Margin Rich

Value of Increasing Portfolio Cash Levels

Posted on May 19, 2015 by Margin Rich

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:

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,

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.

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

Posted on April 6, 2015 by Margin Rich

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.

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:

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).

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:

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.

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.

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.

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:

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.

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.

Short-term Equity Risks Arising

Posted on March 26, 2015 by Margin Rich

Despite Wednesday’s(3/25/2015) market weakness on virtually nothing but fear, there is plenty of technical action showing that markets appear fine. The question is how reliable is the action. Breadth indicators across multiple indices are positive. Small caps are leading large caps. Consumer discretionary to staples are favorable. Rate sensitive ETFs(TLT & XLU) have been conducting basic retracements which is perfectly natural coming off their hard sell-offs, but I think their selling will resume which will continue to indicate higher risk appetites once stocks take a little breather of their own. If the equity markets do what I think they’re going to do, which is correct a little harder here in the near-term, then I suspect TLT and XLU will chop for a bit while stocks let off of a little steam.

Everybody has their own methodologies for reviewing the markets to get a feel for the probability of directional plays. I really like to use inter-market analysis to help me potentially sense where the greater market may be headed. I have been watching biotech very closely as it has been the hottest sector and a market leader for some time. Real weakness in biotech may be a precursor to overall market weakness. That action last week in IBB had me suspicious. To me it appeared to be a blow-off. Call it what you want, a throw-over or a bull-trap. Either way the price action raised my hackles and officially put IBB on my radar as a temporary short. Current price action in IBB and the S&P 500 may be proving that out.

Now clearly, biotech is in a raging bull market and has been for several years now. You don’t want to fight that trend. It’s better just to ride it upwards for continued profit, because it’s going to take a lot more M&A in that sector before we see a top in biotech. However, there was a bit of froth in biotech M&A during the first quarter of 2015. Observe the following chart courtesy of Reuters and just look at Q1’s performance amongst pharmaceutical companies compared to the last 5 years.

We haven’t seen that kind of aggression since coming off the lows of 2009. There’s been approximately $60B of M&A activity in pharmaceuticals to start 2015, which accounted for 10% of overall M&A activity in the quarter. Twenty-one billion alone of that $60B was done in the Pharmacyclics purchase by AbbVie. That also signaled to me a potential short-term top for biotech as J&J and AbbVie slugged it out for rights to the cancer-fighting company.

So the real question then is how is this information actionable? Well that depends on your appetite for risk and how you’re looking to allocate capital in the short-term or long-term. If you’ve been visiting this blog for a while then you’re well aware I’m always ready to roll the dice based on my ability to interpret market action. I think shorting biotech via IBB or XBI is a good opportunity. I could have positioned earlier, but I was waiting for the price action to confirm so as to hopefully avoid being whipsawed.

If any readers are inclined to risk come capital, I think that IBB’s price action has stated to market players that it looks good for a short-term short. A small bounce at this price point is likely; especially in light of that 4% down day. I suspect the bounce could move the share price back up into the $355 to $365 range giving weak hands sufficient room to liquidate. That liquidation could then kick off the next leg down in biotech. There is a very strong floor at $290 as that is where the current 50-month EMA rests, so any option players will want to factor accordingly. I’m not stating that I think IBB will definitely hit $290, just that it’s a strong price point of support.

If IBB’s share price creates un-compelling options price points for smaller traders, then the XLV is a solid alternative. It has higher relative strength due to the size and various types of non-biotech holdings, but XLV possesses sufficient exposure to biotech that it will correct as well and it’s options may allow for a wider range of speculators to employ strategies.

As for the larger market i.e. the S&P 500, I wouldn’t expect anything deeper than a 10% correction if even that deep. There’s strong support at its 50-month EMA, as well, which is currently at $1,987. A 10% correction would take us down to approximately $1,900, which is also a round-number “power line” that I see providing strong support. I also suspect that any sell-off would result in yet another V-shaped recovery so be prepared to remove any short bias as a new leg higher ensues for the S&P 500 and biotech. Remember, these are interpretations based on my inter-market analysis. There are plenty of breadth indicators putting a more positive spin on things.

