The Last Gasp

As you know by now, I think we are in the final stages of the topping process in major markets.  This is going to be a multi-month affair.  I suspect the top and crash begins later next year, but so do many other pundits, pros, and bloggers which makes me leery.  There’s nothing worse than contrarian consensus by large groups in the game of speculation.

Like its predecessors, the crash won’t look like one at first.  Sure, players will get scared and react but then we’ll see a bounce off the first initial move to the downside.  This will be an opportune time to liquidate positions to make a final cash raise to either capitalize during the crash or wait for the inevitable value opportunities that will arise.

There is a set of indicators that go along with this move downward and bounce that has proven efficacy as a guide.  It’s the 5 month and 10 month Exponential Moving Average (“EMA”).  Observe.

SPX - 5 & 10 Crossover (10-10-2016)

These aren’t magic indicators.  I’m not saying they are guaranteed to work.  I’m only saying they’ve proven themselves as guides when a real bear move has begun.  There are a multitude of economic and financial indicators that I also like to use along with anecdotal evidence, too.  Keeping an eye on this particular set of EMAs however can potentially keep your losses to between 10% and 15%, assuming you act.

In a bear market where there’s the potential for a halving of portfolios, I’d say 15% in losses is solid.

Volatility in the biggest asset classes will be unimaginable.  The algorithmic, high frequency trading operations in combination with central banks have broken all markets.  There will be no liquidity for the big timers when the bear begins.

HFTs are the true market makers and all algorithms are written to pull away and sell when bottoms fall out of markets.  Look at the S&P 500 in May of 2010.  That was really the first indication that markets would never liquidate in a typical fashion ever again, until HFTs are properly regulated, taxed, or removed from existence in markets.

There are plenty of examples between May of 2010 and now, but the move in the pound sterling at the start of October provides such a fine illustration.  What’s more liquid than the currency markets of the most developed and powerful Western nations?

Nothing.  And yet still we see the destructive power of HFT on any market.  Does this look normal in a power currency?

Sterling Madness (10-16-2016)

In earlier Asian trading, the intraday damage was even worse.  Observe this bit of madness.

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These moves are a product of liquidity being immediately vacuumed from the asset classes where all the largest players play.  This will happen again and again when the markets make their final turn.

You can liken it to a hull breach for an astronaut in space without a suit on.  One second astronaut HYG is floating around the lab in a jump suit, happily conducting experiments with OPM.  But OPM in high-yield instruments in a low-yield environment can be a volatile material if not handled appropriately in a proper setting and an explosion occurs breaching the hull, sucking HYG out into the liquidity-free vacuum immediately to death.

Did I say liquidity?  I meant oxygen.

You get the point.

Coming back to what a last gasp means; it means there will be a final run in risk assets to squeeze out the final profits of this bull.  Many, including myself, have called it a melt-up, but I grow weary of the term.

Please don’t be fooled by some of the ignorance being freely proffered out there that we are in the early years of a cyclical bull, similar to 1982.  We are not.  The evidence is broad, clear, deep, and obvious.  One needn’t a fancy finance degree or years managing wealth in order to see this.

The end game is here, but not before that last gasp for profits that I keep describing.  I suspect that many of the sectors that powered this bull market prior to 2016 may reassert themselves to take us home.  Why is that?

Interest rates.  Plain and simple.

Those with access to leverage at these historically low rates will borrow capital to fund buyouts and takeovers which will drive asset prices upward.  The upward move will then draw in speculators looking to hop on the trend or front-run it.  This quest for yield whether in debt, equity, or private equity i.e. IRR, will be the fuel for the last gasp up in asset prices.

Despite what I think may happen in semiconductors or social or biotech or emerging markets as risk-on gains speed, keep your eyes on the one asset class that has taken out all comers in 2016.  The Rocky Balboa asset class for the year.  You know what I’m referring to and this is even with the recent sell-off.

2016 Performance Chart (10-16-2016)

Precious metals.  You don’t have to love them or hate them.  Opinions don’t have to be binary.  Be agnostic when speculating.  Follow the trends.  Follow the money.  More importantly, follow central banking and political lunacy.

Let’s look at one more chart that potentially validates that this bull market is long in the tooth.  It depicts the times over the last 50 years when payouts to equity investors have exceeded  profits.

Total Payouts via ZH (10-11-2016)

You can ignore what is glaringly obvious or you can prepare.

Speaking of obvious, let’s begin to wrap this post up with another pithy little ditty of a quote, this time from one of the world’s great speculators.  It’s been reprinted time and again, but it’s simple yet brilliant message is timeless.

I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up.  I do nothing in the meantime.

– Jim Rogers

I haven’t touched on trading since the summer and I just wanted to share some set-ups that appear to potentially be building little piles of money in a corner waiting to be picked up.

Keep an eye on these sectors, either short or long:

Short:  sugar, energy(big 3), US dollar, and technology

Long:  grains, bouncing precious metals, and the pound sterling

Despite your opinions, never forget about counter-trend rallies, even in the face of what appears to be an unstoppable trend.

Should the Investing Public Be Worried if Some of the Biggest Banks are Genuinely Scared?

Questions of investing and speculating always require context within time-frame. Players in all asset classes, professional or not, approach the game from their own perspective.

Traders surfing the waves of volatility may be looking only days or weeks out. Investment managers overseeing a growth-oriented portfolio may be looking ahead months or quarters while a value-oriented portfolio manager may be looking years out. The 401k-watching worker bee may be wringing their hands at every market move and every ignorant headline despite the fact that they have 30 more income-earning years left before retirement.

The game is tougher than ever even for the professionals and it’s difficult to decide a course of action with the information overload coming at market players. Determining what’s noise and what is actually valuable information is critical in making the right moves within your portfolio.

