The Death of Equities Revisited
(Guest Commentary by Rick Konrad – September 9, 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 revisits the late 1970s/early 1980s when the mainstream media declared “equities were dead,” and discusses the similarities with today's institutional and retail behavior and sentiment. Rick likes what he sees from a contrarian standpoint. Rick also argues that there are always good, value companies that could be purchased in any market environment—ending with a “classic” Benjamin Graham screen that has outperformed the S&P by a significant margin over the last five years. 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 “From Bleak to Dire-Hindenburg Omen and Fear” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address should you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. 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.
In a recent survey, some two-thirds of the American public believes that the US economy is already in the second dip of the double dip recession. As we all know, many individual investors have been voting with their feet: The American retail investor has liquidated about $225 billion of equity mutual funds in the last year and instead, has moved $600 billion into bond funds.
However, the beginning of September seemed to mark a bit of an inflection point in the stock market's fortunes. Fears of September and October crashes of the past (how often have we been told that these are the worst months) set us up for a nice bounce. Sentiment has been horrific…so bad that even Mary Shapiro of the SEC made some noteworthy comments about individual investors distrust of markets just last week in a speech to the Economic Club of New York:
Particularly as this may relate to the May 6 “Flash Crash,” the SEC is continuing to “address weaknesses” in market structure that could have contributed to the severity of the May 6 volatility. There has been a related loss of investor confidence in the markets as a result of the crash. Schapiro said that “retail brokers dealers have told” SEC that “individual investors have pulled back from participating in the equity markets since May 6.” What's more, the chairman pointed to an outflow from retail mutual funds, “every single week since May 6.”
The most recent Department of Labor statistics also helped to shift sentiment from the dread of August. Private employment actually increased by +67,000 for August after an upward revision to the +107,000 gain for July. In addition, payrolls were revised up for June and July to show 123,000 fewer jobs lost than previously reported.
Juxtaposed against this positive data came some contradictory data released just a couple of hours after the Department of Labor release. The Institute for Supply Management dropped to 51.5 in August from 54.3 in July, dangerously close to a reading below 50 which would signal contraction. The employment component fell to 48.2 from 50.9, indicating net job layoffs in the private sector, while new orders also declined to 52.4 from 56.7.
It is easy for us to get caught up in the stat of the day game, what someone has described as “drive-by investing.” When one loses perspective of a longer term horizon, one can get dragged into assigning far too much importance in the relevance of today's statistic. Generally, the information content that can be derived from a single data point tells us essentially zero about value, a significant portion of which relates to future cash flows rather than looking backward. Also, in this incredibly politically charged environment a couple of months before the mid-term elections, I tend to be far more suspicious of the quality of the information being released. Economic releases can be politicized if not propagandized. Later revisions would revert the statistics back to some semblance of truth.
Put bluntly, putting too much weight on numbers that have no relevance and are likely wrong and subject to significant revision later seems like a rotten way to run a portfolio.
Broad sweeping generalizations about the death of equities also tend to get publicized at significant inflection points in stock market history. Perhaps the most famous one was the “Death of Equities” Business Week article of the early 1980's. Here are a few excerpts:
“The masses long ago switched from stocks to investments having higher yields and more protection from inflation. Now the pension funds--the market's last hope--have won permission to quit stocks and bonds for real estate, futures, gold, and even diamonds. The death of equities looks like an almost permanent condition--reversible someday, but not soon.”
“At least 7 million shareholders have defected from the stock market since 1970, leaving equities more than ever the province of giant institutional investors. And now the institutions have been given the go-ahead to shift more of their money from stocks--and bonds--into other investments. If the institutions, who control the bulk of the nation's wealth, now withdraw billions from both the stock and bond markets, the implications for the U.S. economy could not be worse. Says Robert S. Salomon Jr., a general partner in Salomon Bros.: "We are running the risk of immobilizing a substantial portion of the world's wealth in someone's stamp collection." Until now, the flight of institutional money from the financial markets has been merely a trickle. But it could turn into a torrent if this year's 60% increase in oil prices touches off a deep recession whilepushing inflation sky-high. As it is, the nation's financial markets and its capital flows have been grossly distorted by 13 years of inflation. Before inflation took hold in the late 1960s, the total return on stocks had averaged 9% a year for more than 40 years, while AAA bonds--infinitely safer--rarely paid more than 4%. Today the situation has reversed, with bonds yielding up to 11% and stocks averaging a return of less than 3% throughout the decade.”