The markets are tricky, rigged, and no place for the ignorant. Manage your risks accordingly and utilize any potential correction to get long. There is continued quantitative easing on a massive scale across the world and the Fed is still reluctant to raise rates just yet. Current liquidity levels and yield curves continue to put a wind in the sails of higher risk assets. As Q1 draws to a close, take a moment to review your portfolio and see where you stand in 2015.

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

Posted on March 17, 2015 by Margin Rich

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:

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.

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.

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.

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.

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.

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.

Canada Be Ballin

Posted on February 28, 2015 by Margin Rich

I thought I’d take another sports break from the markets. Don’t worry it’s not more gambling advice but my calls may be just as implausible as those NCAA football picks from last fall.

Don’t look now but Canada is putting together an exceptionally talented basketball team to compete on the world stage. The battle is routinely just for second place behind the NBA’s traveling all-star team every two years, but with their youth and athleticism, Canada’s ready to really upend the international basketball hierarchy. Spain, Argentina, and France are aging and if the Canucks can put together the right type of offensive and defensive schemes from a chemistry standpoint, then Canada just may have a slim chance at the championship games at the Olympics next year and the World Cup in 18.

It may be hard to wrap your mind around right now considering that Steve Nash passed on even playing for them due to a total lack of competitive ability by the national team. Plus c’mon, Canada is the land of hockey and always will be. But consider, the last two #1 overall NBA draft picks were Andrew Wiggins and Anthony Bennett, both Canadian. To genuine fans of the sport of basketball, Canada’s potential rise in the world ranks should not come as a surprise. We’ve been watching top-level talent filter down into the NCAA programs for several years now.

Assuming contracts and obligations allow for participation, here’s the roster I’d like to see Canada field for the foreseeable future. The statistics are for the current NBA season, except for the 3 players at the bottom who do not play in the league.

All of the players except for Sacre and Bachynski can play at least one position bigger or smaller, so the team is highly versatile from a size and capability standpoint. This current roster seriously lacks in international experience and the average age of the team is only 22 years old. However, that overall youthfulness may play in their favor if they have the sheer energy and stamina to outpace teams. That’s going to be tough going up against the seasoned countries previously listed whose ball control and championship experience may negate any favorable age difference that Canada brings to a game.

The only player that really jumps out for most fans is probably Andrew Wiggins as he’s the clear front runner for rookie of the year, but the world stage may be all that some of these other players really need to showcase their respective skill-sets. Wiggins is a proven commodity. Bennett wasn’t a number one overall pick for no reason. The kid was dominant in his single season of college as a freshman at UNLV. He’s dealt with some unusual injury issues and there are questions about his stamina at the pro level but this summer may provide a window into what he may finally be capable of in the NBA. Sometimes all it takes is a spark of confidence to build some momentum with a young talent.

I think Thompson may be the most unappreciated talent out of everybody. Half of his rebounds are offensive which is simply incredible. I hate to use hyperbole here but I haven’t seen a nose for the ball like Tristan Thompson’s since watching Dennis Rodman. I think Thompson has the athleticism and skills to lead the NBA in rebounding for several seasons. He just needs starter minutes and the confidence to go after that title as the best rebounder in the league. He’s beastly as a power forward and I really think he’s going to open a lot of eyes next year at the Olympics; maybe even in the playoffs this season.

Stauskas and Ennis have made virtually no impact in their very young NBA careers thus far, but that doesn’t mean anything as repping your country and having the confidence of the coach to really put your talents to use without fear of retribution can potentially help these two youngsters blossom. Stauskas was the Big Ten player of the year and he pretty much scored at will against some of the toughest teams in the NCAA. He’s a willing passer who can make savvy plays as a 6’6 sharpshooter. Ennis was unfortunately drafted onto a Suns team that already had 3 stud point guards which has appeared to have dampened his confidence. The player I watched as a freshman at Syracuse last year was the best freshman point guard in all of Division 1. He only averaged 12 points a game, but the poise and confidence that he played with belied his age and experience. It’s my hope we get that level of control on full display while representing Canada.