I have long been pounding the table on building cash reserves while staying invested in the markets. I’ve also stated that I thought the downturn of late 2015 was the start of the next major bear market. I think that dip and recovery in 2015 was the bear waking up and the poor start in 2016 is investor realization of that bear. However, because everybody now sees it, the markets aren’t going to execute a full-frontal stage-dive. That’s not how these things work, right?

I think we get a recovery into new highs followed by another much smaller correction and consolidation potentially followed by another new high. After that, I suspect all the bull energy will be fully used up and the bear will begin in earnest. Remember, these are simply my suspicions based on behavioral observation of the markets; nothing more than forecasts of potential outcomes.

It’s been a long time since I’ve hit readers with some good old chartporn, but I’m in the mood to throw a bunch of squiggly pics out there to possibly help the reader better assess the market situation in 2016. Observe a 20-year, monthly chart of the S&P 500 along with some relevant indicators.

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Observe the long-term breakdowns in the indicators matching the actions of 2008 and 2000. Does that mean crisis is imminent? Nope, but I do think it reinforces my call that a new bear has started. Notice also in 2001 and 2008, we saw strong support and a bounce off of the 50-month moving average. Too many technicians are looking for that and thus too many algorithmic shops will be front running ahead of that signal, blowing out orders to drive the market higher.

I suspect this bounce we are currently in the midst of may be a bit stronger than people realize. Market players have been so used to the V-recoveries and yet they’ve already forgotten what they can be like. It appears that players are numb to the potential of a multi-week to multi-month V-bounce from the January 2016 lows. Despite what I surmise about a stronger than expected bounce, nobody can blame investors for either running for the hills or shoving their heads into the sand.

We’ve already seen the peak in net profit margins for this business cycle in the largest US corporates at the same time that markets continue to be overvalued, despite the corrective moves in December and January. Observe the following chart courtesy of ZH via Thomsen Reuters via Barclays. It depicts how the recession fuse has likely been lit.

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And with recession generally comes a bear market correction. Or is it the other way around?

Regarding overvaluation, have a look at this comparison chart from AQR depicting market returns based on various starting points of the Shiller P/E. AQR is the shop that Cliff Assnes, billionaire hedge fund manager, founded and runs.

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This coincides with GMO valuation models for future returns based on current valuations. There are plenty of Shiller P/E naysayers who believe that the indicator is bunk. The fact of the matter is that evaluating a normalized 10-year look at P/E ratios is a simple and intelligent way of quickly gauging valuation levels compared to prior periods. Of course every period in history possesses its own specific circumstances as the backstory of the valuation levels, but the raw Shiller P/E paints a clear picture for equity performance going forward.

Besides I don’t see or hear anybody calling Bob Shiller a dumb man. Despite what you may think of his ratio, Shiller is a respected academic even within the professional financial community.

Let’s take a look at a chart from one of every perma-bull’s favorite bear-shaped piñata, Dr. John Hussman. Unfortunately, Hussman catches a lot of flak. Less so after admitting to his analytical mistakes coming out of 2011 but I think he catches a bad rap for simply calling it how he sees it. Hussman’s analysis is based on a quantitative and thorough study of the markets. Can the same be said of a vast majority of the financial blogosphere? No it cannot, including myself. Observe the Hussman Hindenburgs. They nailed the current action coming into Q4 of 2015.

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The criterion of the Hussman Hindenburg is detailed in the upper left corner of the chart. Dr. Hussman’s Hindenburg indicators proved to be quite prophetic in 1999 while essentially nailing the top in 2007. For your own long-term holdings, ignore these signals at your own risk. Dr. Hussman, like Dr. Shiller, is respected amongst fellow financial professionals. Have a look at Research Affiliates’ (“RA”) own analysis on current valuation levels.

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In a research piece they published in July of 2015, RA evaluates the differences in relative valuation metrics (CAPE, Hussman, Tobin) and absolute valuation metrics. They came to the following conclusion.

Our answer to the question “Are stocks overvalued?” in the U.S. market is a resounding “Yes!” Our forecast for core U.S. equities is a 0.8% annualized real return over the next decade. The 10-year expected real return for emerging markets equity, however, is much higher at 5.9% a year. The return potential of the nondeveloped markets is so high, in fact, that the valuation models, warts and all, paint a very clear picture.

May want to rethink that lack of EM exposure going forward, depending on your time-frame.

Shall we move on to a couple of less orthodox indicators of potential trouble in the markets? Observe the two following charts which pertain to income as opposed to valuation or price action. In the first one, created by McClellan, we get an interesting correlation to total tax receipts for the US government as compared to US GDP.

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Notice that in 2000, the US crossed the 18% threshold and stayed there awhile before rising even higher at the beginning of the market selloff. For the GFC of 2007, America almost got to 18% but not quite and we still literally almost vaporized the entire financial system. Currently, we’ve reached 18% but that may or may not mean anything. In each previous occurrence, tax receipts stayed at the level for months or even years so this is an indicator worth watching but only in conjunction with many others.

Interestingly, federal tax receipts as a percentage of GDP currently reached 18% right before the markets began selling off last year. Repeat after me. Correlation is not causation, but the timing is still interesting.

The other chart that doesn’t get a lot of coverage but is very well known is net worth of US households and non-profit organizations as a percentage of disposable personal income. You can find it courtesy of our friendly Federal Reserve Bank of St. Louis and their FRED tool. The grey vertical bars in the FRED charts denote recessions.

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It’s been a clear indicator in 5 of the last 6 recessions and we also had that annoying fakeout in 1987. Much like the prior graph, this particular chart should be coincident with additional economic indicators if one is attempting to forecast potential economic as well as investment outcomes.

