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My Passion Is Puppetry

We are supposedly living in the Golden Age of television. Maybe yes, maybe no (my view: every decade is a Golden Age of television!), but there’s no doubt that today we’re living in the Golden Age of insurance commercials. Sure, you had the GEICO gecko back in 1999 and the caveman in 2004, and the Aflac duck has been around almost as long, but it’s really the Flo campaign for Progressive Insurance in 2008 that marks a sea change in how financial risk products are marketed by property and casualty insurers. Today every major P&C carrier spends big bucks (about $7 billion per year in the aggregate) on these little theatrical gems. This will strike some as a silly argument, but I don’t think it’s a coincidence that the modern focus on entertainment marketing for financial risk products began in the Great Recession and its aftermath. When the financial ground isn’t steady underneath your feet, fundamentals don’t matter nearly as much as a fresh narrative. Why? Because the fundamentals are scary. Because you don’t buy when you’re scared. So you need a new perspective from the puppet masters to get you to buy, a new “conversation”, to use Don Draper’s words of advertising wisdom from Mad Men . Maybe that’s describing the price quote process as a “name your price tool” if you’re Flo, and maybe that’s describing Lucky Strikes tobacco as “toasted!” if you’re Don Draper. Maybe that’s a chuckle at the Mayhem guy or the Hump Day Camel if you’re Allstate or GEICO. Maybe, since equity markets are no less a financial risk product than auto insurance, it’s the installation of a cargo cult around Ben Bernanke, Janet Yellen, and Mario Draghi , such that their occasional manifestations on a TV screen, no less common than the GEICO gecko, become objects of adoration and propitiation. For P&C insurers, the payoff from their marketing effort is clear: dollars spent on advertising drive faster and more profitable premium growth than dollars spent on agents . For central bankers, the payoff from their marketing effort is equally clear. As the Great One himself, Ben Bernanke, said in his August 31, 2012 Jackson Hole speech: “It is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases.” Probably not a coincidence, indeed. Here’s what this marketing success looks like, and here’s why you should care. This is a chart of the S&P 500 index (green line) and the Deutsche Bank Quality index (white line) from February 2000 to the market lows of March 2009. Click to enlarge Source: Bloomberg Finance L.P., as of 3/6/2009. For illustrative purposes only. Now I chose this particular factor index (which I understand to be principally a measure of return on invested capital, such that it’s long stocks with a high ROIC, i.e. high quality, and short stocks with a low ROIC, all in a sector neutral/equal-weighted construction across a wide range of global stocks in order to isolate this factor) because Quality is the embedded bias of almost every stock-picker in the world. As stock-pickers, we are trained to look for quality management teams, quality earnings, quality cash flows, quality balance sheets, etc. The precise definition of quality will differ from person to person and process to process (Deutsche Bank is using return on invested capital as a rough proxy for all of these disparate conceptions of quality, which makes good sense to me), but virtually all stock-pickers believe, largely as an article of faith, that the stock price of a high quality company will outperform the stock price of a low quality company over time. And for the nine years shown on this chart, that faith was well-rewarded, with the Quality index up 78% and the S&P 500 down 51%, a stark difference, to be sure. But now let’s look at what’s happened with these two indices over the last seven years. Click to enlarge Source: Bloomberg Finance L.P., as of 3/28/2016. For illustrative purposes only. The S&P 500 index has tripled (!) from the March 2009 bottom. The Deutsche Bank Quality index? It’s up a grand total of 10%. Over seven years. Why? Because the Fed couldn’t care less about promoting high quality companies and dissing low quality companies with its concerted marketing campaign – what Bernanke and Yellen call “communication policy” , the functional equivalent of advertising. The Fed couldn’t care less about promoting value or promoting growth or promoting any traditional factor that requires an investor judgment between this company and that company. No, the Fed wants to promote ALL financial assets, and their communication policies are intentionally designed to push and cajole us to pay up for financial risk in our investments, in EXACTLY the same way that a P&C insurance company’s communication policies are intentionally designed to push and cajole us to pay up for financial risk in our cars and homes. The Fed uses Janet Yellen and forward guidance; Nationwide uses Peyton