Lessons Learned and Looking Forward
(Guest Commentary by Rick Konrad – December 20, 2007)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.
In this commentary, Rick will be sharing his thoughts on the many lessons financial participants have learned this year, as well as what he sees are important fundamental changes in the global financial markets going forward. Rick will end the commentary with four of his current favorite individual stock ideas. (Henry's note: Over the next couple of weeks, I will also be articulating my “market thoughts” on the upcoming year as well as some reflections on 2007). Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “The Price of Conformism” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Henry is taking a well-deserved R&R break and I suspect most of us who are involved in investments feel we deserve a break as well. Those of us who have followed Henry's advice managed to sell out in May with the Dow at 13,299, nailing down a very impressive gain and avoiding a lot of agita. The institution of a short position at 13,956 has provided a substantial gain as well. In his last commentary, Henry has alluded to a potential buying opportunity lying ahead in the U.S. market but just not yet. What should an investor do as 2008 beckons? Year ends represent a time to review, reflect and to plan and I intend to provide some of each at this time….i.e. a few market thoughts.
I think one of the lessons of 2007 is the importance of a mosaic approach in approaching investments. The rapid deterioration in the availability of capital and the rapid slowdown in the US economic picture required a broader perspective than what bottom-up analysis provides. Top-down macro insights are needed especially at economic inflection points. An awareness of market sentiment and other technical indicators also went a long way to avoiding trouble. Henry's record amplifies this!
The development of these significant macro trends became increasingly apparent as the year moved on…the market uptrend slowed, stalled, and died. The uptrend in energy prices, the ballooning of metals prices, the decisive depreciation of the US dollar, the depression of housing, and the concomitant contraction in earnings growth are all trends that were evident to macro players much earlier than to Wall Street analysts and to some investment gurus. Take the case of Mohnish Pabrai, often viewed as a protégé of Buffett. Relying primarily on fundamental principles and a culture of patience, Mohnish rode his investment in Delta Financial (DFC) from initial positions at $9.00 into a reporting position (greater than 5% ownership) and into a 99% loss in barely more than a year. Despite authoring a book on a mosaic approach to investing, echoing Charlie Munger's beliefs, Mohnish could not listen to all of the “disconfirming” evidence and kept buying the false certainty of his valuation. I am not chastising the man who I regard highly, but rather counsel that even the best among us fall prey to fooling ourselves and worse yet, ignore the obvious.
Another valuable lesson of 2007 was that it is easy to be lulled into believing that gradualism is the norm. Despite the best wishes of central bankers, economies tend to respond with significant step function shifts. Capital markets tend to be even more volatile. The return of dispersion across sectors and regions as well as the return of volatility was a major theme for the past year largely because of this. Volatility has afflicted all markets with risk premia rising accordingly. One of the best perspectives on this can be gained from the corporate bond market where spreads between Treasuries and BBB credits opened by 50%.
A third lesson…private equity buyers ain't got nothing without being backstopped by capital! A valuable lesson has been imprinted here as well. Until early 2005, most such buyout deals equity deals had an escape clause. The contracts generally permitted buyers to terminate the acquisition agreement without penalty if, despite the buyer's reasonable (or reasonable best) efforts, the debt financing necessary to consummate the transaction proved to be unavailable. Historically, most buyers needed this “back-door” just in case! Of course, a “deal” with a financing condition has far less appeal than one without. Private equity buyout firms were at a disadvantage relative to corporate strategic buyers who could draw down on their own existing credit lines rather than have to seek additional financing.
Earlier this year, clearly a peak in private equity buyouts occurred coincident with an important contractual change. The competition for buyouts became so rampant that financing conditions were dropped. “Seller-friendly” acquisitions became the norm….financing conditions disappeared. Other terms and conditions have also been watered down. This environment, since the credit crunch, has made the private equity buyer look much less powerful than he had been and has led to a rise in strategic buyers. Sellers are demanding ever higher break up fees to ensure that the deal is actually going to be completed.
The fourth lesson from 2007 is the rising influence of new capital market players. Financial power which had been the domain of developed economies has dispersed into new hands. Think of the Abu Dhabi deal for the new Citigroup preferred and the Singapore deal for UBS. Oil rich countries and Asian central banks are now among the largest providers of capital in the world. According to McKinsey, in 2006, oil-exporting countries became the world's largest source of global capital flows, surpassing Asia for the first time since the 1970's. The recycling of dollars as a result of high prices paid by consumers largely in the developed world has created a huge cache of savings elsewhere. This petrodollar liquidity has buttressed the capital needs of our markets. Sovereign wealth funds such as the Abu Dhabi Investment Authority hold nearly $1 trillion in foreign assets. Beyond petrodollars are the reserves of Asia's central banks which hold some 65% of the global total. That's right, a whopping 65%! As Dorothy said, “Toto, I've got a feeling we're not in Kansas anymore.”
