Dealing with Losers

Stocks are Down

 

Overall I’m pretty pleased with the ATG portfolio’s performance since inception 5 months ago.  We’ve stuck to our guns of investing in 8-10 stocks with a patient deployment schedule (we’re still over 50% in cash), taking some gains in response to quick abnormal up-ticks as well as adding to positions on down movements.  For the most part we’ve been able to stay ahead of the major index returns without taking too much risk, carrying responsible diversification without watering down our best ideas, and I believe we’ve done a good job of sticking with the principals of the ATG investment philosophy which I provided in the very first ATG blog post:

  1. Look for companies that are the best or near the best at what they do and have “moat-like” characteristics.

 

  1. Ask yourself if this is a company that you would be willing to invest in for 15 years based on their product, industry, and reputation.

 

  1. Pay close attention to a company’s balance sheet and capital investments.  A High amount of leverage is not necessarily a bad thing, but make sure you believe the company is properly capitalized to execute their business plan and that they adequately invest in growth and development.

 

  1. Once you have identified companies that fit criteria 1-3, filter out the companies that appear to be undervalued relative to their peers and the general market based on factors such as P/E ratio, return on equity, and price to book.

 

  1. Pay more attention to how companies perform and the hard numbers than what their executives say or the guidance they provide.  As an example, I love buying companies that dip on disappointing guidance and profit beats for the current quarter.

 

  1. Once you have picked your investments, track them closely and don’t be afraid to either take gains or cut losses based on the movements of the market.  I don’t necessarily advocate short-term trading, but taking advantage of quick, abnormal movements in specific equities is an advantage the individual investor has over institutional investors and mutual funds.  I truly believe a disciplined active management approach to specific equities can help an investor mitigate the impacts of larger adverse macro movements and help take chips off the table in a bubble environment.

 

Having said all of this, the portfolio has taken a major hit the past month, primarily due to two stocks:  Enseco (ESV) and Och-Ziff (OZM).  Below is a chart showing the performance on these two stocks over the last few months:

ESV, OZM

 

It has been a rocky ride- at one point ATG was actually up over 10% in both stocks before they started their painful descent.

Naturally the question comes down what we should do about it.  There are three choices:

  • sell and move on,
  • double down and buy more, or
  • do nothing and see if comes back. Let’s break it down individually:

Ensco, PLC (ESV).  This is company that owns and operates offshore drilling rigs around the world.  They are generally recognized as one of 2nd or 3rd the largest rig providers and pride themselves as having the newest fleet of rigs amongst their competitors.  Along with all the offshore rig companies, ESV’s stock has been under pressure lately due to concerns about over-supply of rigs through 2016 which could impact their utilization combined with a dramatic drop in oil prices over the past month.  What attracted me to ESV in the first place was their market-leading position combined with a great dividend (6%) and cheap P/E ratio around 9% due to negative buzz on the rigs in general as highlighted below.

I’m not smart enough to know where oil prices are going.  They may continue to lag due to international events and the fracking boom, but history suggests a bounce back up.  As for the company, I don’t see any negative developments- their utilization rates remain high, an impairment of older fleets on their balance sheet is behind them, and I don’t see any financial burden that would leave me to believe that would force them to cut their 6.9% dividend.  At a forward P/E of 7.59, there is plenty of room for slack as supply risk on the rig-side plays out over the next few years.  In fact I see this dynamic playing into ESV’s favor over the long run as competitors are currently discouraged from building new rigs and putting long-lead capital dollars to work.   To put a long story short, we’re doubling down on ESV.

Och-Ziff (OZM).  Och-Ziff is one of the largest alternative asset management firms in the world.  In simple terms, they invest billions of dollars in various vehicles on behalf of large institutional investors and charge both asset management fees and performance fees.  Their recent drop has been due to:

  • Negative publicity surrounding a lawsuit involving bribery and fraud (see moMANon’s prior post detailing the issue);
  • Calpers’ recent announcement (Calpers is the largest pension fund in the country) that they are exiting the hedge fund arena due to excessive fees and monitoring costs and
  • Lackluster fund performance. Through August, their three funds have reported paltry YTD returns of 2.57%, -1.47%, and -4.25%.