I want to move on to a particular area that everyone should be concerned about and that is nonperforming loans (“NPL”) at major banks. Not just at US banks but around the world. China’s commercial banks have raised fear levels in even the most seasoned professional investors due to their NPL levels increasing so drastically in 2015. I’ve long stated how debt levels in Italy have the potential to dismantle a good portion of the financial system because the Mediterranean Boot is such a key economic cog in the European Union. Some of the biggest commercial banks in Italy are on the verge of toppling during a period where now the ECB is less amenable to the previously used “bad bank” options. The pressure is beginning to mount for Italy’s leadership to formulate a strategy around potential bank failures.

You might be inclined to observe the following chart and think all is at least well for the US.

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But take a look at the following chart in commercial-only loan performance and begin to understand why the total situation looks toppy from the economy to the markets.

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For the record, commercial loans comprise approximately $2 trillion of the outstanding debt within the banking system. It is clear to see that a bottoming and an upturn occurred before the last 3 recessions and market dislocations. Now we are currently in the early innings of an upturn in NPL. If commercial loan performance behaviorally adheres to what we saw in the prior two recessions, we will see at least an additional 2% of total commercial loans become impaired assets. That’s potentially between an additional $40 billion to $50 billion at minimum that banks will have to provision for. No easy task in light of current leverage levels and collateral utilization across the repo and derivative space.

This is especially concerning because of the systemic importance of each bank to the entire financial system. Just look at the consolidation that has occurred since 1990.

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Couple this concentration with a lack of regulation allowed by Gramm-Leach-Bliley and you can see that debt impairment at the banks is not going to have a happy ending. And if you think Dodd-Frank was the answer to all of our problems, I might stop laughing sometime in March.

What would work to alleviate a lot of the financial pressures around the world in the short term is a weaker dollar. I don’t say that as a proponent of a weaker dollar. Rather, I am stating that currency exchange due to a weaker USD could help sugarcoat revenue reporting across international corporates. It would relieve pressure in the management of reserves for countries with an excess of US treasuries. The oil price could stabilize temporarily but it is well-documented that abundant supply and less-than-expected demand is still the story. Commodities could lift and thus commodity producing countries who are already fighting with their reserves issue could see a double-positive impact. All these effects would be temporary as world debt levels are at unsustainable levels and a bear market for all assets has potentially already arrived. It just has yet to completely sink its claws and fangs entirely into the world’s financial system.

Coming back to the initial question behind this post. Should the investing public be scared? Maybe not scared. Let’s call it aware. They should be aware of all the happenings that are occurring right now. Cash levels should be raised. Certain assets should be paired down depending on losses, gains, and risk exposure. More importantly it’s time to take stock in your own investing psyche. If you are building cash levels, will you have the courage to act at the appropriate time? That’s what raising cash boils down to. Do you have an understanding of the intrinsic valuation levels of specific asset classes that will motivate you to put cash to work?

Aside from brushing up on your ability to properly assess valuations, take a look inside yourself and evaluate your ability to deploy cash when fear is running rampant and the nadir of multiple markets appears to be nowhere in sight.

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Value of Increasing Portfolio Cash Levels

There are essentially two major views on cash in one’s portfolio. One view, which is predominantly held, is that cash yields nothing and thus must be allocated into an asset that does yield. The other view is that cash provides the ability to strike when value opportunities arise, and that ability is virtually priceless when the blood is running. What would you have given to have a warchest full of cash to deploy in March of 2003 or March of 2009?

The Spring 2015 edition of Columbia Business School’s (“CBS”) student-led value investing newsletter, Graham & Doddsville, profiled Matthew McLennan of First Eagle Investment Management, the house that Jean-Marie Eveillard built. By the way, Graham & Doddsville is published 3 times a year in the winter, spring, and fall. The newsletter contains interviews with investment pros, highlights of the CBS program, and investment theses by students. It can be a tad redundant of a read, much like Marginrich.com, but every now and then you can glean some quality insight from the interviewees.

McLennan shared some valuable insight on the value of cash, eloquently stating:

We can’t predict what the future will bear. At First Eagle, we view cash as a residual of a disciplined underwriting approach and as deferred purchasing power…We don’t feel the need to force cash to work just because it is a zero-cent yield today, because the return to cash has two components: it has the current yield, and it has the option of redeployment in distress. We feel, given the state of the financial architecture, there will be more windows of opportunity over the coming years to buy businesses that offer potential return hurdles in windows where the markets are less complacent.

It’s this option of redeployment why cash warrants a higher allocation right now. The spectrum of investors is vast with varying risk tolerances, varying asset levels, varying time tables, etc. Whether you’re a professional or an amateur, there is enough compelling evidence to espouse this view. Let’s start with valuations.

Sure, the major US stock market indices are hitting new all-time highs but the price action looks weak, and that’s on the back of some of the highest levels in history of current valuations. Traditional valuation methodologies such as the CAPE and Tobin Q are at levels only seen in 1929, 2000, and 2007. Does that not concern you?

Doug Short provides charts that depicts the CAPE, which he calls P/E 10, and Q plus the Crestmont P/E and S&P 500 regression from its price. One chart that particularly captures the moment in valuations, allowing for some perspective, is the Average of the Four Valuation Indicators with the standard deviations highlighted. Observe:

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What immediately jumps out about the chart is that we are currently two standard deviations above the mean for the average of these four indicators, and we are also at a level higher than where we were at right before the Great Depression.

So what! This time is different, right? We’ve got interest rates at basically zero and quantitative easing in Europe and Japan after having just finished in the US. With rates at the zero bound and QE occurring in the most major of markets, equities appear “fairly” valued. Which begs the question, then what is extremis? Is it 10% higher from current price levels on the S&P 500? 20% higher? 30%? Who’s to say? Certainly not the overwhelming majority of professionals. There will be some that nail the top; statistically it’s inevitable. However, the preponderance of evidence unequivocally shows that the professionals are as ignorant about the future of stock market price levels as the people who unfortunately rely on their opinions. They have no idea when the music will stop which is why they keep dancing and dancing and guiding the public to do the same.

