As Q3 earnings season approaches, there is a drought of company-specific news and events to analyze. Regardless of the lack of fundamental data points, investors appear committed to positioning themselves for another end of the year entitlement rally. I continue to have no opinion on the market’s near-term direction, but a year-end performance panic wouldn’t surprise me. During the current market cycle the S&P 500 has increased seven of the past eight Q4’s, averaging slightly over a 6% gain. This cycle’s only negative Q4 was in 2012 with the S&P 500 declining -1%.
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While equity investors enjoy daily record highs in the popular benchmarks, I continue to patiently wait in low yielding cash and cash equivalents (granted, yields are thankfully moving higher). As an investor uninterested in owning equities, it’s a rather uneventful and boring period of the market cycle. While I acknowledge stocks could go higher, I remain committed to a process and discipline that requires an adequate absolute return relative to risk assumed.
Considering the lack of information coming from companies and the markets, I thought today would be a good time to share some questions I recently received from readers and my responses. I selected questions I receive frequently, are useful in helping understand my absolute return process, and address the current environment. As always, feel free to email me with any questions and comments.
Jim O’Shaughnessy: Revisting The Ideas Buried In The Graveyard
ValueWalk's Raul Panganiban interviews Jim O’Shaughnessy, Chairman, Co-chief Investment Officer, and Portfolio Manager at O'Shaughnessy Asset Management. In this part, Jim discusses revisting the ideas that got buried in the research graveyard and his favorite books. Q1 2020 hedge fund letters, conferences and more Oh, man. Yeah, for the the research graveyard, do you ever Read More
Q: See anything or any sector that is somewhat interesting?
A: Since energy has rebounded, I’m not finding much. Actually almost bored to tears. Considered buying S&P 500 call options to cause the market to crash! Seriously…extremely boring market.
Everyone KNOWS markets are going to rally into year-end. And they certainly could…year-end performance panic has happened seven out of the past eight Q4s during this market cycle. Only down Q4 was 2012 with -1% decline. You have to wonder if this concerns central bankers – the environment they helped create. While a stock market that never goes down may be what they want, the complete lack of volatility and pureness in asset prices must be concerning.
Q: In regards to your most recent blog on inflation, other than government data, have you come across data points that suggest inflation isn’t going to increase? Also, suppose you knew inflation would increase with 100% certainty, how would that change the way you invest? What companies would you gravitate towards? What securities would you gravitate towards?
A: Yes, there have been some areas where price is not increasing or even decreasing. Often these areas are found where there is too much capital/over supply (energy bust 2014-2015 good example). Food was also a good example, until KR reported this quarter that trend has reversed. While there will always be cycles within certain industries causing inflation to fluctuate, I’m currently noticing more signs of rising costs than declining. I suspect this will continue in Q3, especially with higher energy prices vs. Q2. We’ll see…still need more data points to come to a conclusion.
I currently have a very patient position (liquid and waiting) and I’m not making investment decisions based on my inflation views (volatility in cost and price should be included in your required rate of return and normalized cash flow assumption). My main issue remains valuations. Small cap valuations are high regardless of my view on inflation.
That said, I think it’s important when valuing individual businesses to understand how margins are or have been impacted by inflation or deflation. For example, many companies dependent on natural gas have benefited from abundant supply. A chemical company would be a good example. Or how about PZZA and cheese prices? In effect, when normalizing margins I believe it’s important to normalize input costs as well. I believe extrapolating low input costs (including labor) indefinitely carries risks and assumes margins will remain elevated indefinitely.
Hope this helps. Looking forward to Q3 earnings season and more information.
Q: How did you form your investment philosophy? Did you try other forms like GARP or relative valuation before? How do you think about position sizing? And selling?
A: Great questions. The process question can be found by reading through my blog as I touch on it in several posts. I particularly recommend the post “What’s Important to You”. I plan to do a post on my sell discipline soon…that would be a 1000+ word email, so I’ll let you know when I post. Position size has to do with risk/return and quality (degree of operating and financial risk)…that’s a good post topic as well I’d like to address. Really enjoyed the article on cheese you sent…7% margins seem reasonable for a monopoly! MSFT’s much higher!!!
Q: If you are right and there is an unexpected bout of cost-push or other consumer price inflation in our near-term future, I think the game is over. After all, what options does the Fed have if inflation becomes the problem, not disinflation? I can’t think of the Fed being in a more difficult position: stagflation.
