Howard Marks, Co-Chairman of Oaktree Capital Management, is not only one of the world’s greatest investors but has also been one of the most generous in terms of sharing his knowledge and experience with the value investing community. As we look forward to learning once again from Howard Marks at Best Ideas 2015, I’d like to reflect on the following insight, one of many, shared by Howard Marks when he last addressed the ValueConferences community in August 2013:
“To me, the most important single question at a point in time with regard to strategy, I’m not talking about tactics, I’m not talking about what’s going to go up tomorrow, I’m not talking about eternity, but for the middle term, let’s say three to five years, the most important thing at a given point in time is how you’re balancing offense and defense…we want to have a lot of offense when prices are low, psychology is depressed and the outlook is bad to most people but we don’t think it’s so bad. And we want to have defense when prices are high, psychology is buoyant and everybody sees a brilliant future, and we don’t think the future may live up.”
What is offense and defense in investing? On page 145 of The Most Important Thing, Howard Marks defines offense as “the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains” And what’s defense? “Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.” While on the surface there might not seem much difference in doing the right thing and avoiding doing the wrong thing, Howard Marks goes on to say that there is a big difference in the mindset needed for one or the other:
” While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or nonaspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.”
So where do we stand today? In August 2013, Howard Marks unequivocally stated “we’re in the middle.” The implication being that investors ought to balance offense and defense as that is what successful investors do in the middle. Roughly one and a half years later, at the beginning of 2015, we wonder what Howard Mark’s assessment is of the current investment climate.
Howard Marks: Be Aware of the Temperature of the Market
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Debt Remains Cheaper than Equity Financing – Investment Grade (“IG”) Should Be Levering Up
As the cost of equity remains high relative to the cost of debt it makes sense for companies to use cheap financing to buy back their own shares or acquire other companies, divisions or assets. Buybacks have been a significant theme 2010 to date. This trend can suggest both IG bond shorts and equity longs.
US Corporate Bond vs Equity EY
Source: CitiResearch, Datastream
The E/P versus bond financing gap is still wider today than anytime during the 2003-2007 period. Going forward we expect a continuation of ongoing buyback activity and an increase in global M&A actions over the next 12-18 months. Europe, in our view, will be particularly pronounced. See below.
Dividend Equities are the New Bonds, but with Upside (Especially Ours – Those with Plausible Revaluation Catalysts)
Low interest rates mean investors are starved of yield. In Europe, the ECB QE will extend it. Concurrently, the secular trend of an aging investor in Developed Markets stokes the need for income securities. The current search for yield is not just a product of recent quantitative easing (QE) policies. US Treasury (“UST”) yields have been falling towards the global equity dividend yield for many years before QE came along. This year’s unexpected fall in UST yields has intensified the chase. This continues to compress spreads in the credit world and drive income-hungry investors towards equities broadly, dividend paying equities, specifically. Equity dividend yields in DM have continue to match or exceed yields on your choice of 10 year sovereign bonds – approximating ~ 2.5%.
US 10 Year Treasury vs DM Dividend Yield Dividend Yields vs Local Sovereign Bond Yields
Source: Datastream, MSCI
Liquid, Large Cap Equities > Small Cap
We continue to prefer larger, liquid equities as well. We are likely in the midst of a maturing bull phase of the cycle
– returns from Large Cap Equities have tended to outperform in such periods. A maturing bull market has been historically characterized by rising volatility, widening credit spreads, l\Large Cap outperformance and equity bubbles. The long-term underperformance of global Large Caps means they trade at 20% PE discount, despite their high quality characteristics.
Stronger Relative Fundamentals of Large Caps
Source: Citi Research. Datastream
US and Now European Special Situations – The Three Arrows in the Quiver
We first wrote back in April that it appeared to us that European business managers, similar to those of the US, have ample access to inexpensive capital and, having witnessed the outperformance of the securities of US companies employing shareholder-friendly behaviors, are increasingly acting in a similar manner. We had begun to see, and anticipated heightened spinoffs, strategic acquisitions, special and/or increased dividends and share buyback programs among larger European companies. The Fund has already participated in a number of European special situations, notably earlier on in its life, the Alcon/Novartis shareholder disputes, leading to their combination, more recently, Vodafone’s sale of its Verizon stake, Vivendi’s sale of its Activision stake.