Cory Joseph really just started to hit his stride last season for the Spurs. When Patty Mills went down, that gave Joseph a ton of backup minutes to Tony Parker and you can tell that coach Popovich’s confidence in Joseph really helped him breakout. Joseph is having a nice season this year for the Spurs. That championship experience will be extraordinarily important as Joseph will most likely be the leader of this young Canadian roster. I am looking for him to be the key guard on this team and expect him to get a lot of looks as a scoring playmaker.

Olynyk is a nice stretch big man who should be the key “pick & pop” man for the team. I can see how he may be labeled a little soft as he’s only averaging 5 rebounds a game as a 7-footer, but the same could be said for a majority of Caucasian foreign-born big men playing in the NBA. He’s not a rim-guarder like Tyson Chandler but he has proven his serviceability on defense. This Canadian team will rely on Olynyk more for his scoring than defense as the other two 7-footers on the possible-roster are simply defensive additions for the sake of rotation. Dwight Powell has shown some decent potential. I like his size. I like how he played at Stanford. He’ll learn a lot this year with Dallas that will hopefully help him make a strong contribution to the Canadian team.

Even though Sacre makes a very minimal contribution to the Lakers and Bachynski is not even in the league, these offseason opportunities give these kinds of players the chance to really prove what their capable of and maybe relive some of their old college glory. It’s my hope that they step up to the high level of competition and play at the maximum that their talent levels afford. If they do that then Canada will have gotten all they need out of these two. As far as additional big men go, I could easily substitute Andrew Nicholson for Bachynski here but he’s been in the dog house and I worry his confidence may be shot. Plus, he’s a full five inches shorter than Bachynski, however, his athleticism and length could quite possibly make up for the height differential. With him being a former stud-college player and then falling into the dog house after a very solid rookie year, I just worried about how Nicholson would perceive his role on this roster. Bachynski has nothing to lose and should very well know exactly where he fits on this team especially since zone defense is common at the international level. How else are you gonna offset the size, strength, speed, and sheer athleticism of the US team?

There’s also the intriging potential of Kentucky freshman Trey Lyles. At 6’10 and 250 lbs. and one of the top contributors on that deep Wildcat team, he would make another fine young addition, but I’m not sure where Calipari stands or the school for that matter in allowing Nash to potentially add Lyles so again I’m sticking with Bachynski here…but I fully recognize Nicholson and Lyles as the much better talents. Undoubtedly, Lyles will be a big-man mainstay for the Canadian program for years to come; hopefully as early as 2016 but probably beginning in 2018.

Melvin Ejim and Phillip Scrubb are very interesting. Ejim played for a very tough Iowa State team last year that went 28 – 8. Ejim was part of a 3-headed attack alongside DeAndre Kane and Georges Niang that was very difficult to defend by any team in the NCAA let alone other Big 12 squads. He averaged 18 points a game and was the Big 12 player of the year. Unfortunately, he failed to get drafted and didn’t make enough of an impression as a free agent to stick with an NBA roster. He’s a tweener and he plays bigger than his height. He averaged 8 rebounds a game so he can bang the boards with anybody despite being only 6’6. The problem is that at that height, you have to be highly effective on the perimeter. Otherwise you might as well just go to Europe which is exactly where he is right now. I think he makes an interesting pairing with Tristan Thompson at SF and PF when they’re on the floor together. I watched a lot of Iowa St. games last year and Ejim can really play.

Scrubb is currently a senior at Carleton University in the CIS. In case you were unaware, the CIS stands for Canadian Interuniversity Sport and it’s the Canadian equivalent to the NCAA. There’s approximately 47 schools that are in the CIS. Carleton University is the Canadian equivalent to UCLA from the 1960’s and 1970’s. They’ve won 10 out of the last 12 CIS championships and Phillip Scrubb is the 3-time reigning CIS player of the year. The dude can straight-up ball with any kid down in the US. Why he skipped a higher profile position at a Division 1 school is anybody’s guess but here’s a sampling of some of the torchings he’s put on American universities over the last few years.

