Tag Archives: pro

Basic Maths – If An Industry Has A Longer Economic Cycle, Valuation Metrics Should Reflect This

By Kevin Murphy Why might an investor look at a business trading at the top of its historic price range and think it cheap yet, on a different date, look at the same business trading near its lows and think it expensive? It should not really be possible, but it can happen if the investor is using a one-year earnings number – be that forward-looking or historic – to arrive at their valuation metric for a business. The inherent problem with this approach is that a business’s earnings can vary very significantly from year to year. As such, a single year’s figures may be good, bad or indifferent and, unless you have studied the history of the business, you are not going to know which it is. Far better, we would argue, to use a valuation metric that better takes account of the economic cycle. Long-term visitors to The Value Perspective will by now have guessed we are warming up to an article on our preferred valuation metric, the cyclically adjusted price/earnings ratio. Known for short as the ‘CAPE’, this effectively smooths out the peaks and troughs of an economic cycle by dividing a business’s current share price by its average profits over a number of years, adjusted for inflation. The idea of the CAPE was originated in the 1930s by value gurus Ben Graham and David Dodd, who suggested that seven or, better still, 10 years was enough to reflect the earnings cycle of a business or market. We, however, are no longer sure that universally holds true and since that may sound close to sacrilege – especially coming from a site dedicated to value investing – we should quickly explain why. Over the last 12 months or so, basic materials businesses – in other words, mining shares – have been showing up as increasingly cheap on a CAPE basis. Until recently, however, we have held back from investing and the reason we have done so is because we do not believe that even 10 years comes close to encompassing a full economic cycle for a mining company. From the initial discovery of iron ore, copper or whatever it may be – through obtaining planning permission to develop the site as well the necessary permits to operate it to sorting the transportation network, buying plant and machinery, hiring workers and so on – it perhaps takes a mining company five years just to bring a mine up to speed. In short, these are long-cycle businesses. So while we could just set up our computers to screen the market for Graham and Dodd profits, we believe it makes more sense to get to the bottom of what the CAPE metric is aiming to do, which of course is to arrive at an average. And if we believe seven or 10 years is not a long enough time period to generate a meaningful valuation for this sector, the answer is obvious – use a longer period. The past 18 months notwithstanding, the last decade has broadly been a very good one for miners. Go back 20 years, however, and commodity prices were much lower than they are now – as, by extension, were mining company profits. Averaging out these two contrasting decades should thus offer a much more holistic view of the profitability of the basic materials sector – so that is what we have done. (click to enlarge) Source: Schroders Datastream, 2015 As you can see, the sector currently stands on a 20-year CAPE valuation of 10x, which is very close to every other trough over the period. What particularly catches our eye is the way the sector has tended to bounce each time it has approached those lows while the potential upside, should valuations revert towards their long-term mean of 16.2x, helps to explain why almost every stock we have been looking at over the course of the last month has been in this space.

Built For Action

We humans are doers. We want to move, to make, to accomplish, to act. We do not take kindly to sitting idly by. We do not enjoy being bored and most of us struggle to sit quietly alone. It is increasingly easy to distract ourselves, to push away the quiet. Unless I’m asleep I am within arm’s reach of my phone about 95% of the day. Why sit quietly when Twitter and Instagram await?! Last year I read 10% Happier: How I Tamed the Voice in my Head by Dan Harris (at the recommendation of this post by Shane Parrish at Farnam Street). It is a great reflection on the difficulty of our busy lives and our ability to focus and slow down. Harris, after having a panic attack on national television, explores a path towards meditation and trying to relieve his anxiety. In doing so, he finds that meditation is hard. It’s really hard. Sitting and trying to focus on a single thing (typically breathing) without being distracted by thoughts of work, family, hobbies, to-do lists, dentist appointments and everything else. We are just not very good at doing nothing. This is especially true as investors. And we really don’t like it when are portfolios do nothing. We’re sitting in the doldrums right now. Returns everywhere are nowhere. Here’s a quick rundown of 12-month returns through 9-15-15: S&P 500: 1.77% Russell 2000: 3.05% Barclays Aggregate Bond: 2.32% MSCI EAFE: -6.34% MSCI Emerging Markets: -23.58% US Real Estate: 1.89% Other than Emerging Markets being pretty painful, those are some pretty unexciting numbers. A weighted average of those for a balanced investor is probably going to put you in the -3%ish range for twelve months. A little painful, but probably not panic-inducing for most. And yet, it itches. You get your statement and look at the numbers and it just tickles your nerves a little bit. “Should I do something?” it asks. “What’s not working?” it wants to know. “Have I made a mistake?” “What should I do?” “How do I fix it?” They are quiet questions, but there they are, lingering in the back of our minds. We only get one chance at this investing thing, and we’re terrified that we’ll get it wrong. We’ll miss out on opportunities or hire the wrong advisor or buy at the wrong time or have to listen to our brother-in-law at Thanksgiving talk about how he nailed it AGAIN this year. Hopefully, we have the other voice too. The calm, rational one that reminds us that we have a plan. A pretty well-thought-out plan. A plan that involves boring years and periods where returns don’t meet our expectations. This voice should remind us that we knew about that going in. It doesn’t necessarily make it easier to remember that, but it ought to handcuff us. Even though we simply hate to do nothing, we should. We are not built for it. We are built for action! If it looks broken, fix it! The problem is that what “looks broken” to us is based on our desperate need for immediate gratification and split-second feedback about our decisions. But split-second feedback makes us absolutely terrible investors. In the moment, we can’t take the long view, so we need to listen to our past selves about why we made the plans we did and how we already know what to do in these situations. Generally: nothing.

