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First Days And ADM

Well the first days of my break from work are going well so far. We’ve been hanging out at the beach, which has been a nice break from our normal life. Removed from my home repairs and trip planning… I’ve been able to spend time reading, writing and researching potential investments. My hope is to spend a few hours each morning, both now and on our upcoming road trip , reading/writing/researching. While this intentional time doesn’t bring the immediate financial rewards, like clocking in at my former day job, I find it immensely satisfying. We (my wife and I) still spend a lot of “busy time” with our son, but we try to schedule breaks for each other to relax and think. One of the things I’ve been meaning to do is dig into Archer Daniel Midland’s (NYSE: ADM ) financials and business model. Now that I’m unemployed, I have time to do just that. I acquired several hundred shares of ADM stock back in 2008 and held it for several years, before selling the shares for a tidy profit. In the summer of 2012, I again bought a few hundred shares of ADM stock, when the share price dropped from the $30s to about $26. My wife and I were actually on our honeymoon at the time… and I know she was wondering what she was getting herself into. A few months later, the price recovered and we again sold at a tidy profit. We did so another time, this time for a smaller profit. (The short-term swing trades we purchased through my Roth IRA brokerage account for the tax advantages.) You may wonder why I have traded in and out of ADM stock when we otherwise do very little trading. There are a few reasons, but one of the biggest is that until 2015, the share price traded in a fairly consistent range. (Take a look at the stock chart over the last 5 or 6 years.) That range was useful to me, as I was trying to slant the risk/reward ratio in my favor. I was, and am, also bullish on the industry that ADM participates in. While the net margins aren’t great (single digits) and the capital costs are high, ADM has positioned itself well within the food/sweetner/animal feed space. That being said, you may wonder why I didn’t just plan to buy and hold the stock for the next several decades. After all, many investment greats suggest not buying the stock of an individual company unless you intend to hold that stock for a very long time. I clearly had no intention of long-term ownership. The next two sections address what were/are my chief two issues historically, but I thought with so many of my investing friends snapping up shares of ADM, and the share price dropping into the lower $30s, it might be worth a look. Ethanol Ethanol is essentially an alcohol which can be made from various plants. The process requires sugar, so most ethanol in the United States is made from modified corn, sugar beets, or sugar cane. About 10 years ago, ADM got into this business in a huge way. American politicians foolishly, in my opinion, encouraged the production of ethanol through tax incentives and subsidies. At the time, oil prices were very high, and these programs were set up under the guise of “reducing our dependence on foreign oil”. Therefore, ethanol was mixed with gasoline as a fuel additive, because subsidized ethanol cost less per gallon than refined gasoline did. What’s not to like?! Well, I’ve never been a fan of political interference in the business world, particularly as politicians have a horrible record of capital allocation, but my political grandstanding aside, it was a risky bet for ADM. The company spent billions to purchase (or build) the various processing facilities in the appropriate farming regions. While ethanol had legislative support for a few years, the useful life of a processing facility could be expected to far outlast the average politician’s ethanol attention span. Fast-forward a few years, and you can see that the price of oil has fallen tremendously, and with it the margins on ethanol production. ADM’s management has talked about the collapsing, and about the volatility of ethanol margins for a few years now. They have also spoken extensively of the excess capacity of ethanol processing facilities as a result of the federal government subsidizing the building boom of such facilities over the past 10 years. Ethanol margins have actually been negative for nearly 2 years now. Management must know that they made a mistake investing so heavily in ethanol production, because they don’t even break out that part of the business in reports anymore. Instead, it’s lumped in with processing food sweeteners and additives. Unfortunately for the company, the genetically modified corn it purchases to make ethanol isn’t actually useful for anything else. It has been developed for its high sugar content and doesn’t lend itself to human or animal consumption. I guess it can have cattle graze the corn stubble once the ears of corn are harvested. (Makes me glad we grow wheat for human consumption and sorghum for animal grain on our farm.) Anyway, despite the miserable business line, the company has remained profitable and been paid down some debt. Speaking of debt… Debt The companies that make up the long-term holdings in our portfolio tend to have little, or at least reasonable, levels of debt. The reason is obvious. While the profitability of a given business can suffer, it’s really hard to go “bankrupt” if you’re not in debt. ADM’s debt load was my other chief concern a few years ago. The business requires large capital expenditures, which reduces the amount of free cash flow. A few years ago, debt exceeded the cash on hand by a tremendous amount. That, coupled with such a huge push into the ethanol space was enough to make me a trader, or rather than an investor, in the company’s common stock. Fast-forward a few years, and the total outstanding debt per share has fallen by almost 30%. Additionally, the Return on Equity and Net Margins have improved over the last 4 years (to 9.8% and 2.7%, respectively). While not great metrics, they aren’t horrible for such a volatile (and capital-intensive) business. Most importantly, as you can see from the table below, the amount of debt coming due in the next few years is fairly small as a percentage of the total. See the due dates in the table below. You’ll also notice that the bonds due in the next few years have interests rates far above the prevailing rates. These factors, along with the reduction of debt over the last few years should continue to give the company flexibility for the next few years. Click to enlarge ADM’s 2014 Annual Report So, will we invest in Archer Daniel Midland’s common stock over the next few months? We just might. I feel like the company’s financial position has improved over the past few years, though I still don’t love ADM. It has been reporting somewhat poor results for the last couple of years, which, I largely believe, is based on industry headwinds. I think it’s a good sign that against such a tough backdrop, the company has remained profitable and paid down debt. It should gain market share. The common shares currently have a Price-to-Earnings multiple around 11 and sport a dividend yield near 3%. Most interestingly, company insiders have made several stock purchases over the last 3 months. Those purchases have far outpaced the few stock sales and were made at higher prices. I don’t like the business prospects enough to be a long-term investor in ADM, but I like it enough to buy a slug of shares if the price approaches $30 in the near term. Ugh, I know, I’m a hypocrite. What are your thoughts on ADM common stock? Disclosure: I do not currently own shares in ADM, but may buy in the near term. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by GuruFocus.com and Yahoo Finance.

