Value Investing

Semper Augustus – Annual Letter Highlights [Part II]

By Investment Master Class

As I mentioned in my last post, Chris Bloomstran’s latest letter is a very worthwhile read. Not only does it cover his views of the market’s new breed of Super Investors, it also offers insights into the current market environment. And this is valuable to all of us. Hearing the views of someone with skin in the game and a long term track record of success is going to always offer more value than an analyst’s perceptions.

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Once again I hope you'll note the similarities between his insights and the Investment Masters Class tutorials. Below are his key points concerning recent market activity and his investment considerations ...

Time for caution?

"When smooth sailing is the forecast, it’s usually a good time for caution."

"When the herd stampedes, danger rises."

"Recent returns over the last several years have outpaced underlying fundamentals across nearly all asset classes"

Reversing the Fed's Balance Sheet

"We have no idea how this reversal in the Fed’s balance sheet plays out. The increase was unprecedented and so will be the reversal."

"Think about interest rate increases as the Fed reloading its pistol. You need ammo if you are going to a gun fight, and when rates were taken to zero, the Fed was out of bullets. It needs to reload to fight the next slowdown, and if rates are zero it has no bullets (that’s how we got QE)."

Bond Buyers?

"With the Fed, for now, no longer in the bond buying business, but rather net selling its debt holdings, who will lend needed capital to the US Treasury, especially if the deficit is growing? The answer can only be private investors, those same investors who were able to allocate capital to assets other than Treasuries when the Fed was scarfing up issuance."

"An investor in fixed income today is beginning a compounding stream with the curve at the mid-1% level on cash to under 3% at 30 years. A rising interest environment will penalise the owner of long-dated debt with price declines, the longer the maturity the more severe the decline. A sustained increase in rates will help by allowing for re-investment at higher yields, but an expectation of returns much above initial yields would be asking for a lot"

Rate Hikes and Recessions

"Every major stock market decline and every recession in the last 100 years was preceded by the Federal Reserve raising short term interest rates by enough to provide the pin to prick the balloon. Note the emphasis on every. Yes, there have been periods where the Fed raised rates and a recession didn’t ensue. Everyone knows the famous saw about the stock market having predicted nine of the past five recessions! That may be true, that rising rates don’t necessarily cause a recession. But as an investor you must be aware that every major stock market decline occurred on the heels of a tightening phase by the Fed. More importantly, there have been no substantive Fed tightening phases that did not end with a stock market decline."

The Importance of Price

"The price paid for an investment is a key determinant of outcome."

"The price paid is the initial bracketing endpoint in a compounding series. The same business at twice or thrice the price can’t be as nice."

Time Arb and Patience

"Time is generally required for investment decisions to bear fruit. We think it is a huge advantage to have the patience, and patient clients, to allow prices to ultimately reflect underlying fundamentals."

Dual Margin of Safety: Price and High Quality

"Our dual margin of safety approach combines high business quality with attractive price. One important aspect of business quality is a modest to reasonable use of debt in the capital structure."

Low Corporate Debt and Outperformance

"We believe the far more modest use of leverage [on balance sheets] is important in many ways and strongly has contributed to our outperformance during all bear markets and times of financial crisis over our two-decade existence. Included are the 2000-2002 and the 2008-2009 episodes, which shaved 50% and 65%, respectively, from the index."

"Low debt levels allow managements versatility on the capital front in times of crisis or distress. An unencumbered balance sheet can tolerate the addition of debt when opportunity presents itself."

Earnings Yield

"The inverse of the P/E is the earnings yield, and it’s one of the most important numbers in investing."

"Our core assumption over time, [is that] if we've assessed profitability properly, we should earn the earnings yield of the portfolio, not even allowing for future growth. In addition, we also expect to earn the closing of any discount to our appraisals of intrinsic value"

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

Portfolio Analysis

"The stock portfolio is now priced at 13.7 times normalised earnings [versus 23.4X for the S&P500], giving us a 7.3% earnings yield, which becomes our new base case return expectation for a ten to fifteen year horizon."

"Our businesses possess a higher margin structure than the amalgamation of the businesses comprising the S&P500"

"As we survey the managements of the companies we own, we have never had a better roster of management teams"

"Our companies earn far more on their invested capital, which we think is a huge advantage. We also possess far higher EBIT on total capital invested."

"We have $73,000 in earnings power per $1 million working for us against $43,000 for the market. Our relative advantage is as great as it was at the last peak in 2000"

Buy-Backs and Incentives

"Captains of industry, who spend scant few years at the helm, on average, have little incentive to think long-term about return on capital when their horizon to get crazy rich spans the short-term. Stock buybacks, regardless how expensive, are a buy ticket. They reduce shares outstanding and are accretive to earnings per share, period. That they are made at absolute levels which drive profits properly measured downward is largely irrelevant."

Capital Allocation

"The reinvestment of retained earnings is one of the most important jobs of the managers of public companies that retain shareholder profit. Assessing how well they invest those retained profits is one of our most important jobs as investors."

