The Unknown Unknowns
(Guest Commentary by Rick Konrad – September 25, 2011)
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 our regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In an uncertain world, investors tend to de-risk by selling equities, high-yield bonds, and other risky assets. Sure, as Rick states, there could be more “unknown unknowns” waiting to surprise the market, but given our inherent behavioral biases, the concept of mean reversion, relatively undervalued equities, and the availability of attractive individual stock ideas, Rick argues that investors should use any additional weakness to selectively tack on risk. Rick also presents two high-conviction stocks that he 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 “Profit from Folly – It is Expensive to be Defensive” for his last commentary). Prior to 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. Rick is a very genuine teacher of the financial markets and treats his role very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the world's third largest CFA society 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.
“As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns- the ones we don't know we don't know.” – Donald Rumsfeld
For many investors, the past week has been terrifying. Though most of us who have the audacity to think we are advisors, are almost as frightened. We pride ourselves on rational thinking, on dealing with fundamentals, on being dispassionate, almost disembodied systematic calculators. Yet, despite the whirring of our brains, we are hardly isolated without peripheral sensations.
Years ago, when I was studying physiology and biophysics, we used to explain away unusual results in our experiments with “Nature sides with the hidden flaw,” a statement of Murphy's Law. Most experiments leave an open flank for error to creep in, distractions that invariably occur in experimental design that allow mis-measurement or miscalculation to occur. Working backwards through the procedure and trying to resume control over the experiment was always the best way to discover where these glitches had occurred.
Sometimes, mysterious results simply could not be explained. I can imagine that scientists at CERN, near Geneva, are frantically trying to work backwards through an experiment that demonstrated that sub-atomic neutrinos were moving at a velocity faster than the speed of light. Neutrinos were fired at a target 500 miles away and arrived 60 nanoseconds, or 60 billionths of a second too soon, or at least 60 nanoseconds sooner than a light beam would. When asked about the implications, one of the chief scientists replied: "I just don't want to think of the implications we are scientists and work with what we know."
Moving from the world of science, to the world of politics, the Donald Rumsfeld quotation came from a press conference where he was attempting to explain the absence of evidence linking the then government of Iraq with a lack of evidence of weapons of mass destruction.
This also has investment relevance. How do we continue to believe we are right, even when we are not? How do we “know” what isn't actually so? A person is absolutely certain of something when he knows that thing; he is uncertain when he does not know it, but he knows he does not: he is consciously uncertain. On the other hand, he is unaware of something when he does not know it, and he does not know he does not know; he does not perceive, he does not have in mind, the object of the knowledge he ought to be seeking.
Let me provide an analogy that those who are short-sighted will understand. As a young child, I had no idea that I was short-sighted. My “known” consisted of my own vision range, my awareness did not contemplate any sort of missing part of vision. It was only after I sat at a back of a classroom and could not see the blackboard that I became aware of my problem.
Most rational investors will argue that valuations in equities are fairly compelling, certainly relative to Treasuries. Within the context of “knowns”, it is not difficult to make such a statement. Clearly, with the majority of S&P stocks now having a yield above that of the ten year Treasury, one can be lured to feel comfortable buying stocks. In addition, dividends on stocks have the ability to grow; a distinct advantage versus a Treasury bond which has but a fixed coupon.
This type of rational thinking has generally had a positive outcome, at least based on historical periods when stock yields were above Treasury yields…it is fair to call this a known known. The unknown known is the timing. How much lower can stock prices go, and higher can stock yields go before they reverse and stocks begin to outperform.
The unknown unknowns are another matter. What elements are there that we are missing? Though there have been many miserable days where the market appears to be oversold, remarkably any subsequent bounces have either been nonexistent or paltry at best. With leverage still at multi-year highs it appears selling pressure remains the bigger risk to equities.