Let me provide you with a perfect example. Here’s a December 2007 article from Bloomberg Business(pre-BusinessWeek acquisition, hence the references) titled Where to Put Your Cash in 2008. In it, seven stock market analysts were polled including some from the largest banks on Wall St. The list includes Chief Investment Officers or Chief Equity Strategists at banks such as Citigroup, BofA, and BNY Mellon. Here is where each member of the poll stated they thought the S&P 500 might be trading at by the end of 2008, 1. 1,520   2. 1,675   3. 1,680   4. 1,700   5. 1,675   6. 1,625   7. 1,700; for an average of 1,653.

Anybody recall right off the top of their head where the S&P 500 closed on December 30th, 2008? It was 890. 890!!! Even the most pessimistic of the 7 missed the mark by a whopping 42%. That is egregiously inaccurate for some of the most allegedly well-informed and experienced market forecasters. And what’s worse, these calls were made in December of 2007 well after the market had begun to turn down and create a lower-high. Now of course, hindsight is 20/20 and maybe BusinessWeek excluded any bearish pollings which may have been more accurate, but the fact is these chiefs help in the decision making of multi-billion dollar organizations with multi-billion dollar portfolios.

Many pros utilize statistical models that provide a false sense of security; not just the pros but the academics masquerading as professionals at the world’s central banks and asset management houses, too. They think everything in the world is simply a matter of accurately determining the mathematical expression of potential and probable outcomes. Because as long as you can assess portfolio risk via language like this,

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then the world is your oyster. Recall 1998 and the wrench that LTCM threw into the equity markets thanks to its genius partners who could quantify anything and everything in the world so profits were guaranteed. More recently in 2007, every financial house and shop knew risk was mitigated because the statistical models quantitatively guaranteed it. Human behavior simply cannot be accurately quantified with any long-term consistency and the markets consistently forget that. If that were not the case then IBM would be the most successful hedge fund in the world with Watson precisely quantifying all human risk variables and factors to own the world of speculation.

The so-called smart men don’t have any better knowledge of the future than some guy off the street. The future cannot be statistically quantified within an if/then statement. The rationale of the central planners and economists is consistently, “If this then that”, but the world is not tied up and wrapped up so neatly with a bow on it. The same can be said for our economy and financial markets.

People think that the people at the top have all the answers and will provide fair warning for everyone, but that’s not the way it works and people’s incessant memory loss of all things financial prove that out. You don’t know when a component of your car’s engine is going to malfunction. It just happens. Same goes for the economy and the markets. Along will come an unforeseen event i.e. black swan i.e. fat-tail that will critically damage the component of the engine causing the machine to breakdown. Let me remind you, that the same people that stewarded the financial crisis of 2008 are still in power at all the major private, public, and government entities.

I don’t mean the same people in the literal sense, but the same kinds of individuals. All without extra sensory powers of foresight and omniscience. They continue to utilize the same models that have been so greatly leaned on since the 90’s. The kind of statistical models that say “Oh, this event could only occur once in every 10,000 years so we have nothing to worry about regarding the management of our risks.” When the next downturn comes along, and it will because cyclicality is but one of nature’s simple inevitabilities, all these smartest-people-in-the-room types will be poring over their models and wondering how such a deviation from the standard could have caught them unawares.

Don’t be caught in the same trap that ruined the financial portfolios for so many investors on the brink of retirement. Now is the time to prepare yourself, because your RIA or whoever else you entrust your financial future to will not be able to safely shepherd you through the next financial crisis. They can’t. It’s virtually impossible due to career risk, fund charters, and the greed of maximizing assets under management.

There will of course be the small cadre of asset managers that go to cash early by tactically liquidating the portfolio and placing intelligent counter bets to strategically capitalize on the next great dislocation; in the process becoming hailed as new gurus. However, the financialization of our economy has driven so much talent into the markets that it’s statistically impossible for most money managers to not lose big. Inherently, the players in the field know and understand this but the people placing their hard-earned money with these players generally do not share the same level of comprehension.

I’ve been sharing my thoughts for some time now on the potential benefits of raising cash levels. I don’t think it’s alarmist. I continue to think it’s prudence. I’m not saying exit the markets. Just start to build cash levels. Examine the chart below with the obvious benefit of hindsight.

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Let us assume the next great dislocation takes the S&P 500 down by 50%. This assumption is based on the approximate haircuts of 47% and 56% in 2000 and 2007, respectively. For the sake of the illustration, let me also generously give the S&P 500 another 30% of upside from current levels. That would put the S&P 500 at about 2,770. Halve it and you have 1,385 which is still 35% lower from current levels, a bear market by any standard but the 50% markdown would be avoided for a portion of holdings. Then with valuations in the trough, one can begin to selectively capitalize. All the variables are unknowable. It’s a simple exercise for the sake of illustrating the value of having cash available at the appropriate moment in time.

As previously stated, if you think leaving your hard-earned money in the hands of a professional will protect you, you are mistaken. Chuck Jaffe, MarketWatch columnist, penned a recent article which imparts this very notion. The piece’s opening headline states, “Only four funds have beaten the S&P 500 for the last eight years.” That’s four as in you can count the number of actively managed funds on one hand that can beat a simple index of the S&P 500 over the last eight years. Those four funds are all in healthcare, which means it has taken the tailwinds of what is arguably the strongest demographic opportunity for the next 10 to 15 years to beat a simple index.