In 2012, Scrubb dropped 28 on Northeastern. Ok, so what. Northeastern sucks. But then he embarrassed Jay Wright’s Villanova guards for 32 points in a loss. In 2013 against a then 12th ranked Wisconsin Badger team, he threw down 30 points while dishing out 12 assists. That same year he had 14 points and six assists in an overtime loss to a very good Syracuse team. Last year he put up 24 against Illinois-Chicago and then back to back 30 point efforts against Memphis. There is no doubt about this kid’s skills but he continues to fly under the radar because of his choice to stay in Canada.

This year has been a little off for him. He’s only averaging 16 a game for Carleton and the rest of his numbers are a little lower, too. For some reason he’s only playing around 24 minutes per game despite the fact that he’s played in every game except 1 this year. For a back to back to back player of the year, you’d think he’d be clocking at least 32 minutes a game at a minimum as the CIS games consist of 2 twenty-minute halves just like the NCAA. So really I guess his reduced output is a matter of perspective as he’s putting up 16.5 points, 4.5 assists, and 3.5 rebounds despite only playing 24 minutes a game. The CIS 3-point line is the same as FIBA’s which is just a few inches shorter than the NCAA’s. Scrubb shoots 3’s at a 47% clip. He’s gotta stroke and if he plays with as much poise against some of the world’s best as he did against the D1 squads, then I think he’ll make a nice contribution as a 3-point bomber. This is assuming he gets enough minutes to make a solid contribution, again, he is the only non-pro on my preferred Canadian roster.

The Pan-American games are in Canada this summer and it will give the Canadian team a chance to garner some crucial time together against other internationals while in their own backyard. Steve Nash is the GM of this squad and I trust that him and his head coach, Jay Triano, will pair down the roster to the most talented and capable of winning. I think the roster I laid out can take out all comers at the Pan-AM’s. The US usually skips it, so Puerto Rico won the last one. I feel confident that the roster laid out above or one very close to it can easily take out any South American or Caribbean team for the gold as long as Argentina sends its B-squad, which it should. From the Pan-AM’s it will be the final qualifying FIBA tournament in Mexico in the later part of the summer. The two finalists in Mexico will earn a berth to the Olympics, which would be Canada’s first in 16 years.

There are some very big questions to consider here, of course. What if these players that have had a tougher time in the NBA or abroad don’t play up to the talent they displayed in college? What if each individual fails to understand their role within the team and instead jeopardize success by trying to show off what they can do as a tactic in contract negotiation? Team success takes sacrifice and the lack of experience by this squad means this roster is going to need to understand that in a hurry. Most importantly, will Canada ever reverse its stance on insuring its players against injuries when they’re representing the country. Most of the other top FIBA teams do and it would go a long way towards ensuring that the best talent available is able to represent Canadian basketball.

Currently, the Canadian team is ranked 25th in the world by FIBA. After the 2016 Olympics and the World Cup in 2018, I have no doubt this team will be ranked in the top 10. You never know. Depending on how things come together, we may just see this new golden era of Canadian basketball see the team play its way into a top 5 world ranking. Full disclosure, I do have dual citizenship in Canada and the US thanks to my pops, but I was born and raised in the US so you can’t exactly label me a homer. I just really like the potential of Canadian basketball to shake up the FIBA status quo and I look forward to what the future will bring for the team.

You didn’t really think I’d sign off without mentioning any markets, did you? Be sure to maintain a close-eye on 10-year Treasury yields, TLT, XLU, and the US dollar. With the strength of the finish in equity markets this past month, I suspect those 4 categories will tell a very strong story of where equity markets are headed going into the spring. Volatility has really tapered off and there are many indications that the smart money is sniffing something around the corner. Nothing huge, but something none the less. Trade intelligently. Currencies and fixed income are singing a tune worth listening to…and GO CANADA BASKETBALL!