The smooth road to nowhere
June 30, 2013
Market Summary – 2nd Quarter, 2013
Some records deserve admiration. Michael Phelps’ winning eight gold medals in the 2008 Summer Olympics is one example. Joey Chestnut devouring 69 hot dogs (and buns!) in 10 minutes at the 2013 Nathan’s Famous Hot Dog Eating Contest is, in our opinion, less laudable. Meanwhile, the bond market recently set a new record of its own that is causing more indigestion than eating any number of hot dogs.
A record $79.8 billion was pulled out of bond funds in June1. Mortgage rates, meanwhile, experienced their highest weekly increase in more than 25 years2 during the last week of June. Bond prices are continuing to fall sharply with interest rates having almost doubled since last summer3. With many bond investors just now opening their brokerage statements and seeing heavy losses in their bond funds, the sell off has likely only just begun. To our knowledge, no bond has escaped this rout unscathed.
The current turmoil in the bond market is another expensive reminder that no asset class can be considered safe without regard to its price. Investors who sought to avoid the short-term volatility in the markets by investing in bonds and bond proxies4 are finding that these perceived safe-havens that seemed to be less volatile were anything but safe. The smooth road that investors thought they were taking is actually a path leading to nowhere, and is fraught with the very risk that they intended to avoid. On the contrary, it is those investments that few wish to own and are more volatile on a short-term basis that offer the greatest opportunity for longer-term capital appreciation, and are materially less risky5.
Widely held misunderstanding of risk
At MPMG we have steadfastly rejected the conventional belief that certain asset classes are defensive and less risky than others. We brought this misconception to the forefront in several of our past newsletters. We even devoted an entire newsletter at the end of the first quarter of 2012 (“A Momentary Lapse of Reason”) to the subject. Risk is not avoided through the selection of specific asset classes. Rather, it is the price that one pays for an asset that is the principal determinant of its riskiness.
The insatiable demand for these falsely perceived “safe” investments has resulted in their prices and valuations skyrocketing to such unsustainable and bubble-like levels that they are now one of the riskiest investments of all! Historically, assets such as bonds and high dividend/low growth equities were considered to be defensive because they were cheap. They offer little in terms of growth, and as a result they were not highly coveted by investors so they sold at a discount to the broader market. It was the low valuations that made them safe. But once the valuations were driven up by strong demand to unreasonable levels, they ceased being safe and became risky.
History is filled with once safe investments that became overvalued time bombs. One of the more high-profile instances occurred in the late 1960s and early 1970s with the “Nifty Fifty” stocks, a set of 50 premier growth stocks whose businesses and products were so desirable that their stocks were considered to be safe at any price. These stocks were so coveted that their collective valuation was more than double the average of the market, and several sold at between 50 and 100 times earnings. Ultimately, these high-flying stocks, which soared in the early 1970s, crashed in the 1973-1974 bear market and fell an average of 62%. In a span of two years, Xerox tumbled 71%, Avon dropped 86%, and Polaroid – with the highest price to earnings multiple of the group — fell 91%. More recently, home prices climbed to completely unreasonable levels because “investors” felt confident that they could pay any price for a historically safe asset that rarely went down in price. Housing, the highly-visible crown jewel of many people’s personal wealth, ultimately proved that any asset (not just stocks and bonds) can be highly risky if one pays too much.
Today, the surge in demand for perceived safe-haven investments is similar to the irrational exuberance that investors demonstrated in bidding up the price of the dotcom and technology-company laden NASDAQ index during the late 1990s. Last year we showed you a chart that illustrated the similarities of each asset’s ascent. We have updated this chart (Chart 1) to show not only how the two assets rose in a similar fashion, but also how they now appear to be falling in a comparable pattern. Bond proxies are treading on similar ground, and we maintain that the losses in these perceived safe-havens have only just begun.
The road not taken
Some clients have commented that the MPMG All Cap Value Composite portfolio seems more volatile than it has in the past. They recall that it seemed that their MPMG portfolio was able to outperform the market with less volatility. Now, they tell us that although they are pleased with our long-term performance, they wonder if the road to prosperity needs to be so bumpy.