Despite all the bad news above, OZM is still making money and attracting fund inflows ($400 million in the last month alone).  Last quarter’s earnings surprised to the upside, there’s excess cash flow to cover their 6.6% dividend, and if they can improve fund performance over the  remainder of the year there could be additional performance fee distributions at the end of the year.  In fact, the consensus forward P/E ratio for OZM is an astounding 6.75, which is less than half of what the overall S&P is valued at currently.

When faced with disappointing stock picks and what action to take, I try to step back and apply the investment principals at the top of this post before making a decision.

In this circumstance it has led me to hold my faith in ESV (passed all 5 criteria) and question whether OZM belongs in the portfolio.  Given OZM’s weak fund performance and negative publicity, I question whether they can sustain their position as a market leading money manager with moat-like characteristics.  There is a decent chance their performance and reputational issues are a temporary blip and this is the perfect time to buy into their stock, but I’m strongly considering pulling the rip-chord and switching them out for a group like Blackstone (BX).

moMANon- speak now or forever hold your peace!

-Maverick

 

 

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Easy Money

Roullette

 

On my first trip to Las Vegas at 21, I arrived with an ingenious plan to win money that I’m sure thousands, if not millions of others have attempted with similar results.  The plan was simple:

  1. Bring $310 to the roulette table.
  2. Bet the minimum ($10) on either black or red.
  3. After each winning bet, continue to bet the $10 minimum.
  4. After each losing bet, double the previous bet until you have finally won, then go back to the $10 minimum.
  5. So long as you never hit a losing streak of 5-straight losses (which carries of 2.38% probability of happening), watch your stack of chips steadily grow ($10 x the # of rounds you play) until it’s time to break dance at Studio 54.

After 20 minutes of implementing my strategy at the Luxor, I stared in disbelief at the electronic display board with 6 red numbers aligned in a neat, un-obstructed column.  With no money in my pocket, I walked around the casino and was stunned to see how many other roulette tables were showing long streaks of red or black numbers on the display.  It led me to think a little bit harder about the true odds of my double- down strategy… It dawned on me that I had only calculated the odds of losing on my first five straight bets (2.38%).  I had not thought through the odds of losing five straight bets at any time over the course of playing several rounds.  Once working through the math I realized my strategy wasn’t’ so fail-proof after all:

# of Rounds Odds of Losing 5 Straight Times at Least Once
5 2.38%
10 13.5%
15 23.3%
20 32.0%
33 50.4%
50 67.1%

As you can see, the odds of losing your nest egg increase exponentially with the number of rounds play to the point where there is actually a greater than 50% chance that you will lose 5 times in a row starting after 33 total rounds.  One could reduce these odds by bringing a bigger stack to the table and stomach a 6+ losing streak, but it ultimately gets you to the same place:  If the odds of losing any particular bet are lower than 50/50, there’s really no magic formula for meaningfully swinging the odds in your favor.  You’re simply trading risk for reward and Vegas is taking a little premium cut on whatever risk/ reward level you decide on.  Now if you have the ability to count cards in Blackjack there’s a real opportunity to swing the odds in your favor (see “Bringing Down the House” by Ben Mezrich for a great tale on that), but that takes true real-time skill and expertise.

What does this have to do with investing?  I’m sure there’s an angle I can pull in here, but honestly I’m just itching for a Vegas trip and wanted to share with you one of my ill-fated, “bullet-proof” betting strategies.

Maverick

What is the Millennial Trade?

Family in Front of House

I don’t understand millennials.  But I realize that needs to change if I’m going to continue investing in the stock market.  As the largest demographic since the baby boomers enters adulthood, their behaviors and preferences will obviously play a dominant factor in determining which companies succeed and which companies bomb out over the next several years.