But with the recent ECB rate cut and European Central Banker’s intimations of prospective QE, we have now in Europe, an analogous fertile ground for the sort of shareholder-friendly behaviors we’ve witnessed and participated in in the US circa 2011-14.
As with US companies, some of these shareholder-friendly activities of European companies are learned behaviors – managements see market and public reaction that is re-enforcing. Alternatively, as with US companies, European managers have become more able financial stewards, as they attempted to wend their way through the Great Recession. The more capable ones have figured out how to wring the most possible liquidity, margin and performance out of an enterprise in a state of siege. Battle tested, and frankly, more professional business managements (US and European) are simply now more adept capital allocators, and as such, are better able to reconcile, for example, shedding non-core assets through a spinoff or sale, returning excessive cash reserves to shareholders, and being game to consider accretive acquisitions of their own, harnessing the same three arrows in the quiver enjoyed by US issuers (1. ample cash on the balance sheet, 2. high stock prices of their equity as a potential currency and 3. access to inexpensive debt capital).
Cash Balances at Record Levels How the Market Has Rewarded Use of Cash
We foresee continued shareholder friendly and net asset value accretive transactions in the US and a coming and growing trend in Europe. Such Social Contract behaviors/events, can be harnessed in a portfolio of Larger Cap equities and often better-than-market dividend payers.
Relative Outperformance of Equities with Buyback Programs
European Equities > US Equities – Historical Correlation
Recently Value has outperformed Growth. In the past, an outperformance of Value stocks in the US (using the MSCI indices) has also been associated with an outperformance of Europe relative to the US. We think this relationship exists because when US investors hunt for Value and Value as a style outperforms in the US, given the growth-heavy nature of the US stock market (high weighting in Tech, Healthcare), they are drawn to look overseas to other regions, including Europe. This could particularly be the case today, since as in 2003, European stocks are trading at a multi- decade high discount to US stocks on both the CAPE and the Price/Book metric, thus qualifying as Value.
When Value Equities Outperform Growth in US, European Equities Outperform US
Source: Datastream, MSCI
Since May, Continental European equities have underperformed the World index by 8.8% in common currency terms, puncturing the trend of outperformance evident since President Draghi’s pivotal “whatever it takes” speech in July 2012, and bringing relative performance back to the point reached after last year’s summer sell-off. Draghi’s “whatever it takes” approach towards the Euro increasingly resembles the Fed’s QE1 program in the sense that it has had a dramatic effect on the region’s credit markets, but has not (yet) brought about a self-sustaining recovery in the economy.
As of this writing, Central Bankers in Europe are dropping deposit rates (as happened in the US) hoping that new lending will be stimulated. The wish of Central Bankers, then, is that banks lend to companies that choose to expand businesses, replace aged assets – these financings help stoke revenue and margin growth, leading to new employment. However global banks and European companies are financial actors and there are the same likely unintended consequences that occurred in the US. Consequences portending events the Fund can capitalize upon.
With the recent ECB rate cut and European Central Banker’s intimations of prospective QE, we have now in Europe, an analogous fertile ground for the sort of shareholder-friendly behaviors we’ve witnessed and participated in in the US circa 2011-14. We recently discussed the ECB rate reduction, prospective QE and implication for event-driven investing in Europe on Fox Business News with Liz Claman – here’s the snippet.
Europe > US – Currency
European Central Bank Intervention should devalue the Euro. Euro weakness is key to the European recovery as each 10% off the euro adds 1% to nominal GDP growth and 10% to EPS as slightly more than half of European sales come from outside the Euro-area.14 There is indeed a clear correlation between the euro weakening and the Euro earnings revisions improving, as shown below:
Strong Correlation between Euro and Europe-Centric Company EPS
Source: Thompson Reuters
The potential winners of Euro weakness are those companies and sectors that have a high proportion of sales in US Dollars and expenses in Euros. These characteristics apply especially to healthcare, pharma and consumer staples (food, beverage, etc). Banks, utilities and real estate are among the potential losers.
The above post has been excerpted from a letter of Tiburon Capital Management. Refer to the letter for full disclosures.
Please refer to our more thorough Tiburon Monthly Markets Overview for the complete perspective. This abbreviated section is more of an executive summary that can help you understand what is shaping our current Portfolio Asset Allocation Decisions.