A: We’ll see what Q3 earnings season says about inflation. I’m not sold on the inflation accelerating idea yet, but definitely noticing more signs. I need more data to conclude. Also, for what it’s worth, so far I’m not seeing a noticeable earnings catalyst on the upside or downside in Q3. I think the greatest threat to stocks near-term won’t be earnings, but that stocks simply quit going up for no specific reason (old age and fatigue). And on the potential for more upside we have the good ol’ year-end performance panic by the “pros”.
Will be interesting next several months. I think as long as stocks go higher, rates continue to increase…a nice game of chicken could be forming between the stock and bond market! 2yr yielding approx 1.5%…I view gradually increasing rates as a raise so in an indirect way I’m benefiting from expensive equities getting more expensive. Asset prices and the economy are one trade, it seems. As long as asset prices remain inflated, I think the Fed will have to keep raising rates…especially if my theory on rising costs receives more supporting data in Q3.
Q: Do you know of good, niche conferences for small caps or small and mid-caps?
A: I do not go to conferences. I did earlier in my career, but as my possible buy list has grown I’ve found calling companies to be the only way I can keep up vs. visiting companies or conferences. That said, if an industry were to get extremely depressed, I’d be interested in attending. Great way to see a lot of companies in one industry at once.
Q: If you think about it, that’s the mechanism that would catch the majority of people off sides, just enough growth to give confidence that the market has more room to run and suck everyone back in before an unexpected pop in inflation and rates.
A: I agree…how fitting would it be for this nontraditional cycle to end in a traditional manner! We’ll learn more once Q3 earnings are released…right now I’m just noticing a change in trend. Degree and consistency is still uncertain, in my opinion. That said, my water utility bill just went up 8% and my favorite “cheap” taco joint just raised their chicken soft tacos by 7%!!! So maybe I’m biased.
Q: Would you consider investing in overseas market or build your competency in these regions?
A: While I think there may be more value in international stocks vs. US equities, it is outside of my expertise. My focus is on domestic US small cap stocks. I believe staying focused on a relatively fixed opportunity set over many years provides me with a competitive advantage. In addition to having a better understanding of their businesses and appropriate valuations, I believe my familiarity will allow me to act more decisively when opportunities return.
Hopefully specializing on the same stocks for decades pays dividends when this cycle ends! Currently my beliefs on my opportunity set being grossly overvalued has only forced me to recommend returning capital and being unemployed Really looking forward to this cycle ending…just wish I knew when.
Q: I would like to know if you could share with me some books that really changed your view about finance.
A: I don’t have a lot of book suggestions. I spend most of my time reading about individual businesses. In fact, that would be my recommendation…read as many 10-ks as you can on different companies and as you read them try to determine how you think they should be valued. The best investment process is one you develop and believe in, in my opinion. I wrote a post “What’s Important to You”…you might want to check it out.
Q: In your opinion, do you foresee a specific catalyst responsible for the coming downturn in the cycle? Could it be the Fed and their quantitative tightening and balance sheet reduction programs? What are your thoughts on the argument that we need to adjust to a new low interest environment (has the game actually changed)?
A: Sometimes cycles end with a catalyst (2007-2008 Bear Stearns/Lehman) while other cycles they just die from old age/no catalyst (March 2000). It’s tough to say. If I had to guess, one day you’ll come into work and everything will change. What that catalyst will be for certain is unknowable, in my opinion. It’s such a unique cycle as we’ve never seen central banks act in this manner before…no real history to guide us.
Ideally this cycle ends due to the loss in faith of central bankers. If this is the case, I believe the decline will be more enduring and create more opportunity. In other words, the decline won’t be rescued by central banks as they’ll be viewed as the problem, not the solution. Furthermore, without central bank interference, I believe free markets and capitalism will be more effective and productive in properly allocating capital (what I once did for a living). But all of this is really out of my expertise. All I really know is prices within my opportunity set are expensive relative to risk assumed and if I were to get invested today I’d most likely lose money and would not be in a position to generate attractive absolute returns.
As far as rates staying low indefinitely…it’s possible. But if that’s the case, growth rates would also most likely remain depressed. Risk assets are pricing in strong growth (highest valuations in history do not go well with no growth). I’m optimistic the interest rate and market cycles have not become extinct…if so, how boring and how sad – investing as we know it will have died. In any event, fortunately your questions will be answered over time…I wonder the same things and can’t wait to know the answers. I suspect when your questions are answered, our opportunity sets will look much different…thankfully!
Q: I don’t understand what you meant by profit cycle. Are you saying that all businesses and sectors have their own profit cycles that you can reasonably assume to repeat cyclically? Also you said that you want to know everything about the business that determines normalized margins which determines normalized FCF. By normalized, do you mean factoring in where the business is in its current profit cycle?