We’ve all heard the sweeping generalizations about the 80 million or so millennials out there:  urban dwellers, renters, entitled career climbers, more health conscious, more burdened with debt, more attention seeking, more comfortable challenging authority, more liberal, more diverse, negative patience, and more talented than any generation before it.  

This post could go in a lot of different directions, but I want to focus on one trend that is being driven in part by millennials, which is the significant increase in both new supply for apartments and rental rates, particularly in urban infill locations and cities with strong job growth trends like Denver, where I live.  To give you an idea of how hot the rental market has become in Denver, average apartment rents have increased 9.5% in the last 12 months alone despite delivery of almost 10,000 new units, which is more than what was delivered in the last 10 years combined.  Up to this point developers can’t build new projects fast enough to meet the demand of young professionals who (i) want to live in an urban environment, (ii) can’t afford a down payment on a house, and (iii) are willing to pay whatever it takes to have the newest space in the heart of the action.  This trend is certainly not unique to Denver- it comes as no surprise that multifamily REIT’s are up over 30% in the past year amidst the perfect storm of rising rents and record low interest rates.

I get that the urban density trend is not going away any time soon and that millennials think about housing differently than prior generations, but I recently came across a few data points relative to Denver that have led me to believe that the rental market is officially jumping the shark.

According to a recent study by Zillow, typical renters in Denver are spending 31.8% of their income on rent compared to 21.6% historically.  Additionally, average rents in Denver have risen to $1,712 per month, compared with a median mortgage payment of $1,375.

When I see the data above, all I can think to myself is (i) there is no way that spending over 31% of your income on rent is sustainable or desirable under any circumstance, and (ii) I suspect this is driven more by the circumstances of millennials (single with debt) than their true long-term preferences.  We won’t know how deeply entrenched millennials’ views on urban living are until they start having families and are faced with more difficult consequences and trade-offs of the urban vs. suburban environment.

I’m fairly confident I know the answer to both questions above, but the tricky part is the timing.  (It’s like shorting treasuries- eventually everyone knows that rates are going up, but anyone who has shorted them so far has likely been crushed due to poor timing.)

All this rambling leads me to the conclusion that I’m interested playing the overheated rental market by looking at the home builder stocks, particularly KB Homes (KBH), Pulte (PHM), or maybe Taylor Morrison (TMHC).  Despite rising home prices and low interest rates, the home builder stocks haven’t seen the same kind of appreciation that apartment players have experienced.  In fact, many home builder stocks are actually down over the past 12 months (KBH, for example, is down 1% over the last 12 months and Taylor Morrison is down 14%).

I find this particularly strange because in a place like Denver, the existing home sale market is also on fire- there is virtually no inventory available and multiple buyers are showing up the day most homes are listed.  My personal observation has been that most people with children and funds available for a down payment are seeking a very similar style of living that was preferred by prior generations.  There may be little nuances about proximity to public transportation or willingness to forego big lawns, but I think that the home builders are poised very well to benefit from millennials in the manner that apartment developers have seen to date- especially since they seem to be willing to pay up for quality new construction.   In fact, I would think that the apartment REIT performance and Home Builder stock performance should eventually converge given how close the cost of renting has come to the cost of home ownership over the past year.  That could mean a huge drop in multifamily REIT values to meet up with home builder stocks, a “meeting in the middle” of both asset classes, or a big rise in home builder values to catch up with the multifamily players.  2 out of the 3 scenarios result in home builder stock appreciation.

From a valuation and financial stability standpoint I feel OK about buying some home builder stocks today:  PHM, KBH, and TMHC all have attractive forward P/E’s between 9 and 12, ample land inventory, strong revenue growth over the past year and great reputations for being quality home builders.  When looking at debt levels and Price/ Book, however, one group stands out from the pack:  Pulte Homes (PHM)- they have shockingly less debt than their competitors (0.4 debt/ equity ratio vs. upwards of 3.5 for TMHC and KBH), ample cash,  and an attractive Price/ Book ratio of 1.5, which his below the industry average of 1.8.  As a result is doesn’t come as a surprise that PHM is the one stock in the group that has seen some decent price appreciation in the last year at 11%.