Market performance near-term (between here and year-end) can be encapsulated by 3 considerations we will discuss here: the precipitous drop in energy prices, the US consumer as we enter an all important holiday season (as impacted, in part, by lower gas prices) and the negative inter-bank borrowing rates in Europe and prospective unintended (but plausibly foreseeable) consequences.
In an economy defined by slow growth, the energy sector had been a bright spot. Technological advances have led to a surge in oil production, benefiting drillers, refiners, service providers, machinists, engineers, construction companies, transportation providers, and others. However, a glut of supply has driven down oil prices. Some theorize (and it would appear likely) that Saudi production and pricing has recently been predicated on an objective to damage the burgeoning US shale boom and producers. Oil prices, which are the primary driver of energy spending, have tumbled by 28%. Still, there is an offsetting positive: consumer savings. High gas prices are a tax on the consumer, and a decline in prices at the pump should translate into more spending on other products, such as restaurants, entertainment, apparel (perhaps), and travel. The slow recovery in consumer spending that has resulted from stagnant wages may get a boost. From the data and commentary we study, we suggest that the benefit to the consumer outweighs the negative implications for the energy sector.
In a recent piece, Barclays concludes that the current decline in oil prices could lead to a $40bn reduction in energy- related capital expenditures. As energy prices drop, revenues and cash flow in the energy sector abate as well, leading to lessened capex. Therefore, a derivative of lower oil prices are likely reduced revenues in ancillary sectors such as engineering and construction. As energy is not a material component of employment in the US, the relative suffering of the sector shouldn’t materially impact the benefits wrought by lower gas prices – higher personal consumption.
Energy CapEx is Closely Tied to Industry Cash Flows Reduced Cash Flows Mean Reduced CapEx
Source: Barclays Research, FactSet
Falling Energy Prices and Projected Energy Cap Ex (Take Two)
Source: Compustat, I/B/E/S
Barclays goes on to suggest that the recent 20% decline in gas prices should result in approximately $70bn in consumer savings. The timing is significant as the prospect of a “flush” household coincides with the upcoming holidays. Likely beneficiaries are discretionary categories such as automobiles, restaurants, entertainment, apparel, electronics, and furniture. Of these, apparel may not participate to the same degree. On more than one recent public retailer quarterly call, management has been asked about the prospective windfall from lower priced gasoline. Department store and other retail executives have been cautious on this point for some reasons we get into below in Portfolio Asset Allocation Considerations (Auto replacement cycle, internet sales, savings).
Gasoline Crowds Out Household Expenditures
Source: Barclays Research
On balance, we believe lower oil prices are beneficial to the economy. Further, that we can narrow the universe of investments with plausible catalysts by those that will benefit or be hurt (enhancing the prospect of making money on the investment) by the recent move in the price of oil – an Externality, the “E” prong of Tiburon’s BRACE Methodology. The benefits to consumers from lower prices at the pump outweigh the potential loss of capex spending from the energy sector (and can suggest longs and shorts).
Oil’s Knock on Effect Worldwide
We believe that the decline in oil prices is not primarily rooted in slower global growth, but predominantly a function of excessive supply, which in turn is being driven by the renaissance in US energy production. Looking overseas, oil and natural gas producers make up more than half of the stock market in Russia. In Venezuela, where oil accounts for 95% of exports, the yield on the country’s benchmark bonds rose to the highest level since the global financial crisis as sinking crude is undermining its ability to pay debt. It has made people worry that somehow the fact that energy is falling is throwing the world into a deflationary spiral. This fear has stoked volatility.
Oil and Impact on Equity Markets
The five-month plunge in the price of oil has left energy stocks with the weakest influence on US equities in nine years. Oil and gas producers in the S&P 500 Index dropped as much as 20% since June, squeezing their share of that market gauge to 8.9%, the smallest since 2005. To put in context, oil and gas producers were 16% of the S&P 500 in 2008 – 7th among 10 industries.
It is feasible that the lessened importance of Big Oil on the S&P 500 could reduce index volatility. Energy shares fell about twice as fast as the full index during the September-October retreat as concern over a global economic slowdown and a glut of supply sent oil to the longest slump in almost three decades. Oil prices have been notoriously volatile for many years. The less important energy becomes to the index, the less oil prices will roil markets (but are replaced by say, technology and healthcare, perhaps less volatile, but introducing new variables). Energy contributed to almost half of the 4.3% loss in the S&P 500. Ex-energy, the index’s decline over the stretch would have been 2.4%.