Reducing Volatility While Staying In The Stock Market With USMV

During February, we think investors should consider iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). In ranking approximately 860 equity ETFs, we combine holdings-level analysis with ETF-level attributes, such as bid/ask spread, expense ratio and volatility. According to Sam Stovall, US equity strategist for S&P Capital IQ, since 1946, there have been 56 pullbacks, or price declines of 5.0%-9.99%. They fell an average of 7% over a little more than one month and took fewer than two months to get back to breakeven. There have been 20 corrections (-10.0% to -19.9%) since WWII, erasing an average 14% from the value of the S&P 500. They typically took a bit more than four months to go from peak to trough and a similar number of months to recover fully. We think USMV is strong ETF for consideration for investors wanting to reduce the risk considerations of their overall U.S. equity exposure. We expect the market to remain volatile in February due in part to sluggish earnings and modest economic prospects, but we look to the S&P 500 index to end 2016 much higher than where it is currently trading. As such believe this ETF allows investors to stay fully invested while reducing the risk profile of their overall portfolio. Now is a good time, according to S&P Capital IQ, to look at low-volatility strategies. Yet it is important to understand how USMV is constructed. The ETF is diversified across all 10 sectors, but holds the least volatile securities within the sector. iShares, working with an MSCI benchmark, uses sector bands (+/- 500 basis points relative to a parent MSCI index at the semi-annual rebalance). As such, at year end, financials (22% of assets), health care (20%), information technology (15%) and consumer staples (15%) are the largest sectors. Relative to the parent MSCI index, tech is underweighted, while the other three are overweighted. Other sectors underweighted are industrials (4.5%) and energy (1.9%). From a sector perspective, USMV is different than its peer from PowerShares. That ETF has no sector bands and as such has more in financials (27% of assets) and less in tech (2%). USMV ranks favorably to S&P Capital IQ for all four risk consideration inputs to our ranking. Three of these, S&P Capital IQ Quality Rankings and Qualitative Risk Assessments, along with Standard & Poor’s Credit Ratings, are tied to the holdings. The relatively low risk of these holdings are well suited, we think, in the current choppy market. For example, Johnson & Johnson (NYSE: JNJ ) has an A+ Quality Ranking, a low risk assessment and AAA credit rating. S&P Capital IQ equity analyst Jeff Loo, who has a buy recommendation on the shares, view its capital deployment strategy of acquisitions and stock buybacks positively. In October 2015, JNJ announced a $10 billion stock buyback, and the shares currently have a 3% dividend yield. S&P Capital IQ sees earnings per share growing to $6.50 in 2016 and $6.82 in 2017, driven by pharma growth and restructuring efforts. Meanwhile, McDonald’s (NYSE: MCD ) has an A Quality Ranking, a medium risk assessment and BBB+ credit rating. S&P Capital IQ equity analyst Tuna Amobi, who has a buy recommendation on the shares, noted MCD reaffirmed its capital allocation initiatives after relatively encouraging Q4 results — including a 5% increase in global comparable sales — amid early positive signs on its multi-year turnaround strategy. After last year’s sweeping organizational changes Amobi sees further gradual progress on the turnaround initiatives, including an accelerated pace of global refranchising. S&P Capital IQ sees earnings per share in 2016 rising to $5.39 due to operating margin expansion and share repurchases. In addition, USMV earns a favorable ranking input for its below-average three-year standard deviation of 9.1 (ETFs tracking the S&P 500 index have 10.5). Daniel Gamba, managing director and head of BlackRock’s iShares Americas Institutional Business, told S&P Capital IQ in late January that the increased volatility in equity markets has made institutional investors more tactical in using minimum volatility products to lower risk. We think the increased usage of USMV by institutional investors has been a positive for all investors. The average daily trading volume in the past month spiked to 3.3 million, up from 2.0 million during the past six months. The bid/ask spread is $0.01, lower than most ETFs. In addition from a cost perspective, USMV has a modest 0.15% expense ratio. Year to date through January 27, USMV declined only 3.8%, falling less than half as much as the S&P 500 index. In 2015, during a relatively flat year with the broader index up 1.4%, USMV rose 5.5%. We like USMV based on its underlying holdings and from a cost/liquidity perspective. However, should the market volatility diminish quickly and equities to climb higher, this and other lower-risk strategies are prone to underperform in our opinion. Additional disclosure: http://t.co/AHwSBhyHHt