I have surveyed several smart people about their views on the home builder market, including two seasoned professionals in the industry.  While they generally agreed with the long-term demographic factors favoring home builders, there were some valid short-term concerns raised such as timing on millennial taste-shifting, overhang from the huge run homebuilders have already experienced in the past 5 years, rising construction costs, and rising rates.

Before investing I need to do some more research and dig deeper into their filings to confirm that the business is poised for growth and well positioned against its peers, but I think the time is ripe to add a home builder to the ATG portfolio.  This is just the first of many “Millennial Trades” we’ll ponder in building a portfolio that can withstand, and prosper from the onslaught of these strange beings.

Dear Mr. Icahn- Thank you for Saving my Ass!

Hertz2

 

Ten days ago ATG took an entry position in Hertz Rental Cars (HTZ).  My reasoning was primarily based on the following:

  1. I’ve personally noticed a significant increase in rental car prices over the past 6 months for both business and personal travel. On a recent business trip to D.C. an SUV rental was $150/ day; when some friends visited over a weekend a few weeks later, they paid $70/ day.  I remember when you could easily get a $25/ day weekend rental and $50/ day week day rate.

After experiencing these rate hikes, I decided to do a little research on rental car companies and the industry in general.  I was shocked to learn that:

  1. Three companies (Hertz, Avis, and Enterprise) completely dominate the industry, capturing close to 90% of the entire demand and 98% of the airport market. Enterprise owns Alamo and National; Hertz has Dollar Thrifty; Avis owns Budget and Zipcar.  These various brands give the consumer the illusion of competitive pricing, but in reality the three big boys are using them to price discriminate with few competitive barriers to keep raising prices over time.

This realization led me to look at which rental car companies might offer a compelling investment opportunity.  Enterprise is private, so that left Avis and Hertz.  As of August 11, Avis had already reported 2nd quarter earnings and blew it out of the water again, sending their stock up further to a staggering 137% increase over the past 12 months.  While they may not be a bad play, ATG usually avoids chasing momentum stocks as a general rule, which left Hertz.

  1. Compared with Avis’ 137% run, Hertz stock was up 19% over the past year and conservatively valued at a 12 forward P/E ratio. They had some lingering accounting issues and a history of inferior management and results compared with Avis, but I just couldn’t see a scenario where the tailwinds of a consolidated industry and improving economy wouldn’t shoot them higher.  Established company with strong brand recognition?   Valuable product/ service in a growing industry?  Check.  Conservative valuation relative to its peers?  Check.  Count me in.

Immediately after purchasing HTZ, the stock started moving up, probably because thousands of other people like me wanted to buy it in advance of their earnings for the reasons mentioned above.  It was up 15% in a week, and I felt like genius.

On Tuesday this week Hertz announced that they were delaying their quarterly results due to continued accounting irregularities.  They also revealed that they would be drastically missing their prior earnings estimates and would be lowering their guidance once the earnings were finally released.  There goes my genius status- the stock opened down 15% the next morning.

But wait, there’s more!  Late Wednesday afternoon our knight in shining armor showed up in the form of Carl Icahn, who revealed that he had taken an 8% stake in the company with plans to “motivate management” and actively address their underperformance relative to peers.  In the blink of an eye, the stock erased almost all of its earlier day losses, ending down 3% instead of the earlier 15%.  After the bell Jim Cramer dramatically placed Hertz CEO Mark Frissora on his “wall of shame” and proclaimed that his days as CEO were numbered.

While I am thankful for being rescued from the impact of Mr. Icahn’s investment and news gossip of a management shake-up, I hate owning a stock that moves more from activist attention and news headlines than actual performance.  As a result ATG took advantage of the fortunate exit opportunity and sold its position today, managing to lock in an 11% gain in 10 days despite the negative outlook on earnings.

