficulties If there is volatility in the interest rate environment, it can result in very serious damage to both book value and earnings for mREITs which could force them to cut their dividend payouts. If you’re using REM to supplement your retirement, be aware that the dividend could be reduced materially and share prices falling when interest rates are volatile does not necessarily mean that the sector is “on sale”. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45% Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012. (click to enlarge) A quick rundown of the portfolio Using SJNK offers investors better yields from using short term exposure to credit sensitive debt. The yield on this is fairly nice and due to the short duration of the securities the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion REM offers investors exposure to a sector that has a fairly low correlation (less than .50) with the S&P 500. That low correlation combined with a strong dividend yield makes it an appealing option for many investors that do not understand mREIT accounting. When it comes to analyzing mREITs, the worst mistake I often see is investors buying on trailing dividend yield with only a cursory examination into whether the mREIT can sustain the dividend. It is a recipe for failure as share prices can drop sharply after an unsustainable dividend is cut. While the dividend yield is extremely strong, low prices are not necessarily indicative of “sales” because the damage to an mREIT portfolio from period of high volatility can be very material and the damage is generally permanent. When their assets are held at substantially more than par value due to favorable interest rates and the borrowers are paying off the loans at par value, the loss created is a real problem and does not simply correct itself in future periods. Limit the exposure, but using REM as a small part of a portfolio can work just fine. Compared to the presented portfolio, if an investor needed more yield I would contemplate dropping off FXG first and replacing it with more SJNK and then replacing some SPY with an ETF that emphasizes higher dividend yields and lower volatility.