A: Yes, I’m talking about the profit cycle of business, industry, and aggregate profits. Think of an energy service company like HP. During the peak they make about $6/share in earnings. During the trough they make $0. If you value their business using peak earnings you’ll get a very high valuation, while if you value using trough you’ll get a very low valuation. I prefer normalizing, or using what I believe annual free cash flow will be on average over a cycle. While I’m simplifying here to make a point, in HP’s case that would be closer to $3/share. In my opinion, normalizing provides me with a more accurate valuation as I have a more accurate estimate of what cash flows will be over an entire profit cycle, not just one point in time. Hope this helps. Thanks for the email and question.
Q: You wrote, “A central bank’s balance sheet is entirely different. In theory, a central bank’s balance sheet can expand indefinitely as there is no limit to the amount of money it can create to purchase assets.” My understanding is that every dollar the central bank creates actually gets its value by stealing value from existing dollars, IE inflation. If my understanding is correct, if the central bank were to continue creating infinitely more money, would that money not become infinitely less valuable through inflation?
A: Great question. You are correct. While central banks have an unlimited ability to create money, doing so should devalue the currency. However, as all of the major central banks have QE’d together, or have taken turns monetizing debt, the major currencies have not devalued meaningfully relative to one another. Furthermore, today’s inflation to date has flowed mostly into stocks, bonds and real estate. In other words, instead of our dollars buying significantly less goods and services, they buy less assets; hence, the term asset inflation.
So yes, our dollars are worth less today, but the inflation has been focused in asset prices. I don’t know how this cycle ends, but I suspect it will be related to the failure of central bank policy. I don’t believe money creation creates value as it does not require effort or sacrifice – it just doesn’t pass the common sense test, in my opinion.
What a great time to be studying economics! I bet they don’t have many books discussing global QE! I think there will be plenty written after this cycle ends.
Q: A question I do have is for normalizing cash flows do you use Ben Graham’s time frame in Security analysis of 7 years? He mentions this is not too long to include things that no longer affect the business but its a long enough period to get the normalized earnings over a cycle. What would your take be on that?
A: Great question on time period. I customize per business valuation. Some cycles are longer than others. For example an energy service company may have a much shorter cycle than a grocer. Not a great example but you get the point. I’d say most cycles are 3-10 years. And of course this cycle longer than most!
Q: I was wondering if you wouldn’t mind saying how old you were when you were in the CFA program? Also, if you would recommend going through the program in today’s environment?
A: I was 22 when I took the CFA and finished when I was 25 (definitely recommend taking before staring a family!). I think it’s a good program and glad I went through it…I found about 1/2 of the information useful which is pretty good. Tough call on going through the program today. If asset prices never go down again and markets remain overly influenced by central banks, I’d say no…find something more productive to do with your life (if you go into carpentry let me know…need a new chimney and we can’t find anyone…labor market very tight here!). However, if history repeats, central banks lose control, and free markets return, I think studying investing makes a lot of sense…assuming that’s your passion. For what it’s worth, I think free markets will return. I just no idea when or how high asset prices go before the cycle ends.
Q: Based on Graham’s book we have created a spreadsheet to analyze companies based on Graham’s principles plus a few criteria of our own. Could you take a couple of minutes to see if you have any major updates you would add to the attached spreadsheet?
A: When viewing historical results I always like to include the good and the bad. A fixed time frame, such as 5-years in spreadsheet doesn’t always include the peak and the trough. I prefer customizing to include an industry trough or recession. This way you won’t be blindsided when the next trough occurs. Maybe throw in 08-09 in your analysis, or a cash flow estimate you expect during the next recession.
Q: By the way: I’ve read your blog posts, but also a couple of interviews. Maybe it’s just my failing memory, but did you ever go into your “sell discipline”?
A: Good question on the sell discipline. I don’t think I’ve written about it on the blog, but it’s a good topic and I’m glad you brought it up. I’ll put it on the list of topics I want to discuss.
Thankfully, most of my sells were a result of the stock price reaching or exceeding my valuation. So that’s the most common and preferred reason I sell. However, things do go wrong. When I can no longer value a business with a high degree of confidence I often sell. By this I mean when I’m forced to speculate versus invest. This could be due a large portion of revenues becoming uncertain (usually permanent loss such as lost contract or law suit) or normalized margin assumptions become too difficult to predict.