The market also seems to be losing confidence in the Fed's tool chest and its ability to provide a much needed put to this downtrend. On Sept 21st, the Fed said it would begin to rebalance its $2.85-trillion portfolio of securities, by selling $400-billion of short-term notes due in three-years or less, over the next eight months. It would use the proceeds to purchase longer dated 6-20 year Treasury bonds. This is the “Twist” strategy, twisting the yield curve by lowering long-term interest rates and hopefully, spurring businesses and homeowners in borrowing or refinancing.
The only joy we have seen in Mudville has occurred in the bond market where ten-year and 30-year Treasuries are seeing multi-generational lows and the stock market has seen no bounce. The history of the 1960's version of the Twist is not inspiring. The 1960′s attempt at a similar thing is widely regarded as a flop. But circumstances were different back then. Now we are in a liquidity trap; businesses are awash with cash; and households are still digging out of debt. This is not an auspicious combination. So the context for the Fed's initiative is not good. Twisting the yield curve could backfire if it only leads to sharply lower Treasury yields. If corporate junk bond yields do not follow suit, the widening yield spread could be interpreted by many algorithmic traders as a signal of an impending recession.
The economic powers that be have provided little solace. Christine Lagarde, the head of the IMF, said “The world economy is entering a dangerous phase. This heavy debt of sovereigns, households and banks represents risks that could actually suffocate the recovery.”
World Bank President Robert Zoellick added, “I still think a double-dip recession for the world's major economies is unlikely, but my confidence in that belief is being eroded daily.”
Though it is not yet time to dive into this market with both feet, don't let the fear overcome you. Continue to maintain a blend of good quality corporate debt, emerging markets debt, and some junk debt along with your common stock holdings. We have used recent weakness in some closed end junk bond funds to increase our exposure to this area. We continue to avoid Treasuries.
We tend to extrapolate from the most recent past or from vivid events, and what many investors fear is another Lehman kind of an event. As Meir Statman, the famous behavioral psychologist pointed out recently in a Morningstar interview: “We just feel down, and so we tend to extrapolate from the past. And again, studies, what we know from science, what I know from my own work is that, while we tend to extrapolate from the past, thinking that low returns portend low returns in the future, in truth the opposite is the case--that on average, pessimism and fear are actually followed by relatively high returns rather than low returns.”
A few ideas that we are using in our portfolio: With the tremendous downturn in the German market, we have started to buy some of the world class German companies. BASF trades on the pink sheets here under the symbol BASFY. BASF has a broad portfolio of businesses and is diversified across commodity chemicals, specialty chemicals, agrochemicals and is backward integrated in Oil & Gas. BASF has strong market positions in most of its industrial activities and is geographically diversified…it's not just Europe! Management is trying to move products up the value-added ladder and is committed to reducing the overall cyclicality by reducing costs and increasing the focus on more stable growth markets. With a 5.25% yield, steady progress on improving returns on invested capital, BASF is down about 25% this year. At about 4.5 times EV/EBITDA we are starting to nibble.
Illinois Tool-ITW is trading at about ten times forward earnings and offers a yield of 3.2%. ITW is a big company that stays small by successfully operating about 800 business units which focus on niche products with niche customers. Though the products may seem somewhat boring and mundane such as metal and plastic strapping for industrial packaging, ITW straps down high returns by strapping down and securing freight for many industries. Food processing equipment for baked goods and food companies as well as grocery stores is another area that ITW dominates. The next time you are at the meat counter in your grocery and you see the Hobart name on a scale or a grinder, think of ITW. Some industrial processes such as arc-welding or soldering depend on ITW products. In the midst of the recession, ROIC fell to about 9% but is back to about 14.5% on a trailing basis. The current PE is below where it was in 2008 despite the profit recovery. With operations in 57 countries and a highly diversified product base, it is unusual to be able to buy a company of this quality at below the S&P valuation.
As always, take your time. Be aware that this period has brought many unknown unknowns. Be careful out there.
Disclaimer: I, my family and clients own positions in both BASFY and ITW.