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Mother Nature Sides with the Hidden Flaw

(Guest Commentary by Rick Konrad – October 8, 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 begins by pointing out the increasingly high correlation of stock prices within the S&P 500.  This high correlation is a short-term annoyance for stock-pickers, but a killer for long-short equity hedge funds who are judged on short-term performance.  Rick then offers two of his best stock picks, including a microcap stock.  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 “Cyclical or Not?” 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 if 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.


Though it's been 35 years since my undergraduate degree in a physical science, I was raised in a world of deductive reasoning where premises and assumptions led to some conclusions. When empirical results did not conform to what was expected, they were viewed as anomalous—not conforming to the conventional thinking of the time. Generally, we blamed errors in measurement or flaws in the equipment for these non-conformities. Our motto was, "Mother Nature sides with the hidden flaw."  

We live in a wonderfully complex universe both in science as well as in business. Strongly held convictions give way to new theories with great reluctance and denial. Think back to the great apprehension that most of us had about September, historically known as the worst month for the market. After the market's August swan dive, many investors feared September. These strongly held convictions about forthcoming September weakness almost turned into a panic. Clients and prospects cited the "Hindenburg Omen" as a rationale for the market to succumb to some cataclysmic fall. At the time of the first Hindenburg Omen trigger, in the middle of August, the blog Zero Hedge described the Hindenburg Omen as "Easily the most feared technical pattern in all of chartism (for the bullishly inclined). Those who know what it is, tend to have an atavistic reaction to its mere mention."  Unlike the ill-fated Hindenburg, the only thing that crashed and burned in September was the theory itself.

As we all know, we have just completed the best September since 1939, strangely, the start of World War II. Not that the fundamentals really changed all that dramatically from August to September—again, technical reasons created an oversold bounce from the August lows. For students of market history, this should be good news. When September returns are positive, the average fourth quarter performance over the last 60 years has been up about 5.3%, whereas when September returns are negative, on average, the market has returned 0%. Combine a positive September with a mid-election year, and the average Q4 return has been 11.4%. So much for Stock Trader's Almanac stats.  Remember Mother Nature sides with the hidden flaw.

One of the more frustrating aspects of stock markets this year has been the incredible positive correlation of everything. Correlation measures the degree to which prices of stocks (or securities in general) move together. There is an excellent study of correlation just published by JP Morgan's Marko Kolanovic, where this phenomenon is examined.

As you can see, though levels of correlation do gyrate with the business cycle, the average level of correlation has been increasing over time.

Why should the average armchair investor care? It makes the art of stock-picking very difficult when everything moves the same. For those of us who attempt to create market-neutral portfolios by hedging our long exposure with some select shorts, this phenomenon also makes it exceptionally difficult to effectively create value on both sides of the hedge. What drives this correlation?

The most obvious is the macro environment. During periods when there is high macro uncertainty, there is a very high level of equity volatility. For example, during the Internet bubble stocks were volatile in both the New Economy (dotcoms) and more traditional Old Economy names. But the performance divergence caused correlation among stocks to plummet. It was relatively easy to create positive performance in hedges at this time. However, at this time the opposite seems to be true. Stocks are volatile (just check out August returns versus September and the jagged monthly performance this year) but everything moves together. Given this performance, JP Morgan has labeled this the Correlation Bubble.

What has caused this? One of the key factors has been the increased usage of index-based products, both futures and broad-index ETFs. When someone buys an S&P 500 futures contract, in effect, they are placing an order to buy 500 stocks (through index arbitrage.) If you think about it, if investors traded only futures, the correlation of stocks would be 100%.The growth in index volumes, both futures and ETFs has contributed to the high correlations. The volume of trading is much higher than most investors realize:

Though many academics are somewhat suspicious of ETFs and their potential contribution to the Flash Crash of this year, futures notional volumes are approximately double ETF volumes. As well, only about 60% of ETF volumes are broad-sector. Sector ETFs, though they contribute to intra-sector correlation probably help to reduce overall average correlation among stocks.

In addition, high frequency trading (HFT) activity is also likely to have contributed to increased correlations. A significant amount of HFT relates to statistical arbitrage. If the price of one stock increases relative to the other, HFT arbitrage will sell the outperforming stock and buy the underperforming, thus increasing the correlation between the two.