What about today's situation especially my concerns? The European Central Bank stunned investors by pumping $500 billion of funds in to markets. There were plenty of takers; some 390 banks both public and private stepped up to the trough for access to these low cost funds. The US Federal Reserve also announced its own series of special auctions. The Fed said that it received requests for $61.6 billion in loans from 93 bidders, versus the $20 billion supplied. Clearly, as both cases illustrate, there is very strong demand by banks for short-term funds. Fed easing, which seems to be orchestrated by outside forces more so than within the Fed, failed to prevent the last two recessions in 1990 and 2001, both of which began after the Fed started cutting rates. Recession worries loom quite high. I still view a recession as having less than 50% probability but that stand is becoming more difficult to justify. The decoupling of economies and markets that has occurred over the last several years has been very evident in both economic statistics, particularly for emerging economies and in their capital markets. However, my concern, especially for businesses in the Eurozone, is a potential re-coupling. Recent Eurozone equity underperformance as well as the behavior of their financial institutions with significant involvement in sub-prime debt suggests that these markets may correlate more with the US than they have.
Another concern is the huge gap between economist estimates of corporate earnings and that of Wall Street. Analysts had been consistently too cautious in their profit forecasts for some years, but that tide has turned. Most analyst projections of margin expansion and sales growth seem detached from economic reality. Corporate earnings growth that has benefited from the strong performance of financial services companies will be hampered by a dearth of mortgage origination and collateralization revenue.
The uncertainty of the political backdrop is of real concern. As a Canadian, I will remain unbiased when it comes to US politics but the capital market impacts are significant. According to Ned Davis Research, the third year (the Pre-Election Year) has been positive every year since 1943. We seem to be cutting it very close this year. But also note that when the incumbent party has lost the election, the market's election year performance is worse than it has been in other election years. According to NDR, in election years, the S&P has gained a mean of 8.4%, but in the twelve years when the incumbent has lost, it has gained only about 1%.
The Chinese Central Bank has moved to tightening to prevent economic overheating and has placed restrictions on bank lending to curb overinvestment. China's export sector could be threatened by global economic weakening, potential strengthening of the Yuan, rising interest rates, the elimination of export incentives, as well as the expiry of some tax incentives. How overplayed is the August Olympics?
Let me take the opportunity to wish you and yours a terrific holiday! Best wishes for a successful and prosperous New Year. Since it is the holidays, let me present a few stocking stuffer ideas that I am thinking about or already own. I will be reviewing most of them in Value Discipline over the next few weeks.
AmTrust Financial (AFSI) is a small property casualty insurer with focus on workers comp, specialty risk such as consumer goods extended warranty, and middle market specialty property and casualty. The company is multi-national and focuses on underserved niche markets that are low hazard, predictable and non-catastrophic…a niche strategy that makes a lot of sense. With a 25% ROE, an A- rating from AM Best, and no exposure to sub-prime, it appears to offer a great combination of growth and value.
Monaco Coach (MNC) The selling of big motor coaches and other recreational vehicles seems like the most easily deferred expenditure in the world at a time of high energy prices. But sustainable earnings are above the net earnings under GAAP, net income has been positive for the last three quarters, and gross margins on a TTM basis for September 2007 is higher than they were for the corresponding TTM period ending September 2006. Working capital needs which represented a low (by industry standards) 13% are now down to a remarkable 6.4%. Capex at this point is nil. The company plans to buy back $30 million of stock, a new avenue for this firm. Insiders are also buying.
InterDigital (IDCC) InterDigital Communications Corporation (IDCC) designs, develops, and licenses digital wireless technologies which are incorporated into wireless equipment, and mobile handsets. The bulk of the company's revenues are generated through licensing its intellectual property, primarily to original equipment manufacturers (OEMs) of 2G, 2.5G, and 3G mobile handsets and infrastructure. Essentially, the business consists of two parts, R&D to develop intellectual property and a legal department to defend it. The company just won a significant legal battle with Samsung, the result, is an incremental $2.50 plus in cash per share.
Finally, MDC (MDCA) MDC Partners is essentially an aggregator of ad, marketing, and PR agencies much like United Asset Management or Affiliated Managers (AMG) consolidate investment management firms. One of its largest, Crispin Porter and Bogusky has been the most awarded ad agency in the world for the last five years. Clients for Crispin include Coke, Miller Lite, Nike and Volkswagen. I suspect that the valuation of Crispin alone in the private market equals that of all of MDCA in the public market. There's another thirty plus agencies that are part of this group.
Disclaimer: I, my family, or clients own positions in IDCC and MDCA.