From Bleak to Dire-Hindenburg Omen and Fear
(Guest Commentary by Rick Konrad August 26, 2010)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will offer his views on the so-called Hindenburg Omen including its historical reliability in predicting stock market crashes and how many of his clients and general investors are reacting to the recent emergence of this indicator. Rick then discusses two companies, Arris Group and Enstar Group that he currently likes. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog Value Discipline, founder of Value Architects Asset Management, and is a regular guest commentator on MarketThoughts.com (please see The FOMC Old News is No News! 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. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also run 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 graded CFA examinations.
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.
The backdrop seems to go from bleak to dire. A couple of clients in the last few days have talked about the Hindenburg Omen and almost everyone seems nervous and unwilling to act. Volume is scant. Conviction is low. It feels like 1982 all over again (at least the pre-August portion of 1982.)
First, let's talk about the Hindenburg Omen (HO), that technical indicator that seems to have received an inordinate amount of attention. Have a look at the Google Trends picture of how widespread this indicator has been searched this year versus its "discovery" in 1985:
The HO received considerable attention based on a recent Wall Street Journal article. Please see:
http://v.ly/egh (WSJ subscription required). An excellent review of this indicator's relevance in Safe Haven is presented here: http://v.ly/egj. As the article indicates, "A confirmed Hindenburg Omen is not a guarantee of a stock market crash. The odds of a crash based upon the history since 1985 is 29.7 percent. That means the odds we will not have a crash are quite high, at 70.3 percent. However, since a stock market crash is akin to economic death in many circles, you can look at the situation like this. If you were hearing from your doctor that the surgery you are contemplating stands a 30 percent chance of you dying, that becomes a very high percentage probability - one you likely do not want to take if the surgery is not absolutely necessary. A 30 percent probability of a stock market crash is extremely high when you consider that there have been only eight over the past twenty-five years, and the normal odds of a crash happening randomly are only about one-tenth of one percent. You now also have to factor that the Fed is pumping liquidity to prevent crashes once these signals occur. So you do not want to go short the farm."
A recent blog by CXO Advisory Group does some additional statistical testing of this indicator. http://v.ly/egk. I particularly enjoyed the statistical thinking of CXO here. As they conclude:
In summary, evidence from simple tests of a publicly available set of confirmed Hindenburg Omens suggests the possibility of usefulness, but reservations regarding small sample size and potential sample bias are strong. The vivid image evoked by the name may be an important factor in investor and media attention to the Hindenburg Omen.
My conclusion can be drawn from President Franklin Roosevelt's inaugural speech, "The only thing we have to fear is fear itself."
Edmund Burke, some 300 years ago wrote, "No passion so effectually robs the mind of all its powers of acting and reasoning as fear." After more than 30 years of running money, there is always a knot in my stomach when I buy into an ugly market. One of my wisest mentors used to say, "You've got to keep swinging the bat." So true in Little League ball, but also in your investment life.
Though it may be an exaggeration to describe the recent bout of selling as indiscriminate, it is becoming abundantly clear that fundamentals have taken a back seat to liquidity and macro concerns. Given the expiry of a number of the targeted stimulus programs (notably housing tax credits) and China's actions to cool inflationary pressures, a period of economic "chilling" should not be terribly surprising to any of us.
The 12.4% month over month drop in new home sales in July, to 276,000 from 315,000 in June, is worse news than the 27% month over month drop in existing sales reported yesterday largely because of its more timely nature. New sales are measured at an earlier stage of the home-buying process than existing sales (contract signings versus closings) and had already fallen by 32% immediately after the homebuyer tax credit expired at the end of April. Yet, it still seems intuitively that we are still feeling "hangover" after-effects of the expiration of the housing credit. Despite 30-year mortgages at record lows of 4.55%, the rebound in housing will be modest.
It still strikes me that second quarter earnings season has verified recovery both here in North America as well as other parts of the world. Yes, it is moderating, but it seems it is largely on track.
As usual, a couple of names to think about that we think may be of interest:
Arris Group (ARRS): Following disappointing earnings in its most recent quarter, ARRS has gotten creamed from $13 down to around $8.00. Revenues had dropped Q/Q by some 15%. Despite some poor near term prospects, there is considerable strategic value in this name.
ARRS is a supplier of communications equipment primarily to cable service providers. The company's head-end and customer premise equipment allows cable network operators to provide video, data, and voice services to cable subscribers. In particular, the organization has built very strong equipment franchises in Cable Modem Termination Systems (CMTS) and Embedded Multimedia Terminal Adapters (EMTAs). ARRIS is worldwide leader in EMTAs, with approximately 38% market share (2009). In CMTS equipment, they hold the #2 spot worldwide with 31% market share (2008). With the acquisition of C-COR in Q4'07, the company also gained exposure to other key product areas: 1) cable access infrastructure; 2) on-demand equipment and software; and 3) Service Assurance software for cable operators. The company has more recently attempted to further increase its presence in video networking though the launch of its D5 Edge QAM and its recently announced acquisition of EGT, a small encoding vendor. ARRIS is a play on: 1) the DOCSIS 3.0 upgrade cycle for CMTSs and EMTAs; 2) cable network bandwidth growth; 3) increasing competition among service providers; and 4) cable VoIP penetration.
Priced at about 5 times trailing free cash flow, it seems to represent decent value. With a market cap of just over $1 billion, debt of $215 million and cash of over $600 million, the company has an enterprise value of only $600 million.
Enstar Group (ESGR): Imitation is the sincerest form of flattery. ESGR seems to want to emulate the success of Berkshire Hathaway in many ways. Rather than actively managing growing insurance premiums akin to Geico (and a fond farewell to Lou Simpson...you will be missed), ESGR buys insurance portfolios that are in run-off. As it describes:
"Since our formation, we, through our subsidiaries, have completed 24 acquisitions of insurance and reinsurance companies in run-off and seven acquisitions of portfolios of insurance and reinsurance business in run-off and are now administering those businesses in run-off. Insurance and reinsurance companies and portfolios of insurance and reinsurance business we acquire that are in run-off no longer underwrite new policies. In addition, we provide management and consultancy services, claims inspection services and reinsurance collection services to our affiliates and third-party clients for both fixed and success-based fees.
Our primary corporate objective is to grow our tangible net book value. We believe growth in our tangible net book value is driven primarily by growth in our net earnings, which is in turn partially driven by successfully completing new acquisitions.
We evaluate each acquisition opportunity presented by carefully reviewing the portfolio's risk exposures, claim practices, reserve requirements and outstanding claims, and may seek an appropriate discount and/or seller indemnification to reflect the uncertainty contained in the portfolio's reserves. Based on this initial analysis, we can determine if a company or portfolio of business would add value to our current portfolio of run-off business. If we determine to pursue the purchase of a company in run-off, we then proceed to price the acquisition in a manner we believe will result in positive operating results based on certain assumptions including, without limitation, our ability to favorably resolve claims, negotiate with direct insureds and reinsurers, and otherwise manage the nature of the risks posed by the business.
Initially, at the time we acquire a company in run-off, we estimate the fair value of liabilities acquired based on external actuarial advice, as well as our own views of the exposures assumed. While we earn a larger share of our total return on an acquisition from commuting the liabilities that we have assumed, we also try to maximize reinsurance recoveries on the assumed portfolio."
Trading at 1.2 times book value and about 5 times trailing earnings, the company receives the stewardship of Chris Flowers and Chuck Akre both of whom have significant ownership here. Insiders hold about 41% of the firm.
Disclaimer: I, my family, and friends do not currently have a position in either Arris or Enstar.