I could be dead wrong and see the stock continue to climb as investors bank on accelerated turn-around, but I’m betting that the stock will drop again once they finally report earnings and drop guidance.  I think it bounce if they replace the CEO, but then tank again when the new CEO lowers forward estimates to give himself a nice runway of under-promising and over-delivering for his tenure.  I’ve seen this play out multiple times, most recently with Weight Watchers.

When and if that happens, ATG will pounce on buying Hertz again.  In the meantime, we’ll let Mr. Icahn and Jim Cramer’s army of speculators have all the fun.

-Maverick

Let’s Go Shopping!

shopping

In the past 10 days the S&P 500 has dropped over 3% over Russia/ Ukraine tension, Argentinian bond defaults, fighting in the Gaza strip, improving GDP numbers that could trigger an unwinding of quantitative easing, and who knows what else.  Anyone who claims to fully understand the complexities and future implications of each of these events should be thrown in a padded room (or given a spot on CNBC Squawk Box).   

This is the bad news- aside from diversifying across asset classes or dollar cost averaging, there is very little an investor can do to anticipate and guard against these unforeseen events.

Now for the good news- Despite all of these events and the recent drop, the S&P 500 is still up 5.5% on the year and plenty of stocks continue their upward march as the economy improves and earnings improve.  This little 3% “hiccup” from macro and geo-political uncertainty may provide some discount shopping opportunities.

Here’s my take on discount shopping in times like this:

  1. This is a “sale” opportunity and not a “clearance” rack. Make sure you buy quality companies that you believe in over the long haul just in case that sale turns into a clearance after you buy and a patient holding period is necessary.
  1. Start with looking at the stocks you already own and know well: buy more of the stocks you still really like that have taken a hit, but make sure you re-visit their financial position and prospects for growth.
  1. Look for companies that are actually on sale at the moment and have dropped materially from their highs (or have below-market P/E ratios). For example, I’ve been waiting for an opportunistic time to open a position in Disney (DIS) because I love the company, have a 3 yr old daughter obsessed with Tinkerbell, and I believe they have incredible staying power, but their stock price has not been affected at all by the geo-political and macro noise over the past month.  I’ll have to wait on Disney until the next sale or clearance opportunity. 

Based on the criteria above,  ATG has taken an entry position in John Deere (DE), added to its position in Ensco (ESV), and will likely be adding to its position in Google (GOOGL) and Whitewave Foods (WWAV).  We are also looking harder at airline and transportation stocks for sale opportunities.

It’s no coincidence that all the companies listed above are long-standing companies with huge competitive advantages in what I believe to be high growth industries.  Can you imagine a (near) future with increased capital spending on agriculture, energy consumption, continued dependence on online marketing/ e-commerce, more demand for non-dairy organic substitutes and increased travel for commerce and pleasure? 

If so, I’ll see you at the discount rack.  

Measuring Risk

Risk- ATG

I’ve always been puzzled by the notion of “measuring risk” when it comes to investing in the market.  If one were to ask a seasoned finance professional how risk was measured for a particular stock or portfolio, they would likely rely on a concept called Beta, which is simply the overall historical volatility (up or down) of a given stock or portfolio as compared with the overall market.  The higher the historical volatility or Beta, the riskier the stock according to this widely accepted methodology.

If one were to ask Joe Plumber how risk should be measured for a particular stock or portfolio, I suspect a response like “what are my chances of losing most of my beer money” might be pretty common.  It would also be much wiser than the Beta answer above. 

I’m not going to get into “margins of safety” or other value investing jargon in this post.  I would like to point out, however, that this is a classic example where common sense intuition regarding stock risk is far superior to generally accepted measures of risk in the investment community. 