The markets are cyclical and what was old is new and what is new is old. The sun may wane on indexing for a time and active stock picking may get revitalized. If you intend to be one of those stock pickers then it is imperative to have the cash available for opportune investment. I’ll share what I feel is a poignant quote from Charlie Bilello, of Pension Partners, that summarizes the value on boosting cash levels in one’s current portfolio. In the article, Bilello is referring to the ATAC rotation strategies that Pension Partners advise on and utilize, however the sentiment is equally applicable to what has been articulated in this post. To wit(emphasis mine),

Similar to the mid to late 1990’s the last few years have featured runaway gains in U.S. equities. Any strategy that was built to minimize downside over this time has dramatically underperformed as there has simply been no downside to capture. While some would view this as flaw in these strategies it is the only way they can work over time. In order to minimize downside you have to be willing to give up upside in return, and by extension this means underperforming during runaway phases in bull markets. There is no other way if your primary goal is to protect capital. The tide always turns and while out of favor today, preserving capital and managing risk will be back in vogue once more, but only after the declines occur.

Brush up on your valuation skills. The sacrifice of modest current returns versus potential outsized losses while waiting for the inevitable fire sale makes cash a superior asset. Set aside the ingrained notion of maintaining a current unproductive asset bearing debasement losses for the simple notion of sometime in the near future you could be buying the most productive businesses or assets on the planet for 40 to 60 cents on the dollar. Will we get another crack at the beginning of a true secular bull market beginning with a CAPE in the single digits? Possibly, but I’ll take a CAPE in the teens just as well and I’ll want to have the ammo available when such fortuitous circumstances(for some) arise.

Update:  5/22/2015
I readily and regularly admit to not exactly being an intellectual heavyweight, so here’s an interview with Nassim Taleb from the Swiss website Finanz und Wirtschaft. They consistently feature quality international pieces from international guests. In the article, Taleb(a legitimate intellectual heavyweight) shares many of the same sentiments expressed in this post; just to add a touch of support to the claims.

Spinoffs – A Review of Energizer

Spinoffs have long been a hedge fund favorite for arbitrage opportunities. That was of course before the days of derivative structures that allow asset managers to take on and hedge risk in countless ways, and not necessarily in the most intelligent fashion. A spinoff is still a good opportunity and there are more than a few academic studies, mostly from the 80’s and 90’s, that provide evidence behind the strategy of investing in spinoff opportunities.

Reading academic reports, even when one is engaged in the content, can at times be like watching paint dry whilst watching Empire by Andy Warhol in the background. However, Joel Greenblatt, one of the most successful hedge fund managers of all time, dedicated an entire chapter to spinoff opportunities in his classic book on speculation, You Can Be A Stock Market Genius. He takes a light-hearted approach to sharing his successful experience with spinoffs. You get the first-hand account of a true professional who has made money strategically utilizing spinoff situations as opposed to the dull but factual report of some PhD who’s never worked a day in the private sector.

Had to dust off my old copy to share some of his stuff but in chapter 3, Chips Off the Old Stock, Greenblatt covers the basics of speculating in spinoff situations while covering several working examples with Marriott, Home Shopping Network, Sears and a few others. He also goes over rights offerings with a Liberty example as anyone familiar with John Malone knows he loves to complicate things with a rights offering. Want an abridged version of how Malone made so much damn money transitioning to Liberty? Have a read of the end of chapter 3 in Greenblatt’s book.

Greenblatt sites a 25-year 1988 Penn State study to support the efficacy of investing in spinoff situations. In summary, the study found that spinoff companies outperformed the S&P 500 by approximately 10% per year in the first 3 years as a solo company. Additionally, the remaining parent companies also outperformed their respective sectors by 6% annually in that 3-year window when the spinoff occurred. That’s high outperformance by any measure. Greenblatt succinctly and eloquently states that:

If you accept the assumption that over long periods of time the market averages a return of approximately 10 percent per year, then, theoretically, outperforming the market by 10 percent could have you earning 20-percent annual returns. If the past experience of these studies holds true in the future, spectacular results could be achieved merely by buying a portfolio of recently spun-companies. Translation: 20-percent annual returns — no special talents or utensils required.

For the ETF-everything crowd, there’s even an offering for you which will allow you to outsource your intellectual efforts in case you’re not so keen on sifting through any Form 10s. Guggenheim offers the Beacon Spin-off Index (CSD), with approximately half a billion in AUM. If you’re already familiar with the offering then you know that results have been less than exciting compared to the picture Greenblatt painted, but such is the case when using an ETF instead of digging in and conducting your own due diligence. Below is a chart of performance since inception. It is easy to see the tight correlation of CSD’s (candlesticks) performance to the S&P 500 (blue dash), however since The Great Recession, it has consistently outperformed the S&P 500 by a couple of percentage points. Not exactly the stuff that makes up 20% annual.

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You Can Be A Stock Market Genius is 18 years old. Many of the academic studies regarding spinoffs are equally as old or older. This means the data and situations covered came long before massive quantitative easing, ZIRP, high-frequency trading, and after Gramm-Leach-Bliley; four of the biggest reasons there is wide-scale questioning of true price discovery in most markets. Despite one’s perceptions of a skewed marketplace, the markets are still functioning and there is money to potentially be made, which brings us to Energizer.

