Elm Ridge letter for the fourth quarter ended December 31, 2016; titled, “We Like The Odds.” The energy focused hedge fund successfully went long near the bottom in early 2016 and have some interesting commentary and positions. See the letter below.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
“Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs.” – Seth Klarman
“Whoa, is this the first time these are all positive numbers?” - My Daughter
We posted a decent end to a solid year, but we think we’re just beginning to turn the corner as value begins a long overdue resurgence. Although it may seem out of character for us to embrace the current thinking on Wall Street, we can see how rising interest rates and revised interpretation of already improving economic statistics will help a host of (not all) banks, insurance companies and some downtrodden cyclicals as they end their lengthy exile from the Good Hedge Fund Seal of Approval list.1
We think we are finally emerging from a dark time. Ever since 2010, when Washington infighting and the sovereign debt crisis first took center stage, the investing world has been running scared, with the 10-year yield tumbling from almost 4% to about 1.5% this past summer. In this “Safety Bubble,” there have generally been just three types of winners: apparent bullet-proof growth stories; stable bond proxies; and financial engineers benefitting from the extension of low cost credit. Value, driven mainly by financials and other economically sensitive areas, took it on the chin.
While it appears that the safety bubble was already leaking air this past summer, it might have taken a surprising election result for the market to really question the apparent consensus view that a host of traditional industries were perennially threatened with slow growth, deflation, a China slowdown and info tech-based disruptions. The fact that GDP, unemployment, wage and inflation statistics (that might have spurred rates upward and got the value ball rolling at the end of September) were already improving well before that event seemed of little import. And while we have our doubts about some of the less thoughtful claims about who is going to benefit from a Trump administration, we do agree that it is highly unlikely that the Republican Congress holds him to the same spending rules they imposed six years ago. Starting with a current federal budget shortfall now below that of the average since Reagan took office,2 a unified government should have little trouble dialing up deficit spending once again. While we often take issue with such consensus thinking, higher long-term rates do make a lot of sense. It’s not a sure thing; but we like the odds.
Just as the election woke them up to the realization that there are a lot more angry people in this country who do not think that a free economy with subsidized credit works for them, cliquish investors seemed to recognize that there are at least a few more companies that can thrive in our new world than were formerly thought to be the case. And when growth folk are confronted with an expanding list of “approved” holdings (diluting the impact of their herding), value benefits. Indeed, value (as measured by the difference between the Russell 1000 Value and Growth Indexes) just posted its best quarter since 3Q08.
It's Where You Are, Not How Fast You're Going
“People will agree with you only if they already agree with you. You do not change people's minds.” - Frank Zappa
“It all has to do with the differences between rates and levels.” - Nobody
But as we look to the rear view mirror, aren’t we just doing what everyone else does, extrapolating the recent past into the future? This is going to force us back into a discussion of levels versus rates-of-change, a topic that I couldn’t even find a quote for. Most of what you will read in the popular press is a recitation of growth rates, which are often confused with the thing being measured. But above average growth doesn’t tell you a thing about whether some long-running measure of activity is above trend. Where you are is often way more informative than how fast you’re going.
We forecast normalized earnings and use them to calculate fair value because stocks do, over time, cycle through these levels. While we might not be able to tell (or more accurately can’t) when the market will appreciate a company’s sustainable earnings power, it will at some point. And when we get our estimates correct and that appreciation does occur, the moves toward our targets can be both swift and – if the gap is sufficiently wide – enduring. We’re feeling better because this nascent value cycle is starting from a rather extreme point as you can see on the next page: both with the readily available price/book data and that for the Elm Ridge P/NEPS, short-tolong ratio,3 our primary internal measurement of the overall potential return.
Starting points like these help – with those on the other side so convinced of their positioning – to make the combination of value and momentum so powerful, as cheap stocks start their move, but have a long way to go, toward (and often past) fair value. And that seems to be where we’re starting, as Empirical Research Partners noted this past summer:
The magnitude of the financials’ [relative share in our best quintile of valuation] is comparable to that of the technology stocks back at the peak of the New Economy era, albeit in the opposite direction. Historically when value has become this concentrated and this antithetical to the market the future returns to value investing have been better-thanaverage [see exhibit lower left]. That’s true even if we exclude the bursting of the New Economy bubble, although in our view that’s not necessarily the right thing to do; the whole point of the exercise is to capture periods of extreme dislocation where a segment of the market is trading at unprecedented, and potentially unsustainable, multiples. Back then it was the tech stocks and today it’s the financials, in opposite directions.4
Our work, based on price-to-book statistics (below right), illustrates just how large that tail wind at a turn can be.
For instance, while we’ve already seen a big move in oil, we think that the commodity, and our stocks in particular, have a long way to go – and thus it still remains our largest sector overweight at just over 45% of our long portfolio. We’re sure you’ve all heard the pundits declaring that oil prices will be capped at $50-55 for the foreseeable future, since the industry just “works” at these prices, and the futures curve flattens at $55. (In fact, our energy deck