I also sell when my financial risk limits are exceeded (3-5x discretionary cash flow). This happened to an energy stock in 2014. They took on too much debt and leverage exceeded 3x cash flow. In this case my sell discipline protected capital as I sold around $20 and stock eventually declined to $3 (due to balance sheet and declining cash flow). But I’ve had the reverse happen too, when I’ve sold due to financial risk and the stock rebounds or is taken over. Regardless, I don’t want to own a business if they can’t pay their debt off in 3-5 years internally. Most small cap maturity walls are around 3-5 years out.
Finally, there are also times when I get the valuation wrong and my new valuation drops below the stock price. This happens less frequently, but it happens. When my valuation is in decline it means I got something wrong. If my new valuation remains above the stock price I’ll continue to hold the stock, but I won’t add to it until my valuation stabilizes.
Wow, didn’t mean to, but it appears I just wrote a post on my sell discipline.
Q: With the money my tightfisted friend no doubt squirreled away during his Halcion years, and a track record that is more than credible, maybe you have thought about teaching at one of the better graduate business schools?
A: If I was as smart as you I’d love to teach. Keep in mind I’m a product of the Kentucky public school system and former hair mullet member…hardly professor material!
Q: When you are looking at DCF, outside of managers directly saying on an earnings call what their maintenance capex vs. growth capex looks like, how do you distinguish the two? Do you even try to distinguish the two if not specifically mentioned by managers?
A: Good question. There are times when management overdoses on cap ex and has depreciation expense above maintenance cap ex. If it’s a large number I may add back to free cash flow a few years, but typically won’t do it long-term…but this is rare. Normally I base free cash flow more on after tax EBIT than EBITDA minus maintenance cap ex.
I’ve found managements tend to have a way of underestimating maintenance cap ex, but they can often run lower cap ex if needed (often in times of distress – see energy 2014-2015). I like to think of it as distressed cap ex, or how much cap ex they could spend just to keep things afloat. But if you do this, I think it’s only fair to lower growth rate assumptions…there are no free lunches when cutting back on investment.
Pet peeve of mine is using EBITDA to value energy companies when majority of EBITDA is depletion. Rarely do energy companies fail to reinvest depletion…most spend more. If it’s an expense and shareholders will never see it, why capitalize it? I prefer replacement value of reserves (interesting topic I’ll address soon in blog). In any event great question. As always, there’s not always a strict rule of thumb when it comes to investing and valuation. I always like to customize valuations on each business to fit what makes most sense to me.
Q: Have you ever seen this chart before?
A: Excellent chart. Shows overvaluation broader this cycle. In my opinion, “the market isn’t as expensive as year 2000” argument has a lot of holes in it! Thanks for sending.
Q: Now I have also bought Foot Locker (FL) and Hibbett Sports. Both great balance sheets, for both the latest few quarters were not so great. But does this really justify a crash of more than 50% in half a year?
A: Interesting. I’ve been looking into retail and energy. Currently working on HP, but I plan to look for beaten down retailers with good balance sheets next. I missed DSW’s move, but just like energy…usually retail gives you plenty of second chances!
Q: I have allocated 20% of my portfolio to small caps as a way to diversify, am I putting my money at risk doing this when we make a downturn? I am wondering if I should shift those investments to my SP500 index funds?
A: Yes, small caps carry risk…always have, always will. Many don’t make money, but many do…often depends where we are in the profit cycle. Currently profits and margins are high on average…and so are prices (at record highs), but that doesn’t mean prices can’t go higher. The risk of small caps often varies with the price you pay. You or your adviser should determine your appropriate risk level…unfortunately I can’t do that for you as I can’t give investment advice or make specific recommendations on funds or stocks. Good luck…it’s an interesting cycle to say the least!
Q: You don’t really speak about shorting ever, have you ever shorted the market or individual stocks? Do you have any advice for those of us who never have?
A: I’m more comfortable waiting during periods of overvaluation and picking up the pieces once the cycle concludes. In other words, I like to profit after prices have declined vs. trying to make money on the way down. Historically I’ve been good at spotting overvaluation, but not so good at timing when bubbles pop. I have put options on the homebuilders that expired in 2006 worthless to prove it!
If I had to be long or short right now, I’d probably be short…and I’d probably be losing money too! Instead of being short and losing money, I prefer waiting in 1-1.5% risk-free yields. Patience is essential in my absolute return process and I view it as a competitive advantage – few are willing to practice near cycle peaks. We’ll see if patience pays this cycle. Historically it has, but there are no guarantees.
Q: Did you read Grantham’s latest piece?
A: I haven’t read it…and not sure I want to! Who is left? Next thing you know Klarman is going to get fully invested by buying the FANG stocks!
