Horizon Kinetics commentary for the first quarter ended March 31, 2016.

H/T Value Investing World, Chris Mayer

  • Part I: Reminder of how dangerous the ‘ETF Stock Market’ is and of the enormous risk/value tradeoff between index securities and individually selected stocks.
  • Part II: Why Beta, the go-to fund selection statistic, is entirely misleading – and might lead you off a cliff.
  • Part III: The cash balances and what we’re doing with them. Also, Core Value’s return to ‘equity bonds’ – not the 2002/2003, but the 2016 vintage.

Horizon Kinetics – Part I: Let’s Be Clear About Valuation Risk

Horizon Kinetics’ 4th Quarter commentary established just how much at risk the broad stock market is. Dominated by companies favored by the major indexes and ETFs for their trading liquidity and their low price volatility statistics, they serve the needs of ‘industrial scale’ investing. For the mature companies representing the largest portions of the S&P 500, margins are at historic highs, growth has slowed or stopped, and the ETF demand for the shares has inflated valuations to excessive levels.

The message should not be forgotten just because a few months have passed. So, we’ll supplement the discussion with a newly popular type of ETF: the low-volatility ETF. The iShares MSCI USA Minimum Volatility ETF (ticker USMV), for instance, has almost $12 billion of assets3, more than twice as much as last July. By comparison, the old standard, the iShares S&P 500 ETF (ticker IVV), has only 3% more assets than a year ago. The website ETF.com describes USMV thusly: “The fund typically overweights defensive, dividend-paying sectors … The ETF takes substantially less risk than the market portfolio as shown by low beta.” Really? Language has power, power to distort thinking and decision making. Part I of this review will compare “risk” and opportunity through the prism of formulaic investing, as via USMV, versus individual security analysis and selection, as via Core Value.

Horizon Kinetics

The Consumer Brand Group There are 168 companies in USMV, with several major sectors, which are just ‘safer’ subsets of the S&P 500. A large portion is the well-known brand companies, such as McDonald’s, General Mills, Coca-Cola, and Procter & Gamble. Now demonstrably mature, their revenues are either declining or essentially flat. McDonald’s, the 3rd largest holding, is an example, and the accompanying table provides some of McDonald’s financial data for each of 2008 and 2015. Here are two stories about that data.

One Story: Revenue in those 7 years rose by less than 1% per year, 7.98% in all, net income by even less. The balance sheet was more dynamic: property and equipment rose 14%, but long-term debt rose by over 135%. Its shareholders’ equity contracted by close to 50%. If you could have been told this story in 2008, would you have purchased the shares? Should we have?

Another Story: The McDonald’s share price appreciated by 90% over the 7 years, which is 9.6% annually.

Explanation: One thing that happened is that McDonald’s P/E ratio expanded from 16.9x to 24.6x. That shareholders were willing to pay more for the same earnings accounted for about half of the stock return. Another thing that happened was that interest rates dropped; for 10-year Treasuries, from 4.08% at the beginning of 2008 to 2.30% at year-end 2015 (and to 1.77% now). This permitted McDonald’s to finance a massive share repurchase program that would have been unaffordable but for these artificially low rates, which is why its interest expense only rose by 22% even as its debt ballooned by over 6x this amount.

Whether or not interest rates increase, though, it must surely be realized that the share price appreciation of the past seven years is hardly likely to be repeated.

And Another Story: An alternative might have been Wendy’s. According to etfdb.com, of the well over 1,000 U.S.-traded equity ETFs, none has significant exposure to Wendy’s; 29 have significant exposure to McDonald’s. Wendy’s was purchased in Core Value in 20124 not because it was the most profitable restaurant chain (that would be McDonald’s), but because it was about the least profitable.

In 2012, Wendy’s net profit margin was less than 3%. Domino’s margin was 6.7%, Panera’s 8.1%, and it was 11.8% for Yum Brands (the KFC, Pizza Hut and Taco Bell combo), let alone McDonald’s 19.8% margin. Wendy’s, though, had a plan to induce franchisees to remodel their stores. Experi-ments at company-owned stores had already demonstrated higher customer traffic, revenues and profit margins. A related strategy was to sell most of the company-owned stores to franchisees. Restaurant chains’ owned stores have a lot of revenue but very low profit margins; revenues from franchisees are akin to royalties: much lower but with extremely high margins.

By 2015, Wendy’s net profit margin more than doubled, to 8%. Between 2012 and today, the share price rose 150%. And the remodeling program is only one-third done. As it approaches half-way, remodeling expenditures are expected to diminish, while the earnings contribution from the growing proportion of reimaged stores will increase. Accordingly, Wendy’s expects free cash flow in 2018 – after capital expenditures – to be 33% to 66% higher than 2015’s net income. That’s about a 10% to 18% growth rate.

The Telecom Group USMV also includes top 10 positions in AT&T and Verizon (numbers 2 and 6), but one can’t watch television without seeing competitors advertising for customers to switch carriers based on deeply discounted price plans. Cellphone service is a classically high-fixed-cost, low-marginal-cost business: if the incumbent service providers are forced to lower their prices, there will be a virtually undiluted impact on operating income.

REITs and Electric Utilities Two major USMV sectors are REITs and electric utilities. Marketed as “bond substitutes,” they exhibit low price volatility care of declining interest rates and continuous buying by index funds. They are at all-time high valuations. The utilities trade at a remarkably low 3.5% dividend yield. These different sectors do not represent diversification. They simply represent different, very long-dated exposures to interest rates at an historic low—or put differently, additional ways to suffer severe losses if long-term rates rise. Moreover, elec-tric utilities face a rapidly expanding threat from the popularization of rooftop solar panels. Just a couple of percentage points of demand deficit represents tipping point issues relative to utilities’ ability to expand earnings at all or to earn sufficient returns on high-cost historical plant and equipment to support dividends.

As to the REITs in USMV, they yield only about 3%, or more than 30x earnings. The largest U.S. REIT is mall operator Simon Property Group (ticker SPG). There are 22 ETFs in which SPG is a significant holding. Real estate companies are not exempt from competition or economic cycle risk. SPG experienced a 1% decline in occupancy in 2015, while tenants’ sales per square foot rose only 0.1%. That is the wrong direction for a high-valuation stock with growth driven by rising base rents, overage rents and leasing spreads. The largest holding in USMV is Public Storage REIT (PSA). The self-storage companies have been expanding so rapidly via new construction and acquisition that the issue of market saturation arises. Their earnings growth has been fueled by 6% rent increases and large quantities of debt. This pattern, for which exaggerated valuations

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