Joel Greenblatt highlights this point by comparing two stocks.  Stock A has dropped from a price of $30/ share to $10/ share over the past year.  Stock B, on the other hand, has dropped from a price of $12/share to $10/ share over the past year.   From a “Beta” perspective, Stock A is now considered much riskier than Stock B due to its higher volatility. Said another way, the stock that has already lost 2/3 of its value is still considered “riskier” than Stock B, which has only fallen 20% in value over the past year.

From the example above one cannot definitively conclude that Stock A is safer than Stock B because it has fallen the most; but the inverse is also true- you can’t conclude Stock A is riskier because it simply had more volatility.  To answer that question a different set of parameters need to be considered- earnings stability, industry positioning, debt levels, competitive advantages, management team strength, etc.

What’s my point in stating what is probably obvious to all of you in the words above?  I don’t like risk, but I’m not afraid to embrace volatility.  In my mind they are two completely different concepts.   After all, volatility actually reduces the risk of option securities, whether you are betting on an upside or downside move.    

The Paired Trade

thumbs up, down

 

 

Like moMANon, I’m a little nervous about the market right now.  Not nervous enough to sell everything and dig out the bomb shelter, but nervous enough to add some defensive positions to my personal portfolio.  My current allocation is approx. 65% long equities, 25% cash, and 10% “defensive” positions in a volatility ETF and some gold mining and silver equities.  Yes, 0% in bonds, which moMANon would hate but I just can’t get comfortable with the limited upside, potentially severe downside nature of bonds in today’s environment.  I’ve decided to move up my defensive allocation by short selling a REIT to offset a long position I have in another REIT.

Tomorrow I’m pulling the trigger on a short sell of Regency Centers Corporation (REG), which is a company that owns and operates retail shopping centers throughout the country and is structured as a Real Estate Investment Trust (REIT).  A few weeks ago I generally laid out my arguments of why I’m interested in shorting retail-focused REIT’s: https://atginvestments.com/2014/06/12/speaking-of-summer-shorts/

Since that post, Regency has announced an unsolicited offer to buy a smaller retail REIT called AmREIT, Inc., (AMRE) out of Houston, TX at $22 per share, which is a 20% premium to their current share price, $2 psf premium to their all-time high share price, and a 4% premium to their net asset value (essentially value of their real estate and other assets less liabilities).  While there may be some SG&A (corporate overhead cost) synergies from a merger, this acquisition would still likely be dilutive from a combined earnings per share and P/E standpoint for Regency.  In my opinion Regency has offered to buy a bunch of retail centers at a price above their fair market value for a product type that I personally feel is already getting overvalued.

My offsetting “pair” to this trade is a long position in HCP, Inc. (HCP), which is a REIT that owns and operates healthcare-related real estate (senior housing, medical and assisted living facilities).   While this isn’t a perfect market-neutral trade with REG, I think it will protect me from substantial losses on REG if future gains in the overall market are driven by easy money and low interest rates.  HCP offers  a current dividend of 5.3% vs. 3.4% for REG, which means that I’ll make a 1.9% annual return if the two stocks move positively in tandem.

Email me/ leave a comment  if you’d like to go into deeper analysis and rationale for this trade, but the following table lays out the main reasons for why I’m longing this healthcare-related REIT and shorting a retail-related REIT:

Paired Trade Graphic

 

As compared to Regency, HCP offers a better dividend with a lower payout ratio and cheaper P/E valuation, not to mention a product type (healthcare-related real estate) I’m much more bullish on than retail real estate.  The only clear advantage that Regency has over HCP I can ascertain is that consensus earnings growth over the next 5 years is higher than for HCP (5.9% vs. 3.0%).  Regency doesn’t have an overly impressive track record of earnings growth over the past 5 years (7.9%) and I think the moat-like qualities of grocery anchored real estate are fading quickly. In contract  HCP has grown earnings 31% annually over the past 5 years and has increased their dividend every single year since their IPO in 1985.  Maybe the analysts are right and REG outperforms HCP over the next several years, but I’m comfortable going against the grain on this bet.