Should these conditions persist, it will be tougher to beat markets relying strictly on stock picking. Not that I am suggesting indexing. As Seth Klarman points out in a recent Financial Analysts Journal:

"Stocks trade up when they are put in an index. So, index buyers are overpaying just because a stock is included in an index. I am more inclined to buy a stock that has been kicked out of an index because then it may have value characteristics—it has underperformed. We all know that the evidence shows that when you enter at a low price, you will have good returns, and when you enter at a high valuation, you will have poor returns. The mentality of “I'll save transaction costs and management fees by indexing' ignores the fact that the underlying still needs to produce for you."

Nevertheless, the following table is quite eye opening and shows how much closer sectors are following the overall market. How much of the sector returns relate to overall market returns?

  Today 5 Years Ago
  Large Mid Small Large Mid Small
Industrials 70 57 50 37 27 23
Financials 67 62 52 34 28 30
Energy 61 53 52 16 15 19
Materials 58 60 50 34 31 26
Consumer Discretionary 56 44 41 25 20 19
Utilities 55 59 57 28 30 30
Technology 53 49 42 19 18 15
Consumer Staples 42 29 32 21 19 16
Healthcare 41 36 33 16 11 15
Telecom 40 54 34 25 11 12

As you can see, today's market provides quite different correlations versus five years ago, particularly in larger cap stocks, where direction is largely determined by the overall market. This shift is particularly pronounced when looking at the energy sector, which five years ago was among the lowest correlating sector and currently, is dominated by the "big picture." I refuse to believe that stock-picking has no value; clearly, smaller cap names are less affected by this trend. However, in this higher uncertain macro environment—in an environment where futures activity, high frequency trading, and hedging is robust, and the desire to gravitate toward large cap international names with dividends is strong, the overall trend seems to be more important than most of our financial analysis can differentiate.

A few brief stock ideas:

ENI (E) is one of the largest integrated energy companies. This is truly an integrated company where exploration and production account for only about 31% of total revenues but the highest profitability. Refining and marketing, as is true for most integrated companies is losing money at present. There is consistent contribution from high return on capital businesses such as power generation and engineering. Despite this, the overall ROIC is about 10%, down from peak profitability some 5 years ago when it was over 20%.

Balance sheet risk is low with net debt to trailing EBITDA of just 1.0 X

Dividends are about half of normalized earnings so the shares trade at a 6-7% yield based on a targeted dividend of €1.00 per share for 2010.

The reserve base of about 30 billion barrels proven and probable is located in some politically challenging areas such as North Africa, West Africa, and Kazakhstan. Nevertheless, ENI has been successful in operating in such areas for many years, perhaps an expertise that is difficult to emulate. ENI is developing LNG projects in Nigeria, Egypt, Angola, and Libya to monetize non-pipeline connected and hence, stranded gas reserves. Hence, it seems to be able to find and produce reserves more effectively than many companies that are facing declining production. But the price of reward is always risk, in this case, greater political risk.

Span-America Medical Systems (SPAN), headquartered in South Carolina is focused on providing specialty solutions for bedsores, i.e. pressure management and patient positioning for bed-ridden patients. This is a tiny company with $40 million in market cap so please be careful in trading a stock that averages only about 5,000 shares a day.

Span-America's clinically proven product lines include PressureGuard® therapeutic mattress systems; Geo-Mattress® therapeutic mattress systems; Geo-Matt® overlays and seat cushions; Span+Aids® patient positioners; Isch-Dish® wound care seating products; and      Selan® skin care products. The company also provides specialty foam products for the consumer market as well as custom components for industry.

The company has demonstrated impressive profitability with ROIC of about 23% for the last twelve months as well as ROE over 20% for the last three years on a clean (no debt) balance sheet. Operating margins have been 12-13%.

Recently, there has been a slowdown in sales and concomitantly, in profitability. As the most recent news release outlined: "Our medical sales were down primarily due to weak demand for therapeutic support surfaces from medical customers who have delayed capital goods purchases or reduced order sizes.  However, the decrease in therapeutic support surface sales was partly offset by sales increases in our other medical product lines.  Sales in our custom products segment were also down from last year's third quarter due to a market test program for certain consumer products that was not repeated this year." Certainly, there are concerns about Medicare's competitive bidding program and potential reimbursement rate cuts which may remain in place until next year.

The company has a history of paying dividends for 82 consecutive quarters now as well as a special dividend that was paid in May. This happens to have been the third special dividend that the company has paid, an excellent record of treating shareholders well for a company this size. The five-year growth rate of dividends is just under 20%, about in line with its earnings growth of 18% for this period. At 8 times trailing earnings, I think it seems quite cheap.

Disclaimer: I, my family or clients own positions in both E and SPAN.

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