I’m noticing some cost increases in pricing power in Q2 earnings. Inflation isn’t surging, but it’s noticeable. Not sure Fed or the markets are taking anything related to inflation seriously. While I’m not a big user of govt data, I think wage growth in today’s number makes sense…agrees with what I’m noticing. I might be getting desperate and looking for things that aren’t there, but I think labor market pretty tight…ex disciplined value investors!
Q: Speaking of late-cycle grasping at straws, did you see Ackman’s move on ADP?
A: I did not see that on ADP. I don’t follow them, but I can imagine it’s a target given its stable high quality business. I’m not a big fan of activists that buy small positions of a company and make big demands. When activists buy 5-10% positions and then want the company to leverage up the balance sheet…again not a big fan. If you want to buy 51% of the business go ahead…and take as much debt on as you’d like…or whatever other changes you want to make. But if you only own 5-10%, don’t destroy the balance sheet for the rest of us…maybe the majority of shareholders prefer financial strength over financial engineering.
For what it’s worth, I believe activism is one of the many reasons companies have taken on so much debt this cycle. Strong balance sheets are often targeted. ADP’s valuation already rich. Activists running out of companies to bully…or at least stable ones that aren’t already expensive.
Q: Have you thought about putting together a newsletter with this type of bottom up earnings call transcript analysis in a more consumable format?
A: Yes, I’ve thought about doing something like that…bottom-up macro analysis. However, I continue to remain optimistic that this cycle will end and I’ll be able to manage money again. Time will tell. But I think there’s a market, or need for it. So much of the government data initially appears inaccurate, or the reality is eventually discovered many quarters later…how valuable is information that is eventually revised to look completely different a year from now???
Q: I was wondering if you had a collection of other interviews, previous shareholder letters, etc. that I could read as well.
A: I’ve done other interviews while managing, but most are relatively dated by now. I thought the one below was pretty good but I don’t have a subscription to Wall Street Transcript.
Q: How is the labor market in Florida?
A: I was offered another job yesterday at my daughter’s softball practice…from a lawncare company. The guy said he couldn’t fill his crews and wanted to know if I wanted to do something to stay busy. If I wasn’t living the minivan dream I’d do it. Interesting times! I think there’s a lot of push and pull going on in labor. Pockets of inflation and deflation, but I’m beginning to lean more towards wage increases. Living in an area that thrives on asset inflation probably pollutes my views (every business here is somehow tied to stocks or real estate). And of course if asset prices ever reverted to fair value all bets are off.
Q: Response to an email discussing pros and cons of relative vs. absolute return investing.
A: I completely understand the dilemma. Be absolute return purist and clients may leave and blow themselves up elsewhere when the cycle ends…or sprinkle in some low tracking error strategies and participate enough to keep clients from bolting at the wrong time. It’s a tough balance and you’re certainly not alone.
It’s funny…I believe most RIAs used my fund not as a core strategy but as an absolute return sliver. I’d guess most RIAs have stock mkt exposure but want some absolute return exposure. Sounds like you are more absolute and want some relative return exposure. Makes sense.
I’m thrilled there are RIAs like you out there that continue to think as a fiduciary. The last thing I’d want to do as an advisor right now is lose 30-50% of my clients’ capital. It won’t be defendable, in my opinion. Not with today’s prices. And while I think those sort of declines aren’t certain, I believe they’re possible based on valuations…at least in the small caps I follow. I can’t really speak outside of my opportunity set, but looks like slim pickings out there for asset allocators. I wish you the best…sounds like you have a very good understanding of the environment.
Q: Did you read Montier interview in today’s Barrons?
A: That was great…thanks for sending! Also cool shirt. On another topic…was at my daughter’s softball practice today and was speaking w another parent who sells windows. He asked what I did for a living and I told him I’m unemployed. He said really, you want to sell or install windows? I said I have no experience in either. He said not a problem as they can’t find anyone with experience and are considering all applicants.
He also told me they just gave a $2/hour raise to all installers and delivery employees. Just out of the blue. Said they’re trying to get in front of any turnover. I know just one data point but wouldn’t it be interesting if labor costs go up +3-4%…and trending up so the term “transitory” couldn’t be used. So much riding on belief Fed will QE again on next decline in asset prices (a sharp decline won’t be allowed or will be temporary).
What if they can’t QE during the next decline…inflation wouldn’t allow it? I’d like to see higher rates. It would put valuation mean reversion and financial justice on the fast track! One can only dream…
Q: Just returned from a business trip to London – if inflation is moderating why was everything so expensive?
A: It’s a good point about London. Everyone talks about deflation in Japan but it’s one of the most expensive places to live in the world, especially cities like Tokyo. How does that make sense?