Manning and a catchy jingle. From a game theory perspective it’s the same thing. Where do the Fed’s policies most prominently insure against financial risk? In low quality stocks, of course. It’s precisely the companies with weak balance sheets and bumbling management teams and sketchy non-GAAP earnings that are more likely to be bailed out by the tsunami of liquidity and the most accommodating monetary policy of this or any other lifetime, because companies with fortress balance sheets and competent management teams and sterling earnings don’t need bailing out under any circumstances. It’s not just that a quality bias fails to be rewarded in a policy-driven market, it’s that a bias against quality does particularly well! The result is that any long-term expected return from quality stocks is muted at best and close to zero in the current policy regime. There is no “margin of safety” in quality-driven stock-picking today, so that it only takes one idiosyncratic stock-picking mistake to wipe out a year’s worth of otherwise solid research and returns. So how has that stock-picking mutual fund worked out for you? Probably not so well. Here’s the 2015 S&P scorecard for actively managed US equity funds, showing the percentage of funds that failed to beat their benchmarks over the last 1, 5, and 10 year periods. I mean … these are just jaw-droppingly bad numbers. And they’d be even worse if you included survivorship bias. % of US Equity Funds that FAILED to Beat Benchmark 1 Year 5 Years 10 Years Large-Cap 66.1% 84.2% 82.1% Mid-Cap 56.8% 76.7% 87.6% Small-Cap 72.2% 90.1% 88.4% Source: S&P Dow Jones Indices, “SPIVA US Scorecard Year-End 2015” as of 12/31/15. For illustrative purposes only. Small wonder, then, that assets have fled actively managed stock funds over the past 10 years in favor of passively managed ETFs and indices. It’s a Hobson’s Choice for investors and advisors , where a choice between interesting but under-performing active funds and boring but safe passive funds is no choice at all from a business perspective. The mantra in IT for decades was that no one ever got fired for buying IBM (NYSE: IBM ); today, no financial advisor ever gets fired for buying an S&P 500 index fund. But surely, Ben, this, too, shall pass. Surely at some point central banks will back away from their massive marketing campaign based on forward guidance and celebrity spokespeople. Surely as interest rates “normalize”, we will return to those halcyon days of yore, when stock-picking on quality actually mattered. Sorry, but I don’t see it. The mistake that most market observers make is to think that if the Fed is talking about normalizing rates, then we must be moving towards normalized markets, i.e. non-policy-driven markets. That’s not it. To steal a line from the Esurance commercials, that’s not how any of this works. So long as we’re paying attention to the Missionary’s act of communication , whether that’s a Mario Draghi press conference or a Mayhem Guy TV commercial, then behaviorally-focused advertising – aka the Common Knowledge Game – works. Common Knowledge is created simply by paying attention to a Missionary. It really doesn’t matter what specific message the Missionary is actually communicating, so long as it holds our attention. It really doesn’t matter whether the Fed hikes rates four times this year or twice this year or not at all this year. I mean, of course it matters in terms of mortgage rates and bank profits and a whole host of factors in the real economy. But for the only question that matters for investors – what do I do with my money? – nothing changes . Stock-picking still won’t work. Quality still won’t work. So long as we hang on every word, uttered or unuttered, by our monetary policy Missionaries, so long as we compel ourselves to pay attention to Monetary Policy Theatre, then we will still be at sea in a policy-driven market where our traditional landmarks are barely visible and highly suspect. Here’s my metaphor for investors and central bankers today – the brilliant Cars.com commercial where a woman is stuck on a date with an incredibly creepy guy who declares that “my passion is puppetry” and proceeds to make out with a replica of the woman. Click to enlarge What we have to do as investors is exactly what this woman has to do: get out of this date and distance ourselves from this guy as quickly as humanly possible. For some of us that means leaving the restaurant entirely, reducing or eliminating our exposure to public markets by going to cash or moving to private markets. For others of us that means changing tables and eating our meal as far away as we possibly can from Creepy Puppet Guy. So long as we stay in the restaurant of public markets there’s no way to eliminate our interaction with Creepy Puppet Guy entirely. No doubt he will try to follow us around from table to table. But we don’t have to engage with him directly. We don’t have participate in his insane conversation. No