The central tenet of our value-based investment philosophy is buying the stock of out-of-favor and unpopular, but not permanently broken, companies when the stock price is cheap. In years past it was the less volatile companies that offered the greatest value. We carefully selected businesses that we thought offered greater growth prospects than the market had factored into their stock prices. This is where we found value. Now, the greatest value can be found in the more volatile companies that few want to own. These companies tend to benefit (and suffer) from the cyclical nature of the economy, as well as being highly sensitive to the headline du jour. They also tend to generate a large portion of their business from overseas, particularly from more volatile emerging market nations. The nature of these stocks is to be more vulnerable to short-term market whims and headline events, but it does not detract from their potential to generate outsized long-term returns. Not all unpopular stocks offer value, but we find that certain opportunities exist among the unloved, ignored, and misunderstood companies that create great wealth for patient investors.
It is important for our investors to appreciate that greater short-term volatility does not mean greater long-term risk. We don’t let our investment decisions be affected by headline news that moves a company’s stock price in the short-term, but does not materially impact the fortunes of the business in the long-term. We invest in a company because of the quality of its business. Let the fast money with short-term time horizons focus on making pennies by repeatedly trading in and out of positions without meaningful investment hypotheses to protect them if the market moves against them. We will remain focused on making dollars through tactical investments that are backed by great businesses. These are businesses that can’t be easily recreated by competitors. They produce unique products that the world depends on – necessities of life in many cases. These businesses earn strong profits without taking on a lot of risk or debt. They also have limited competition, entrenched customer relationships, and strong (or even spectacular!) growth prospects. Greater market volatility creates greater opportunity to buy great businesses at greatly reduced prices. It is by buying great businesses at low prices that allows investors to reduce risk, and amass great wealth over the long-term.
The very nature of investing against the grain requires one to challenge conventional practices, look far beneath the surface to uncover value, and patiently wait for your thesis to unfold while most of the market questions your position. The fact that it may take time for our thesis to unfold and for the stock’s price to increase in a meaningful way tests one’s resolve. The lack of both patience and a long-term view are the key reasons that value investing has few disciples. Too many seek immediate gratification, to their long-term detriment. History validates that value investing is the most successful investment style over the long-term.
It may not be a smooth road, but like Robert Frost we believe that choosing “The Road Not Taken” will make all the difference when it comes to protecting you from the excesses of the market and creating meaningful and sustaining wealth in your portfolio. The road may be bumpy at times, but we believe that it will ultimately provide greater wealth and peace of mind than a smooth road to nowhere.
Here are two recent additions to the portfolio that we found and believe to be unpopular, ignored, misunderstood, and cheap.
Itron Inc (ITRI, $42.746): ITRI is a leading technology provider to the global energy and water industries. Products include (i) electricity, gas, water and heat meters; (ii) data collection, and; (iii) communication systems. We believe that upgrades to “smart” two-way meters are a global trend, as countries around the world are upgrading their power grids to accommodate growing urbanization and to measure and conserve energy consumption more efficiently. Advanced digital meters and services are essential elements in these smart grids. ITRI’s stock has been pressured by questions over the strength of its new business backlog and the choppiness of new contract wins, but we feel that the market does not fully appreciate the company’s strong free cash flow, much of which has been used to reduce ITRI’s debt load by more than 50% since 2009. ITRI also has strict backlog guidelines and we believe that very little of the potential deal flow is evident in reported backlog as of yet. ITRI trades at less than 11.5x next year’s earnings and less than 1x sales.
Liquidity Services, Inc. (LQDT, $33.766): LQDT is the leading online retailer of surplus and salvage assets, enabling transactions through auction format. Effectively, it is eBay for surplus and salvage assets, including returned merchandise that retailers cannot resell. LQDT provides reverse supply chain services for seven of the top 10 U.S. retailers, two of the top three online retailers, three of the top four warehouse clubs, and eight of the world’s largest industrial multinational corporations. Given that consumer preferences are shifting to online purchases and that returns for online purchases are about three times greater than returns for purchases made at freestanding retail locations, we believe that the long-term outlook for this unappreciated sector remains strong. With limited direct competition, a firmly established buyer/seller base and scalable business, LQDT could show cash flow growth of at least 15% for several years. LQDT is firmly entrenched as the leader in this $150 billion market opportunity and with less than 1% market penetration the growth prospects for LQDT are staggering. Despite these positive tailwinds and an entrenched market position, LQDT has dropped by almost 50% since its May 2012 high as the company has fallen short of expectations the past few quarters. It was after this pullback to the low $30s that we initiated our position. We believe that the downside risk from the current price level is fairly muted, as much of the existing revenue is recurring, the company has zero debt, and the stock trades at a discount to its peer group.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.