Now, let's move ahead 30 years to today. The head of global strategy for Citigroup at the beginning of the month declared: “The 40 year cult of equities is dead.”
“Equities in Japan and Europe trade on dividend yields higher than their respective government bonds. That is only 10% away on the S&P. Of course, this de-rating of equity against bonds reflects current double-dip and deflation fears, but it also a profound reassessment of both asset classes. The cult of the equity is dead. Long live the cult of the bond. It will take more than the avoidance of a double-dip to turn the equity outflows around. Sure equity prices would probably rise in the short term if that were to happen, but a sustainable rerating could only be achieved if investors were to be attracted back to the asset class. Although likely to be painful in the short run, an inflation-inspired global bond sell-off would probably offer the best chance of that happening. That still seems pretty unlikely for now.”
“Investor appetite for global equities is falling. Figure 3 [below] shows that in 2009 US private sector pension funds held 55% of total assets in equities compared to 70% in 2006. Figure 4 [below] suggests that UK pension funds cut their equity weighting to 39% in 2009, down from the 76% high in 1993. The 2009 rebound in equity prices has helped to reverse some of this decline in equity weightings, but most investor intention surveys suggest that the secular reduction in equity weightings is likely to continue.”
Per ft.com/alphaville September 2, 2010
We continue to avoid broad brush comments about aggregate market valuations, macroeconomics, and politics. We continue to find a few securities where we believe that their valuation dismisses any future prospects. Systematic approaches to buy what “smells” as a contrarian often provide superior returns.
One such approach was developed by Benjamin Graham many years ago as his “Enterprising” selection. Using relatively simple criteria such as current assets having to exceed current liabilities by 50%, restrictions as far as total debt, and constraints regarding price to tangible book, it is fairly easy to build some interesting screens.
I back-tested one of my screens over the last five years and the results were fairly remarkable. One hundred thousand dollars invested in the S&P over this period resulted in a terminal value of $88,300. Using the old and what many may view as antiquated Graham criteria (with a few additional personal touches) and re-balancing quarterly, provided a terminal value of $143,000, a compound rate of return of about 7.4%. Not terrible for a period when many of us were hiding under our desks.
Interestingly, the model added relative value in both up and down periods though it did fail to add absolute value in those down periods. In up quarters where the S&P averaged a gain of 5.91%, the model gained 9.24% adding about 3.30%. In the down quarters where the S&P averaged a loss of 9.45%, the model lost 6.82% again adding about 2.5% to the index.
What does the model suggest currently? Here's a few names:
||Air T, Inc.
||Ameron International Corp
||Apogee Enterprises, Inc.
||Cheung Kong (Holdings) Ltd
||EDCI Holdings, Inc.
||Ecology and Environment
||Companhia Paranaense de Energ
||Flexsteel Industries, Inc.
||Formula Systems (1985) Ltd.
||Gulf Island Fabrication, Inc.
||Industrias Bachoco, S.A.B. de
||Communications Systems, Inc.
||Kaiser Aluminum Corp.
||Kewaunee Scientific Corp
||The Monarch Cement Company
||Nordic American Tanker
||National Energy Group, Inc.
||Preformed Line Products Company
||Standard Motor Products, Inc.
||Spartan Motors, Inc.
||Domtar Corp. (USA)
||Virco Mfg. Corporation
As you can see, most of these are not mainstream names. Most have fairly modest returns on invested capital, but have shown some improvement over their five year averages. In general, most have shown operating margins in the trailing twelve months that are below the industry averages. Many are not generating free cash flow at this point. Many are also very small cap. Be careful and do your own digging and analysis. I will have additional comments both here and in my blog over the coming weeks.
Disclaimer: I, my family, or clients currently own positions in Cheung Kong, Gulf Island Fabrication, Noble Corp, Tidewater, and Universal Corp.