one is forcing you keep a TV in your office so that you can watch CNBC all day long! Look … I understand the appeal of a good marketing campaign. I live for this stuff. And I understand that we all operate under business and personal imperatives to beat our public market benchmarks, whatever that means in whatever corner of the investing world we live in. But I also believe that much of our business and personal discomfort with public markets today is a self-inflicted wound , driven by our biological craving for Narrative and our social craving for comfortable conversations with others and ourselves , no matter how wrong-headed those conversations might be. Case in point: if your conversation around actively managed stock-picking strategies – and this might be a conversation with managers, it might be a conversation with clients, it might be a conversation with an Investment Board, it might be a conversation with yourself – focuses on the strategy’s ability to deliver “alpha” in this puppeted market, then you’re having a losing conversation. You are, in effect, having a conversation with Creepy Puppet Guy. There is a role for actively managed stock-picking strategies in a puppeted market, but it’s not to “beat” the market. It’s to survive this puppeted market by getting as close to a real fractional ownership of real assets and real cash flows as possible. It’s recognizing that owning indices and ETFs is owning a casino chip, a totally different thing from a fractional ownership share of a real world thing. Sure, I want my portfolio to have some casino chips, but I ALSO want to own quality real assets and quality real cash flows, regardless of the game that’s going on all around me in the casino. Do ALL actively managed strategies or stock-picking strategies see markets through this lens, as an effort to forego the casino chip and purchase a fractional ownership in something real? Of course not. Nor am I using the term “stock-picking” literally, as in only equity strategies are part of this conversation. What I’m saying is that a conversation focused on quality real asset and quality real cash flow ownership is the right criterion for choosing between intentional security selection strategies, and that this is the right role for these strategies in a portfolio. Render unto Caesar the things that are Caesar’s. If you want market returns, buy the market through passive indices and ETFs. If you want better than market returns … well, good luck with that. My advice is to look to private markets, where fundamental research and private information still matter. But there’s more to public markets than playing the returns game. There’s also the opportunity to exchange capital for an ownership share in a real world asset or cash flow. It’s the meaning that public markets originally had. It’s a beautiful thing. But you’ll never see it if you’re devoting all your attention to CNBC or Creepy Puppet Guy.

Bumps In The Road

There are frost-heaves ahead. Is your portfolio ready? Click to enlarge Photo: Kevin Connors . Source: Morguefile At this time of year in New Hampshire, we have to deal with frost heaves. Rain and melt-water from winter storms seep into the roadbed, then lift the road when the water re-freezes. How we deal with the bumps says a lot about what kind of people we are. Some folks sail blithely through, figuring that their car’s shocks can handle the stress. That’s fine as long as they have a good suspension – and strong stomachs! Some of the bigger bumps can really rattle you. Others slow down, picking their way through, creeping over the biggest heaves. That’s fine as long as you don’t need more momentum later, like when you’re going uphill on a snowy day. Still others start to cruise moderately through, but they seem to find perfect speed to maximize effect of the bumps. Their vehicles shake more and more violently, until it looks like their cars are skipping and hopping. From behind, you can see them bouncing inside the car. My engineer daughter tells me that they’ve found a resonance frequency that does the maximum damage. It’s like this in investing. If you see a rough patch ahead, you can just cruise through, riding down and riding back up, if you have the stomach for it – and no loose fillings! Or you can raise cash, lowering your expected return in the short run in exchange for the peace of mind that comes from having dry powder. That’s the go-slow approach. But you really don’t want to be shaken around and panic, selling as the market tanks and buying back in after things get more expensive. That’s a sure way to bottom out – or get launched right off the road! Click to enlarge S&P 500 over the last 20 years. Source: Bloomberg Frost heaves present us with bumps in the road – like the squiggles and jiggles of the market. It’s good to know how to deal with them. Because after they subside, it will be time for mud season.

Things Stock Screeners Miss, Part 1 – Why Is This Stock So Cheap?