A year ago, Energizer Holdings (ENR) announced they would be splitting the company in two. The company believes it has reached critical mass for its two operating segments and that each unit would benefit as a stand-alone operation. Everyone knows that Energizer makes batteries, including the Eveready brand, as well as various lighting devices as part of their Household segment. What is less well known is their Personal Care segment which manufactures razors, sun block, feminine products, and various baby care products. Both segments produce quality operating margins but Personal Care has become the revenue leader for the company due to some bolt-on acquisitions in conjunction with overall declining demand in the alkaline battery space. Have a look at Personal Care’s competitive positioning in its respective product categories, courtesy of their February CAGNY presentation:

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Even though Gillette’s grip on the razor space is massive, Schick’s entrenched position at number 2 in the world allows for some impressive cash flows. Additionally, holding the number 1,2, or 3 brands in the rest of the product categories has Personal Care, which will be renamed to Edgewell subsequent to new Energizer’s spinoff, well positioned to continue generating solid free cash flows. One of the current Energizer Holdings stated focus areas for management is free cash flow. In fact, a handy chart is provided right on the 2nd page of the most recent 10-K that shows the last 5 years’ worth of the company’s free cash flows (FCF).

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With long-term debt of around $1.8 billion, we’re only talking about three and a half years for total payoff at current debt levels with this sort of consistent FCF generation. Additionally, in the shareholder letter on page 3, the CEO refers to the importance of maximizing free cash flow for any business while discussing the FCF results under the company’s working capital initiative. Earlier in the decade, ENR began to focus on reducing working capital to help maximize FCF. For initiative purposes, the company adopted a proprietary metric, “Adjusted NWC”, in which they strive to lower net working capital. Typically, for working capital, investors utilize the current ratio to help ensure efficient allocation of resources. Specifically, Energizer is focused on the reduction of receivables minus accrued liabilities, and inventories minus accounts payable. Accounting details aside, intentions are to generate higher free cash flows to increase shareholder value and you really can’t ask for much more from a corporation’s management. Here’s a slide, also from the February CAGNY presentation, illustrating the point:

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We now know we have company management publicly aligned on shareholder-friendly initiatives, so let’s go over some of the particulars of the spinoff. Edgewell’s ticker will be EPC while the Household brands will maintain the Energizer name and continue to trade as ENR. For convenience and clarity, I will simply refer to each new company as their ticker symbol and if needed will refer back to the current combined company as Energizer Holdings.

The spinoff will be a 1 for 1 share distribution in a very straight-forward, tax-free separation without a convoluted package of rights offerings or tax strategies. The Form 10 is the document where anyone can review the details of the spinoff. For some, combing through the Form 10 can be the most cumbersome part of analyzing a spinoff transaction, however, so much of the content is simply boilerplate legalese that it doesn’t take as long as one might think to go over the entire document. Energizer Holdings filed an amended Form 10 on March 25th of this year and it runs 212 pages, but again, don’t let that length inhibit you if you really want to scrutinize the potential of the deal.

Energizer Holding’s listed reasons for separating the companies are just more basic boilerplate corporate speak: “focus on distinct commercial opportunities, allocation of financial resources, management focus and separate capital structure, targeted investment opportunity, creation of independent equity currencies.”

Great, but let’s take a look under the hood of the SpinCo., which is new Energizer (ENR). Edgewell (EPC) will technically remain as the “parent” company. In the Form 10, SpinCo. prepared financial results for a year-end as of September 30th, 2014 as if the company already split as of October 31st, 2014. Let’s first examine ENR’s top line over the last 3 years.

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So if this is your first time seeing ENR’s sales results, you’re probably thinking “Whoa!” Where’s the growth? Decreased net sales for the last 3 years with a total failure to generate any organic growth, which is an unaudited metric that corporate managements usually take extra care to positively affect. But wait, it gets worse.

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You can see that the trend in the top line was already flattening from 2010 to 2011 precipitating the decline that really kicked in in 2013. This slowing can be interpreted in two ways. One is that the business is stodgy and its main product line, alkaline batteries, lacks innovations to carry it forward into the evolving universe of devices. Or, the lack of sales growth is only temporary as management allocates greater resources to R&D to spark innovation across the product lines. Additionally, growth could be purchased through intelligent bolt-on acquisitions that work to enhance the culture of free cash flow growth. ENR’s free cash flows in conjunction with access to low-cost capital will provide management with flexibility to explore this option down the road.

The production of FCF by ENR has been a bit choppy the past few years but the average has still been about $200M a year.

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None the less, ENR is producing declines in revenues and profits across all geographic segments around the world. Additionally, SG&A continues to be higher than what I would like from a focused management with this particular expense category coming in at $391M as of September 30th, 2014. Making SG&A approximately 21% of net sales, which in my opinion is bit high but I understand separation costs and the working capital initiative have bitten into this area. We’ll partially chalk it up to a cost of building capital efficiencies.

One of the areas that has a tendency to get closely examined in a spinoff is executive compensation. How will pay be aligned with operational goals? Will those same goals be necessarily shareholder friendly? These are important questions to ask. More so I think with companies that utilize an excessive amount of share-based compensation and really dilute existing shareholders while the company may still be struggling to even generate a profit.

Happily that is not the case with Energizer Holdings and current executive compensation policies will roll out to new Energizer and Edgewell. Salaries for the CEO, COO, and CFO for new Energizer are reasonable with base salaries in the $400’s annually for the CEO and COO while the CFO is in the $300’s. Stock awards and short-term non-equity incentives i.e. cash bonuses will take the three of them up into the $1M to $2.5M range for total annual compensation. In a company of approximately 5500 employees and a stated goal of quality capital stewardship, I’m ok with the top 3 employees earning around $5M total for now. Again, the focus is on free cash flow while creating shareholder value and the retention of quality talent requires fair compensation in light of general employment market conditions.