Oil and Consumption as we Approach this Holiday Season
While we tend to agree with the view that lower crude prices will favorably impact consumption, Barron’s posited the contra – that the hit to domestic energy producers is greater than the benefit of lower prices to energy consumers. Further, that despite the tailwind from lower fuel, consumers aren’t rushing to spend extra income (some bubble scarred US consumers are using this as an opportunity to save). This is not an unreasonable concern. The “windfall” from lower oil prices doesn’t necessarily translate lockstep into consumption. Why not use the extra cash for savings, mortgage payments, credit card balance reduction or payment of increased utility bills if we are in for Polar Vortex II? Further, as we have discussed in the past, we think that the low wage earner has been marginalized in this recovery since the Great Depression. So if lower gas prices will stoke increased consumption this holiday season, presumably it would be among a lower wage earner where the gas prices are more punitive. Consumption in 3Q14 seems to indicate that it is likely a more affluent consumer that has been doing the shopping since oil’s decline. MasterCard and SpendingPulse data showed that through September, 2014, US luxury sales ex-Jewelry was the strongest category, up 8.9%, while Electronics/Appliances were up 8.7%, lodging up 6%, grocery +1.8% and automotive +1.6%. The weakest sub-sector was department stores – down 2.7%.
And then there is the matter of how and what we consume this holiday season. Anecdotally, from the various retailers 3Q14 conference calls, it seems there’s less optimism about the gas windfall finding its way into department store and other retailer coffers, and to the extent they are meaningful beneficiaries. The rapid conversion of American shoppers to electronic (versus terrestrial, in shopping mall) shoppers is driving down margins. On Macy’s 3Q14 conference call, Chief Financial Officer, Karen Hoguet, said that there’s a correlation between lower fuel price and spending, but she doesn’t believe that the department store chain will benefit as much since shoppers are shifting more of their purchases to areas like home improvement, health care and gadgets. “I think customers are choosing to spend their disposable dollars in different ways, and that’s part of the reason why we’re not more optimistic about the lower gas prices,” she said. Others, such as Bon-Ton’s and The Gap, lament the inevitability of gross margin declines from shoppers increasingly engaging electronically.
Overall, we are of the view that low gas prices will translate into increased consumption. Further, that this consumer windfall isn’t dollar for dollar – some leakage occurs and remains in savings or pays bills, but still and all, offsets the reduction in the oil sectors capital expenditures’ impact on GDP. Winners and losers can be derived from these views, as propounded above.
The above post has been excerpted from a letter of Tiburon Capital Management. Refer to the letter for full disclosures.
In my dual role as managing editor of The Manual of Ideas and managing director of ValueConferences, I see many investment manager presentations cross my desk (or, more accurately my email inbox). The presentations are almost always designed to inform potential investors about a firm or fund, with the obvious goal of attracting interest and, ultimately, capital.
Unfortunately, most presentations fall far short of portraying the investment manager in the best light possible. They fall short of adequately explaining the manager’s special advantage or edge. In addition, many presentations are just not easy on the eyes — a soft factor that does make a difference when presenting your firm and approach. Potential investors are not only relying on your investment prowess — they also want to make sure you are running a tight ship on the operations side. A sloppy or amateurish slide deck may signal less-than-optimal execution elsewhere.
An Example of a Great Presentation
I recently had a look at a presentation that I think does a great job of explaining the emerging manager’s investment approach. It is the kind of presentation that shows a manager’s ability not only to explain his strategy and advantage, but also to engage the right kind of assistance in making sure that the presentation is as clear and appealing as possible. These are all business-related skills that reflect positively upon a manager’s ability to build a firm that can be successful in the long term.
Take a look at the following investor presentation by JDP Capital Management:
Jeremy Deal presented at Wide-Moat Investing Summit 2014 and shared his in-depth thesis on a compelling wide-moat business that was misunderstood by the market. It was a perfect way to highlight his edge and analytical rigor.
Jeremy Deal founded JDP Capital Management LLC, a San Diego-based hedge fund manager, in 2011. The firm is a Registered Investment Advisor that manages a private limited partnership focused on deep value, distressed, and special situations within public companies. The investment strategy seeks risk-adjusted, unleveraged outperformance though a private equity-like fundamental research process on each portfolio company.