Summary Investors that heavily rely on stock screeners for new investment ideas should be cognizant of screener limitations. This article will provide some common examples of low P/E stocks that may be included in your stock screener output. Warren Buffett famously stated that he is “85% [Ben] Graham and 15% [Phil] Fisher”. Retail investors should not ignore qualitative analysis when considering investment ideas. The internet has drastically reduced the information asymmetry between institutional investors and your average retail investor. The internet has introduced investors to discount brokers — do you remember the E*Trade Financial (NASDAQ: ETFC ) ” Wasted 2 Million Bucks ” ad? — and stock screeners. They can be credited for reducing the frictional costs of trading by reducing trading commissions and both the costs and time associated with equity research. Score a big win for the Average Joe investor! However, stock screeners have limitations that can be easily forgotten as you grow more accustomed to using them. Nearly all free and most paid stock screeners are limited to numerical filtering and sorting, with a minimal amount of qualitative analytical functionality. As long as investors are consistently aware of these limitations, stock screeners can be an extremely valuable research tool. This article will provide examples of situations that may cause a stock to appear in your screener output, and how to determine if it is truly undervalued or a likely value-trap. Large Expected Decline in Earnings or Major Ongoing Litigation These stocks tend to be well-known companies that look “cheap” on both an absolute and relative basis. Without digging deeper, it would appear as if Mr. Market has temporarily lost his mind and provided you an outstanding investment opportunity. As Lee Corso would say, ” Not so fast, my friend! ” Investors need to do some scuttlebutt and read the company’s annual reports to confirm why a company is selling at low valuations. Below are some common situations that may cause a stock to appear cheap on a stock screener (some of these situations can provide outstanding returns for investors, if correctly handicapped): Loss of a large contract or customer Major litigation or recall of their product(s) Accounting scandals/Restatement of financials Retirement or Death of an important employee (such as the founder and/or the CEO) Large one-time loss [without impairing the core business] The following are some examples of each situation: Loss of a major contract: For the past two decades, NeuStar (NYSE: NSR ) has been the administrator of the telephone-number portability contract handed out by the Federal Communications Commission. The contract, which allows consumers to take their telephone number to other service providers, gave NSR a rolling 5-year monopoly on telephone portability. This SA article attempts to decipher the effect of the contract lose on NSR’s financials, which accounted for 50% of NSR’s total revenue and roughly 75% of their gross profit. While NSR currently trades at a TTM P/E of 8.3x, it is unlikely NSR will be profitable in the future with their current businesses. An investor purchasing based on a stock screener’s output may be shocked in 12 months to learn that earnings have all but disappeared. Major litigation: The most commonly cited example of major litigation is the “mother of all lawsuits”, the Tobacco Master Settlement Agreement of 1998, which held Phillip Morris (NYSE: PM ) (which has since spun-off Altria (NYSE: MO ), which is better known as Phillip Morris USA – maker of Marlboro cigarettes), R.J. Reynolds (NYSE: RAI ), Brown & Williamson (NYSEMKT: BTI ), and Lorillard (now part of R. J. Reynolds) responsible for at least $206 billion dollars , to be paid over 25 years! Although many of these stocks have performed well over the decades, investors have certainly earned much lower returns on capital than the historical returns (from the perspective of an investor in 1998). A more relevant example is the recent Volkswagen ( OTCQX:VLKAY ) emissions scandal that surfaced roughly a month ago. The consequences are still not fully known at this time, but VLKAY has been found to have falsified US pollution tests of at least 500,000 diesel engines with software that made the cars appear to be cleaner during testing than during actual road operation (the software hid pollution nearly 40x greater than allowable levels [for nitrogen oxides]). VLKAY currently trades at a TTM P/E of 5.75x (-43.4%, including dividends, since 4/1/15), lower than American car companies even though VLKAY was previously thought to be of higher-quality and having a stronger growth profile than its peers. Investors who think VLKAY is selling at bargain prices should be aware of the potential costs ( estimates of > $18b ) of both direct fines and repairs as well as potentially lower sales due to brand damage. This type of situation is so tempting because it can also be the source for outstanding long-term returns. Although there are many examples of accounting scandals at public companies (certainly many more than there should be), there is one example that continues to stand out to this day, Enron . The name “Enron” is synonymous with corporate greed and the realization of their accounting fraud also caused the dissolution of the major accounting firm Arthur Anderson , due to their own role. One of the only positive consequences of the scandal was the introduction of the Sarbanes-Oxley Act , which drastically improved the accounting and auditing of corporations. This well-intentioned law introduced new white-collar criminal offenses and increases associated criminal penalties and improved overall corporate responsibility. It is one of many changes that have generally made the equity markets safer for retail investors. It is often extremely difficult to handicap the odds of recovery for companies in the middle of an accounting scandal. There are numerous