Grey Owl Capital Management: How Stable is the “Stable Disequilibrium” Today?

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Grey Owl Capital Management letter to client on oil prices, a broad range of investment outcomes and how stable is the “stable disequilibrium” today?

“Never think that lack of variability is stability. Don’t confuse lack of volatility with stability, ever.” – Nassim Nicholas Taleb

Dear Client,

Over the past seven months the price of oil has plunged from a peak above $100/barrel to the mid-$40s today. This is just the most extreme version of the market volatility and divergence we began highlighting in our second quarter letter. A cautious investment stance remains the prudent choice.

After some brief commentary on the state of the world, asset class returns, and underlying market trends, we spend the bulk of the letter discussing our portfolio transactions from both the third and fourth quarter of 2014. After last quarter’s more philosophical discussion, we thought readers might find the discussion of individual securities refreshing. After all, no matter the environment, there are always buying opportunities and, no matter the business, every asset can provide value at a certain price.

Here is the performance table for the Grey Owl Opportunity Strategy as of December 31, 2014:

Grey Owl Capital Management: 2014 – A Broad Range of Investment Outcomes

What might have appeared a low-key year from a US-based investor’s perspective was really anything but. There was significant return dispersion across geographies, asset classes, and sectors. The table below includes annual performance for the major broad asset classes, as well as some of the best and worst sectors. It highlights the significant breadth of returns.

Grey Owl Capital Management

Grey Owl Capital Management: How Stable is the “Stable Disequilibrium” Today?

All the way back in May, 2013, Mohamed El-Erian (then CEO and co-chief investment officer at PIMCO) referenced the drop in gold prices, as well as the decline in Apple and Facebook shares as a warning:

“Essentially, today’s global economy is in the midst of its own stable disequilibrium; and markets have outpaced fundamentals on the expectation that western central banks, together with a more functional political system, will deliver higher growth. If this fails to materialise, investors will worry about a lot more than the intrinsic value of gold.”

In this essay, and a series of contemporaneous articles, presentations, and media appearances, Mr. El-Erian coined the term “stable disequilibrium.” While perhaps early, we believe his warning was correct. In just the last few months we have seen two additional “shocks” – the 50%+ drop in the price of oil and a single-day ~50% appreciation in the value of the Swiss Franc – that seem to emanate from a similar source: global central banks attempting to create stability at a level where markets say it does not exist. In the end, like water finding cracks in a dam, market forces will overwhelm even the bottomless pocketbooks of central bankers.

Grey Owl Capital Management: Interest Rates and Consensus

Beware the consensus and predictions in general. “Interest rates must go up,” seems the most broadly held investment thesis today. And, it has been for several years now. In January of 2014, Bloomberg’s average analyst estimate for the fourth quarter 2014 10-year US Treasury yield was 3.4%. Expectations were that yields would rise from the 2.6% level where they began 2014. Yet, the 10-year US Treasury yield finished 2014 at 1.97%. The interest rates that “must” go up went down!

We continue to hold long-dated US Treasury bonds in our fixed income portfolios, balanced accounts, and our private investment vehicle, Grey Owl Partners, LP. Until such time as the US dollar loses its reserve currency status, US Treasuries will remain the best portfolio hedge against slowing growth and deflation.

It strikes us as interesting that investors (or at least the pundit-class) continue to worry that bonds are overvalued but show no concern for equities trading at a Shiller PE5 over 26 compared to the long-term average in the mid-16s. Commodity prices generally and oil specifically have declined at a precipitous rate. Chinese growth is slowing. Japan and Europe continue to fight very low economic growth and deflation. With new leadership, there is a heightened possibility of a Greek Euro exit. Finally, widening credit spreads and increasing dispersion within US equity markets suggest to us that maybe, just maybe, the bond market is more right than the stock market.

Grey Owl Capital Management: Portfolio Adjustments during the Second Half of 2014

There was quite a bit of transaction activity in the second half of the year. We spent the bulk of last quarter’s letter discussing investment philosophy and did not have the opportunity to comment on individual investments at all. Therefore, six months of transaction rationale follows.

We sold our entire position in Enbridge (ENB) in July at just under $50/share. ENB is a wonderful collection of midstream energy assets (steady, toll-booth like businesses that for the most part are not tied to short-term commodity prices or volumes) and has a massive ($20B+) pipeline of new projects. Yet, at $50/share and ~30x next year’s earnings, the stock offered little margin for error if funding or other issues jeopardized the build-out of these new assets. Our return between our November 2012 acquisition and July 2014 sale was approximately 33%.

In August, we made what will likely be the most important transaction of the entire six month period, adding to our stake in Leucadia National Corporation (LUK). The initial position was established in late 2012 when we purchased stock in the investment bank Jefferies. This first purchase occurred just after the announcement that LUK would merge with Jefferies, acquiring the 71% of Jefferies it did not already own. The deal economics were such that purchasing Jefferies stock before the merger’s consummation let us “create” a LUK share at a price which was lower than the then current quote. Both the initial purchase and our recent purchase were acquired at a meaningful discount to (then) book value. Book value has grown modestly since.

See full PDF below.

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