Have a look at the Short-Term Incentive (STI) and Long-Term Incentive (LTI) plans for new Energizer executives, courtesy of the Form 10:

Executive STI:

Annual Cash Bonus Program – Annual cash bonuses to our named executive officers are based on a percentage of the executive’s annual salary, and adjusted based on performance on metrics determined by ParentCo’s NECC. The 2014 annual bonus program was designed to measure performance against four metrics:

• Adjusted EPS (30% of the named executive officer’s bonus target)
• Adjusted Operating Profit (30% of the named executive officer’s bonus target)
• Company-wide Three-Year Global Cost Savings (20% of the named executive officer’s bonus target)
• Adjusted NWC (20% of the named executive officer’s bonus target);

Executive LTI:

Continued enhancements to the long-term incentive program – Beginning in fiscal 2013, ParentCo’s NECC adopted three metrics for the long-term incentive program, replacing the Adjusted EPS metric used in past years. At the start of fiscal year 2014, ParentCo’s NECC reviewed the compensation elements and determined that the compensation elements adopted in fiscal 2013 continued to be consistent with ParentCo’s compensation philosophy and approved the same metrics for fiscal year 2014:

• adjusted return on invested capital (ROIC), to support ParentCo’s focus on cash flow, including improved working capital performance, and to emphasize the importance of capital allocation decisions;
• cumulative adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), to emphasize growth in core operating earnings; and
• relative total shareholder return to further ensure that realized results are aligned with, and shareholder value creation results from ROIC and EBITDA can be further impacted by relative total shareholder return.

Margin Rich here again, for the cash bonuses the payouts aren’t simply based on earnings or profits. It’s earnings, operating profit aka cash from operations, company ability to reduce expenses, and working capital efficiency to help drive free cash flows. The stock awards are based on ROIC, EBITDA, and total shareholder return. These incentives seem quite shareholder friendly in light of the cronyism, greed, and career risk that runs rampant through the corporate world these days.

Ok, so I realize I’ve presented a little bit of a conflicting opinion here by pointing out the declines of the battery business but sharing appreciation for management’s focus on free cash flow and reasonable compensation packages for executives. The reason is because from a speculative standpoint, this spinoff can be approached in multiple ways. As a long-term investor, or at least 3-years according to the study, going long EPC and ENR provides what could be a solid opportunity to generate a market beating effort. Consider the pros: shareholder friendly management, great free cash flows, reasonable debt levels, and the tail-wind of the average performance of spinoffs according to several different academic studies. The cons: ENR’s declining revenues and profits, lack of innovation at ENR, and the negative perception that comes with the first two cons.

Notice I didn’t include Edgewell in the cons list as I think it may represent the better of the two opportunities. I suspect we may see the money management crowd attempt to short ENR while going long EPC, a classic arbitrage. Consider where the current combined company has seen its growth in the past 12 years. It’s in the personal care division through smart acquisitions. Observe:

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Have a look at how Personal Care and Household have stacked up against each other in sales and profits for the last few years, via the most recent 10-K.

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It’s plain to see where the growth and the slump has occurred within Energizer Holdings. This is why I think the short-term trade is to go long EPC and short ENR. The battery business may get sold off as investors vote with their feet behind the company’s declining earnings. Obviously, nobody has a clue as to how the market is going to react to the post-spun shares. Both could sell off indiscriminately or be bought in a frenzy. These are the obvious risks of speculating, but they’re worth reiterating time and again. Another risk to consider is the ticker-risk with EPC. ENR is the current ticker of Energizer Holdings and the spinoff of the battery business will maintain that ticker. As EPC will be the new ticker that shows up in the accounts of current shareholders of Energizer Holdings, EPC may get sold off indiscriminately despite its higher growth profile in sales and earnings.

There’s plenty to consider here if attempting to capitalize on the Energizer spinoff. This is just a light dusting of research that should be undertaken for an intelligent investment. There’s still cash flows to model. The patent portfolios are fairly significant and would require a detailed look, if possible, to gauge value. Additionally, the capital structure has still not been finalized for new Energizer. Always conduct a thorough analysis but you can see that a spinoff presents a fun opportunity to test your skills as an analyst and speculator. Bear in mind, the professional set has picked this opportunity apart and modeled it a dozen different ways so if any readers attempt to allocate capital on this play; don’t try to be too cute.

There are a multitude of sites that allow anyone interested to stay on top of spinoff opportunities. One of my favorites is SpinoffMonitor.com. You can also check out StockSpinoffs.com or StockSpinoffResearch.com. Energizer Holdings is widely followed, and again, it’ll be analyzed six ways from Sunday by every analyst and money management firm out there. For a fresh research opportunity, consider W.R. Grace, which will be splitting itself into two companies. Grace is a well-capitalized, diversified chemical manufacturer. Each new Grace company will be an upper-tier participant in its respective industry. Have fun and good luck.

Don’t Forget to Read Prem Watsa’s Shareholder Letter, Too

Like many other experienced investors, I appreciate the value of a high-quality insurance operation. Berkshire Hathaway is the gold standard in this industry from an investment standpoint and the recent 50th anniversary shareholder letter was widely commented on throughout the financial realm. It’s not as if the Berkshire family of insurers are the absolute greatest underwriters in the world. They simply have such grand size and scale in combination with enough discipline to continually underwrite at a profit which continues to provide Warren and Charlie with a ridiculous level of float to continue their intergalactic wheeling and dealing. Yeah, I said intergalactic, as in, Berkshire’s about to close a deal for part ownership of Ganymede, Jupiter’s largest moon. Rumors are swirling that Lemann and the boys at 3G will front most of the capital while Warren obtains the preferreds on the newly discovered salt-water bodies.

Much ballyhoo is paid to Buffett and deservedly so, however, Prem Watsa who is his much smaller counterpart up in Canada also provides a must-read annual shareholder letter. Watsa runs Fairfax Financial which has long been considered a “Baby-Berk” and you can scour the web to find countless articles on them. I’m not writing today to conduct a deep-dive on Fairfax. Feel free to dig into their old letters and annual reports for that. I just wanted to share a little content from Watsa’s most recent shareholder letter in light of all the press that W.B. and C.M. received for Berkshire’s. Watsa is a well-respected value investor who is often criticized for his asset allocations but he almost always has the last laugh.