other examples of accounting scandals that leave equity holders with nothing. Investors are usually better off to avoid this type of situation altogether and this is one of the worst reasons a stock may appear to be cheap on a stock screener. Retirement/Death of a key employee: Perhaps no leader in the 21st century (and much of the 20th century) was more important to their company than Steve Jobs was to Apple (NASDAQ: AAPL ). Known for his turtlenecks and highly anticipated (and never disappointing) news conferences, Steve Jobs resigned from his position as chairman and CEO on August 24th, 2011 (he would sadly pass away less than two months later on October 5th, 2011). Stock screeners are unable to capture the importance of leaders and AAPL’s fortunes always seemed tied to whether Jobs was on the payroll or not. At the day of his retirement AAPL’s stock fell -5.5% even though numerous sell-side investment analysts came out in support of AAPL’s future prospects. This SA article does an excellent job of capturing the investment community’s opinions at the time. This is one of the rare reasons a stock may be relatively cheap and it may still be a strong investment opportunity. Rarely can one person so drastically improve the value of a company like Steve Jobs did over his lifetime for Apple, yet nearly everyone believed [correctly, in hindsight] that APPL would be just fine without him. Investors who purchased AAPL on the day of Jobs’ retirement have earned more than 20% compounded returns, excluding the dividend. In general, outgoing CEOs can provide an excellent opportunity for investment and this is one of the few things stock screeners can pick up. Large one-time loss [without impairing the core business]: These are generally the most profitable situations, but can also be the most difficult to recognize at the time. Stock screeners will generally catch these stocks if you search for low P/E and high ROE or ROIC. However, there are two important assumptions that must both be true for this situation to lead to high expected returns going forward. 1) This must truly be a one-time loss and 2) the core operating business must be unaffected by whatever caused the loss. Again, both of these must be true to provide an excellent investment opportunity. This situation can look a lot like situations #1 and #2 since they all involve a large one-time loss. However, situation #1 obviously impairs the core business by definition since the large customer or contract often represents a substantial portion of the company’s overall revenue and profitability. Situation #2 may overlap with this situation, at times, but again the key difference is whether the core business was impaired or not. The current case of VLKAY provides an excellent on-going case study since analysts are currently trying to determine how much the company will ultimately owe in fines, how much in additional fines will VLKAY be liable for (due to the property damage caused to VW car owners through lowered resale value), and over what time period these damages will need to be paid. An investor can estimate the answer to each of these questions and try to model VLKAY’s liquidity situation to estimate whether they will survive or not. British Petroleum (NYSE: BP ) went through a similar situation with the Horizon oil spill . After a temporary bounce in the stock price, BP has since underperformed its large-cap oil peers as they were forced to sell off many assets, which impaired their core business. We can find examples of successful investments within this situation by looking at Berkshire Hathaway’s (NYSE: BRK.B ) stock portfolio. Warren Buffett first invested in American Express (NYSE: AXP ) in Jan-1964 after the stock had fallen -43%. The stock fell because it was discovered that AXP had provided loans against the watered-down vegetable oil inventory of Anthony De Angelis, making the collateral backing the loans nearly worthless and drastically affecting the confidence of the vegetable oil market as a whole. Soybean oil futures crashed by 30% in throughout the following week and the incident became known as The Great Salad Oil Scandal . A major difference between the salad oil scandal and the VLKAY or BP incidents was the fact that AXP’s large loss occurred in a non-core business which provided loans on warehouse receipts. AXP’s main business at the time was issuing traveler’s checks and their loan losses were immaterial in comparison to both the notional amount of traveler’s checks and the profits from the traveler’s checks business. AXP was never in danger on illiquidity (and thus, was safe from potential bankruptcy) so the large one-time loss provided an excellent entry point for Buffett to enter the stock. Buffett’s investment quickly recovered and AXP became a ten-bagger, providing a more than 1,000% gain. If your stock screener search outputs a quality company trading at low prices and your scuttlebutt research leads you to believe that the core business is not the cause for the low valuation, then you may have just found a homerun investment. Hopefully this article was a helpful reminder of how to view stock screener output for readers. Valuation metrics can only be a portion of any strong investment thesis. As investors, we should always remember that we are buying equity positions in real companies and not just fancy paper. I will provide a second part to this article in the coming days that will cover examples of some unique characteristics of equities. Some examples of what will be included in part 2 are uncommon features of stock classes, unique debt covenants, undervalued assets, and many more one-off situations to look out for. Below are the stock charts for VLKAY, BP, and AXP, which show the initial decline and the future results for resolved incidents: Volkswagen: (click to enlarge) BP : (click to enlarge) American Express: (click to enlarge) Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.