Ozymandias On The Street: The Fall Of The Mighty In Fixed-Income CEFS

Taxable fixed-income, closed-end funds have fared poorly in 2015. Highly visible distribution cuts by category leaders have been followed by sharp selloffs and price declines with very high premiums falling to discounts. There may be opportunities in taxable, fixed-income funds although one might want to wait for a decision on interest rates before taking any action. It took a long time but the market has finally decided that the PIMCO High Income Fund (NYSE: PHK ) is not worth a premium. After running a premium in the stratosphere for seven years, PHK closed below par today, just five months after running a premium of 66%. PHK was clearly a house of cards. It was earning less than 65% of its distribution. But investors stuck with the fund and even defended it vigorously long after the writing was on the wall. A distribution cut was inevitable and when it came it wiped the premium off the board. On Sept 1 the fund announced a 15% cut in its distribution. Now, two weeks later (Sept 14), what had been the second highest premium in fixed-income CEFs is gone. This chart shows PHK’s premium/discount history. What you may not realize is that the right side does not show a vertical cut-off of the mountain at the end of the chart; that’s a vertical drop to near-zero. Interestingly, if someone buys the fund at today’s discount, the yield will be 17.4% until PIMCO drops the distribution further. It was that sort of return that driving the premium, and I’d not be surprised to see that premium moving up between now the next cut. Some might argue that with that distribution there is an opportunity, but I’m certainly not among them. Continuing to deliver that distribution after September (ex-date was Sept 9) at today’s -0.43% discount, will mean PHK has to pay out 17.3% on its NAV [Distrib NAV = Distrib Price /(1-(Premium/Discount)]. So, if PHK was a house of cards, parts of that house remain standing. And inevitably they must fall. Look for another distribution cut soon. For those of us not invested in PHK, there is a lesson here. One might choose to avoid all closed end funds, especially in this time of market uncertainty. And the steady declines in fixed-income CEFs ( discussed here ) says that many may have taken that tack. To my mind there is real opportunity in this market even though returns have been dismal and discounts continue to grow. Identifying those opportunities with confidence is going to be tricky however. I’ve written several times about the PIMCO Dynamic Income Fund (NYSE: PDI ), most recently this week . It is, in my view, well poised to provide strong returns in the near- to mid-term future. One of its qualities, which so many funds in this category lack at present, is that it is earning its distribution handily. Its current undistributed net investment income or UNII as a percentage of its distribution is the highest in the category, a category where 55% of funds are failing to cover their distributions from investment income. What other funds might be attractive on this metric? Right now, the strongest subcategory looks to be mortgage bond funds. I’ll be discussing this group in detail shortly, but I’ll mention a few highlights here as preview. The Western Asset Mortgage Defined Opportunity Fund (NYSE: DMO ), the BlackRock Income Trust (NYSE: BKT ) and the First Trust Mortgage Income (NYSE: FMY ) are standouts for their positive levels of UNII. FMY’s modest market cap and volume make it somewhat problematic in terms of liquidity, which is always a consideration in CEFs. DMO and BKT fare better on liquidity metrics. DMO is paying a 10.2% distribution yield; BKT’s is 5.9%. DMO has the best 1yr return on NAV in the category and it has recently dropped to a small discount. Anyone interested might want to start with a hard look at DMO. PDI is another consideration in the mortgage space. Although not a mortgage bond fund its present portfolio (30 June 2015) comprises 66% mortgage securities, so today it is two-thirds of one. The potential advantage is that if mortgages go south, PDI’s management has the flexibility to move out as readily as they moved in. What about those with existing positions? My advice to anyone invested in fixed-income CEFs is to take a look at the NII status of their holdings to see how well the fund is earning its distribution. Negative UNII alone does not necessarily mean one should sell a fund, but a persistent negative on this metric is a most worrisome sign. It could well mean that one should start looking for a suitable exit point. Waiting until distributions are cut to bring them in line with NII can be devastating not only to income, but to the value the portfolio as well. I’ll add as an aside that the value of UNII as an indicator of a fund’s status and distribution stability does not transfer to many of the equity funds. Details are outside the scope of this discussion, but I’ll note many solid equity funds, especially those that use options (option-income or buy-write funds), routinely show negative UNII and its evil twin, Return of Capital. They can even be a part of a fund’s investment objectives as they can create tax-advantages to the shareholder. It’s not clear what the Fed will do this week, but should they finally decide to raise rates, expect a move out of many of the fixed-income funds and sharp increases in the absolute values of discount. That may well be the best buying opportunity since the infamous taper-tantrum. Time spent now searching out quality funds may be rewarded. Disclosure: I am/we are long PDI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.