Value Investing

Whitney Tilson “I feel like a kid in a candy shop”

Excerpted from an email Whitney Tilson sent to investors.

1) Though I’ve never invested in any Chinese company (on the long side anyway) or in the energy sector (other than a brief bet that BP would cap the well after the Deepwater Horizon disaster), a lot of my stocks have nevertheless gotten killed this year, such that my funds are down in line with the market (a bit more than the S&P’s -8%, a bit less than the Russell 2000’s -11.4%).

 

This would be really discouraging if I were fully invested, but instead, with 1/3 of my assets in cash (not counting the 15% total short exposure; i.e., I was 67 by 15 coming into today), I feel like a kid in a candy shop as I decide how much of my dry powder to invest right now into the many companies I’ve owned for years and know deeply whose stocks have fallen to silly levels, vs. how much I want to keep in reserve for future opportunities.

 

So I’m going to split the difference: starting today and continuing next week, I’m planning to invest roughly half of my cash to add to 6-8 of my current favorite positions (including my five largest, in order: Berkshire, Howard Hughes, GE, Spirit Airlines and Canadian Pacific – all bought today), while keeping ~15% in reserve for either new stocks I find or to invest later if my existing portfolio sells off even further.

 

My decision isn’t a market call – I’m certainly not predicting that today’s sell-off marks a bottom. I just think that the stocks I’m buying are too cheap. The key to successful investing is keeping one’s head while others are losing theirs, and having the courage, conviction and cash to buy out-of-favor stocks when they are under intense selling pressure.

 

That said, I wouldn’t be buying if I thought the world was going to get very ugly – but I don’t. I think things are going to be OK, especially in the U.S., which is where nearly all of my portfolio is concentrated.

 

Low oil prices are GOOD for the U.S. – it’s amazing to me how many people seem to think the opposite. And China may have some difficult adjustments, but it only accounts for 8% of our exports, and exports account for only 13% of our GDP, making exports to China all of 1% of our GDP (and China is only ~2% of revenues and ~1% of profits of the S&P 500 companies) – yawn… And, with banks well capitalized, leverage low, fraud negligible and minimal off-balance-sheet nonsense, the chances of another Great Financial Crisis are de minimis.

 

I think that the market is having a temper tantrum, nothing more, so I view this turmoil as a buying opportunity – and a fool’s errand to try to precisely time the bottom.

Tilson adds in a follow up email:

1) A friend wrote in response:

 

My main caveat is that even with this drawdown, markets aren’t especially cheap (they’re certainly not expensive, but they also aren’t as cheap as late 2008 or October 2011).

 

I agree. After a nearly seven-year bull market, a ~10% pullback doesn’t mean stocks in general are cheap. For example, I went to a CJS Securities conference last Wednesday at which 48 mostly small- to mid-cap companies presented and, other than PAH (which I own), I didn’t find any other companies whose stocks looked interesting. This is consistent with the fact that I haven’t added any new positions to my portfolio since Spirit Airlines a few months ago.

 

That said, though they could fall further still, I’m happy to add to a few of my favorites: HHC at half of its intrinsic value (even if you value its Houston properties at zero; see Todd Sullivan’s excellent presentation a year ago, posted here), Berkshire at nearly 30% below IV (see my slides here), Spirit Airlines at 9x earnings (with a huge tailwind from low fuel prices), Canadian Pacific at 10x earnings, etc.

2) Attached is Howard Marks’ latest missive. I agree with his conclusions on pages 13-15: “a rerun of the Great Financial Crisis isn’t in the cards”; and it’s time to take “a somewhat more aggressive stance here in early 2016”

 

3) A NYT article showing how useless Wall Street forecasters are – and an interesting tidbit: “No recession since 1962 has occurred without an advance signal from the bond market known as an “inverted yield curve.””:

What is likely, if not absolutely certain, is that the Wall Street consensus will be wrong.

The Bespoke report reviewed the recent history of Wall Street predictions and found them wanting. Since 2000, it found, the consensus has called for an average yearly increase in the S.&P. 500 of about 9.5 percent. The actual average annual change was less than 4 percent, however, and consensus predictions were inaccurate in every single year, sometimes by preposterous margins. In 2001, for example, the consensus called for a gain of 20.7 percent. But the index fell by 13 percent. In the horrible year of 2008, the consensus was that the market would rise 11.1 percent. As many investors may recall, it fell by 38.5 percent. Not once since 2000 has Wall Street predicted that the market would decline in a calendar year. Yet the market actually fell in five of those years.

This doesn’t mean market analysis is useless. There is evidence, for example, that factors like stock valuations affect overall market returns over periods of five years or more, and that the level of prevailing interest rates influences returns over shorter periods. At the moment, those two factors point in different directions, however.

After years of gains, overall valuations are stretched, by most measures, which may augur poorly for future returns. The price-to-earnings ratio of the S.&P. 500, for example, ended the year above 18, compared with an average since 1926 of a little over 15. That implies that investors are paying more for stocks than they have in the past. Higher prices often lead to price declines, but there is no assurance that this will happen on a known timetable, or that it will happen at all.

On the positive side, interest rates, both the short-term ones set by the Federal Reserve and the longer-term rates established in the bond market, are extremely low by historical measures. That’s the case even though the Fed has begun raising short-term rates. At the moment, for example, the yield on 10-year Treasury notes is about 2.1 percent, compared with an average of more than 6 percent since 1962. With the rates on relatively riskless investments in Treasuries remaining so low, the stock market may seem attractive as long as the economy grows and companies generate profits — in other words, unless the economy falls into a recession.

On that score, the bond market may offer helpful clues. No recession since 1962 has occurred without an advance signal from the bond market known as an “inverted yield curve.” This simply means that short-term rates become higher than longer-term rates, reversing the typical order of things. When that reversal happens, the Bespoke report said, it “represents a belief by the market that current inflation and real interest rates are too high, and that activity will eventually contract, reducing inflation and forcing the Federal Reserve to lower interest rates.”

The yield curve right now is rising sharply, indicating that the bond market does not see a recession on the horizon. While the market has often predicted recessions that have never occurred, no recession has occurred without such a prediction. In short, this is a portent of stability.

 

4) For a contrary viewpoint, here’s an interview with my friend Mike Burry (who Christian Bale is portraying in The Big Short):

Where do we stand now, economically?
Well, we are right back at it: trying to stimulate growth through easy money. It hasn’t worked, but it’s the only tool the Fed’s got. Meanwhile, the Fed’s policies widen the wealth gap, which feeds political extremism, forcing gridlock in Washington. It seems the world is headed toward negative real interest rates on a global scale. This is toxic. Interest rates are used to price risk, and so in the current environment, the risk-pricing mechanism is broken. That is not healthy for an economy. We are building up terrific stresses in the system, and any fault lines there will certainly harm the outlook.

What makes you most nervous about the future?
Debt. The idea that growth will remedy our debts is so addictive for politicians, but the citizens end up paying the price. The public sector has really stepped up as a consumer of debt. The Federal Reserve’s balance sheet is leveraged 77:1. Like I said, the absurdity, it just befuddles me.

Whitney Tilson
Whitney Tilson