Great Investors don't always Outperform

"The great track records are not produced in linear fashion, and are far from consistent. Outperforming over many market cycles is not done each year, or every three years, or five years, or ten years. There are long periods of underperformance that go with every outstanding track record. All the great investors have had clients leave them after periods of underperforming. Walter Schloss, who compiled one of the all-time brilliant track records, shrugged as he was losing clients in the late 1990’s because he was underperforming and wouldn’t give them the tech and internet exposure they felt they needed. He had seemingly “lost his touch” and was out of touch with modern thinking. Many that fired him had been clients for decades, having invested with him since the 1950’s and 1960’s. It must be expected that long term outperformance will come with durations of underperformance, perhaps as much as half of the time over short-term intervals. As the intervals lengthen, periods of underperforming recede. At the end of the day, we all know what happened with the tech bubble. It ended badly."

Acknowledging Fear

"How many investors do you know that sold everything in 1974, or 1987, or 2002, or 2009? We’ve met plenty. And of those, most have rushed back in, but only after sustained recoveries, when the appearance of risk has receded."

Recommended Books

"Ben Graham’s, The Intelligent Investor - the best investment book ever written for the lay person"

"Ben Graham and David Dodd’s Security Analysis is the bible for value investors."

Passing Investing

"A takeaway for those passively invested or index-hugging: It is very difficult making money when the price paid is high."

"The proportion of the stock market passively owned and flowing into passive investment strategies are at records. The concept of passive investing is simple, efficient and grounded in logic. However, a good idea taken to excess can produce a terrible outcome."

"An index holder owns the whole index – every component at the prevailing price, regardless of quality or price. No exclusions. We saw this picture show in the 1990’s and it ended badly. Money is funnelling into the largest of index components, pushing valuations and index weights to extremes. Risk is mounting in passive portfolios, and it’s largely of the passive investor’s own making."

"Large flows [from indexing] can impart a momentum effect, driving narrowing prices in certain assets higher. Often, those allocating capital don’t even realize they are contributing to momentum-induced returns. Many are simply reacting to a fear or envy of not having an allocation in microcaps in countries beginning with Z, especially if all the other kids are already there and making money. The mindset breeds mediocrity at best, and ultimately can be a dangerous thing."

"If we owned the S&P 500 we’d probably be ill from watching companies squander capital. We’d own companies with aggressive accounting that write down assets to boost returns on equity and capital. We’d have shares being bought at prices that we would never pay. We’d own businesses with huge unfunded pension funds that have little chance to earn enough on their plan assets to fund plan liabilities. We’d own companies that exclude one legitimate expense after another from their “pro-forma” or “adjusted” earning presentations. No thanks."

"Mr. Buffett has made clarifying remarks about his advice regarding indexing and passive investing. He duly notes that outperformance can’t be accomplished without certain elements. It requires devoted work and proper wiring, which involves a willingness to deviate from the herd or the crowd. Outside of a value-based approach, there aren’t approaches that have the right orientation."

"As money moves from ETF to ETF, somebody is making an active decision with passive investments. You could make the case that flows to the ETF world are done with less, or little, concern for valuation, with no attempt to capture a disparity that may exist between price and underlying value."

"At what point does the growing proportion of indexed assets become dangerous? The S&P 500 as a proportion of the stock market is far more concentrated now than at any time. Some of the increase is surely the result of mergers and acquisitions. But the degree is concerning. Also, as the index marches higher, it attracts more capital and the momentum drives prices up far faster than underlying value, at a point making it impossible for future results to come close to anything reasonable or expected."

"Recall the logic, or lack of, that for every $100 invested, $3.80 must now go to Apple shares. $2.90 must be allocated to Microsoft. Amazon gets two bucks, Facebook a buck eighty, and so on. It does not matter the price to value. It does not matter if the business will go bankrupt. If it’s in the index you must own it, in the proportion at which it exists. The more money gravitates to the index, away from other pools or strategies, the higher the largest components will rise. Somewhere between then and now, the amount of momentum-induced concentrated risk rises. At a point, prices are no longer reflective of fundamentals. To a passive investor, it matters not. It matters quite a bit to us, however, and it presents opportunity."

"Large cap active investors have been replaced en masse with a passive approach."

"Words can't do justice to the degree to which passive investing is now in an epic bubble, with money funnelling into a narrow group of names. Behold the insanity... Wow, I would never have guessed that passive index flows could create this kind of unnatural disparity across every major equity index! [see table below]"

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

"Capital allocators keep feeding the fat kid"

"Money is pushing the largest even higher and it likely doesn't correlate to underlying fundamentals. It's flow, baby"

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

"We don’t know when the situation will reverse itself. If you believed flows to passive funds and strategies would continue to run, why not just own the five biggest components of each index? Had you done that in 2017, you would have looked like a genius. When the flows finally reverse course, the money invested in passive portfolios is going to get hurt."

"Capitalizing on opportunity requires thought, which can’t be done with software allocating $3.80 of every dollar invested to Apple because that happens to be its weight in an index."

"Passive investing is done with computers allocating capital based on component size in an index. Attention is not paid to business quality, and a rising price attracts more capital. It can be a self-fulfilling phenomenon, until flows reverse. Investing as we know it requires thought, experience, patience and reason. Too much active investing is done poorly.

Chris has identified many important aspects in his commentary that should provide valuable insight to us all.  Whether its the history of Fed hikes, the evolving status of central bank balance sheets, the comparisons of the similarities between the tech bubble and today, or any of his other perceptions, all should go a long way to assisting you to look at your own investment activity with a little more knowledge. And that can't hurt, right?

 

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