Dumb Alpha: The Drawbacks Of Compound Interest

By Joachim Klement, CFA The second installment of this series presented evidence that a simple random walk forecast typically performs better than the amassed expertise of professional forecasters for short-term forecasts of about 12 months. In this post, I argue that estimation uncertainty is not reduced for long-term forecasts either, because mean reversion cannot overcome the effects of compound interest. Luckily, there is a range of techniques, from simple to sophisticated, that can help long-term investors with this challenge. The “Muffin Top” Problem As most middle-aged people can confirm, age inexorably leads to a slowing metabolism. If you don’t change your diet, your waistline expands quite generously. In my case, I refused to notice these changes until I grew an undeniable “muffin top” of belly fat above my belt line. Chagrined, I changed my diet and stepped up my exercise, but so far — muffin doin’. This little anecdote is a rather fitting (if unappealing) metaphor for long-term investing. What I tried to force my body to do was to revert back to its original state (the mean), but the forces of mean reversion were not strong enough to do so. This scenario can happen in the world of investing as well. Imagine someone who wants to invest for the next 10 years and who is thus not interested in short-term forecasts so much as the long-term average expected returns of assets. Common wisdom states that, while return forecasts can be widely off the mark in any given year, in the long run, returns should converge towards a rather stable long-term mean. Because of mean reversion, it should be easier to forecast long-term returns than short-term returns. Compound Interest Ruins the Day In an important article in the Journal of Finance , however, University of Chicago economists Lubos Pastor and Robert Stambaugh showed that, in the presence of estimation uncertainty, mean reversion is not strong enough to reduce the volatility and uncertainty of long-term stock market returns. The main reason is that an estimation error in the first year will propagate and compound over the subsequent nine years, an estimation error in the second year will compound over the subsequent eight years, etc. Take, for example, an investment you know will average an annual return of 10% per year over the next 10 years. If in the first year the return is -10%, the average return over the subsequent nine years needs to be about 12.48% per year to make up for this shortfall. In other words, a 20% estimation error in the first year requires a relative increase in annual returns over the next nine years of 24.8%. If, on the other hand, the asset in the first year has a return of 0%, the average return over the subsequent nine years needs to be about 11.17% to make up for the shortfall. So a 10% estimation error in the first year requires a relative increase in annual returns of 11.7%. Half the estimation error requires less than half the relative return increase to make up for the shortfall. The investment results of the first few years have an oversized influence on the long-term investment returns — something that retirement professionals know as “sequence risk.” If you start saving for retirement and experience a major bear market in the first few years, you are much less likely to achieve your long-term financial goals than if you experience a rather benign environment at first and a bear market later. While the research by Pastor and Stambaugh is theoretical in nature, there is empirical evidence that long-term return forecasts are, in fact, just as uncertain and “inaccurate” as short-term forecasts. Ivo Welch and Amit Goyal have looked at the predictive power of many different variables that are commonly used to forecast equity market returns. They find that the forecast error does not materially change for forecast horizons between one month and 10 years. In other words, despite the existence of mean reversion, the uncertainty about future equity returns does not decrease in the long run. Facing the Challenge If long-term return forecasts are just as difficult to make as short-term forecasts, what can long-term investors do to create robust long-term portfolios? After all, we know that traditional Markowitz mean-variance optimization is about 10 times more sensitive to return forecast errors than to forecast errors in variances . There are in my view several possibilities, increasing from least to most in degree of sophistication: The equal weight asset allocation discussed in the first part of this series does not rely on forecasts, and thus is a simple and effective way to create robust long-term portfolios. Minimum variance portfolios and risk parity portfolios do not require any return forecasts and, if done properly, can outperform traditional portfolios by a wide margin. More sophisticated methods like resampled efficient frontier methodologies or Bayesian estimators can include estimation errors into the portfolio construction process and thus create portfolios that are more immune to unexpected events. Whatever technique one favors, there are ways to deal with forecast errors. Most critically, it is time investors take estimation uncertainty more seriously for the benefit of their clients and the long-term success of their portfolios. If you liked this post, don’t forget to subscribe to the Enterprising Investor . All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.