Watsa’s letters are filled with quality analysis on current economic and market goings-on. Does he explain his whole playbook? Of course not, but he shares enough to make you consider your own stance and allocations. Many consider Watsa’s skills to be right up there with any asset manager alive. I thought I’d share what are a few important notions from his most recent letter, which was released at the beginning of March. Full disclosure, I’m a long-time and current shareholder in Fairfax Financial.

First, I’d like to display the Fairfax CAGR in Book Value as well as Share Price:

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Holding a stock that had a 20% CAGR in the share price over the last twenty-nine years was an easy way to become wealthy for anybody who happened to have been smart enough to have purchased shares and held them. I, unfortunately, am not one of those smart persons. Aside from all the usual valuation metrics and models for the seasoned investors to analyze, at $545/share(USD) the investing novice can pick up some shares and let Prem work his magic for hopefully another 15 to 20 years. Watsa turns 65 at the end of the summer and he’s long said he does not want to work into his 80’s, but obviously we’ll have to wait to see what the future holds. It’s very difficult for a successful business person to just hand over the reins of their babies which they’ve built from nothing. I don’t see Watsa casually walking away from Fairfax just because of age. As long as his mental faculties allow him, I see him running Fairfax.

Watsa has done a brilliant job acquiring add-on insurance and reinsurance operations around the world to expand Fairfax’s international footprint. Additionally, he’s shuffled and empowered managers to tighten up underwriting standards across all lines. The result has been a significant increase in operating profits.

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You can see that just a few years ago, Fairfax was underwriting coverage at a loss across multiple subsidiaries. Only the discipline at their largest revenues source, OdysseyRe, allowed them to maintain a combined ratio under 100% in 2012. For any readers who are not fully aware of how profit reporting works with insurance companies, if an insurer or reinsurer has a combined ratio of 100% or higher, then the company is underwriting policies at zero profit or a loss. It’s what’s called a lack of discipline and even if the CIO has tremendous investment results, consistent underwriting at a combined ratio over 100% is a sure-fire way to insolvency.

This trend in the combined ratio is a very positive development and I look forward to a consistent number in the low 90s or even 80s.

Arguably, the most important component of an insurance business to analyze is the float. Watsa has been very forthcoming about Fairfax’s float levels and how the float has positively affected the company’s “cost of capital” to invest. Disciplined underwriting allows Fairfax to essentially be paid to let one of the greatest investors in North America to invest it’s capital. Observe the following chart depicting some of Fairfax’s long-term float performance.

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In Prem’s own words, “Our long term goal is to increase the float at no cost, by achieving combined ratios consistently at or below 100%. This, combined with our ability to invest the float well, is why we feel we can achieve our long term objective of compounding book value per share by 15% per annum. In the last ten years, our float cost us 0.3% per year – significantly less than the 3.6% that it cost the Government of Canada to borrow for ten years.” A negative number under “Cost (benefit) of float” means that Fairfax was paid to invest. That number is a return on float investment, which over the last 10 years, takes the average cost of investment capital to damn near zero.

For a deeper dive on the importance of the positive carry on float, have a read of Berkshire’s most recent shareholder letter if you haven’t already. Additionally, Porter Stansberry has produced a multitude of fine analyses on the value of quality P&Cs effectively managing float.

Like Berkshire Hathaway and even Markel, Fairfax has a bevy of non-insurance related public and private equity investments with the most well-known being Blackberry. You can read the entire letter or the annual report for the details on those businesses. The last part of the shareholder letter that I wanted to touch on is the equity hedges and Fairfax’s derivative book.

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On the surface, it would appear as if Prem’s portfolio hedging decisions have been less than successful. These are mostly non-cash losses though as a majority of these are simple write-downs and not actually realized losses, but the cumulative impairments since 2010 are substantial. However, we saw the same thing leading up to 2007 – 2008. During 2003 – 2006 while credit was flowing out of every orifice on the earth’s surface, Fairfax suffered significant unrealized losses on their hedging program. Then 2007 and 2008 came along to make Prem look like a genius.

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Look at those outsized gains. Watsa’s multibillion dollar winning bets paid off huge during a time when even the smartest investment players on the planet were sitting around slackjawed questioning the great existential philosophy of what it means to be an asset manager.

Although the losses are primarily unrealized, it also means that Watsa may have positioned too largely and too early. Not only does the hedging program require mark-to-market revaluation but there is also the cash outlay for the payments of premiums. It is clear Watsa feels he has been exercising prudence here despite possibly underestimating the impact of central banking on the investment world. I won’t begrudge him though, because what is more important, is that Fairfax is seeing a shift in the value of their hedging program. The trend is already beginning to move upward.

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Notice how there was a slight improvement in 2013 and a doubling in value in 2014. This may be a precursor to broader market conditions as we saw the same thing leading up to the Great Recession. First, the valuation of the hedging program starts shifting positive and then the early bets pay off in spectacular fashion. It’s definitely something to keep in mind as you continue to invest in today’s markets. I would not discount the fact that Fairfax’s hedge book is beginning to increase in value.

Prem Watsa has earned the respect of everybody in the world of investing. He stomped out short-selling hedge funds via the legal system back in the 00’s. He’s grown Fairfax from virtually nothing into a highly successful international insurance conglomerate. His investment results, although admittedly choppy by Watsa, are legendary due to the big scores. Have a read of the recent 20 page shareholder letter. It’s fairly easy to digest and you get a very honest assessment of Prem’s current view on the investing climate. As Munger would indirectly say; read, read, and read some more.