The Fearful Investor

Failing The Smell Test

I just read Annaly Capital's latest monthly commentary. These guys invest in mortgage-backed securities and have a great record doing it. Here's my favorite quote re the recent positive GDP report:

"GDP gains driven by personal consumption while incomes are falling, joblessness is rising, and credit availability is shrinking, just don‟t pass the common sense test (see Friday‟s 10.2% unemployment rate and the ghastly consumer credit figure, down $14.8 billion from last month and $125.8 billion from the peak in mid 2008). It‟s impossible to deny that the GDP data from this quarter are better, at least relative to how bad things were earlier in the year. Without the multiplier effect of the stimulus kicking in, however, we believe the third quarter 2009 GDP data could look like an accounting extraordinary item, a one-time event that quality-of-earnings analysts would disregard."

Now, I'm all for a rallying stock market, as a rising tide lifts all boats, including my defensive one, but it's hard to see how less income to the economy and less investing by corporations can make forward prospects look good for companies in which I'd like to invest. Sure, things are getting better, but Intel's 3rd quarter, while better than their 2nd quarter, wasn't as good as last year.  Now, easier comps will help going forward, but the growth has got to come from somewhere....

Why Bottom Fishing May Take A Longer Line

We've made money for our clients in the past in basically one way: find inexpensive companies in strong industries. Inexpensive companies are easy to find, strong industries are not.

Microsoft is plenty cheap at about a 10% free cash flow yield, but the revenue trend is undoubtedly down. Remember when infrastructure spending was going to boost all the machinery stocks? The 22,000 being let go by Caterpillar are wondering the same thing.

When an industry is going well, revenues go up, margins go up and multiples go up in a virtuous cycle. We are now witnessing the opposite.

Has the market discounted the worst? Hard to say. But, if estimates aren't low enough, stocks will follow estimates lower. Take Microsoft again. Consensus estimates for Fiscal 2010 (ending June 2010) are for about $2.00/share. I think those numbers could be 25% lower. Sure, the company will generate boatloads of cash, but (a) what returns will they get with it? and, (b) what is the future trend of their revenues?

Before everyone gets all excited about the market bottoming, let's also entertain the possibility that delevering, lower revenues and lower margins may not be so good for the stock market. One day, the bottom callers will be right,the question is how much will they have left when we get there?

Always Wading Into The Pool

At my day job, running Hurley Capital, a value-oriented money manager, our goal is to keep up with the market in good times and protect our capital in bad times. Achieving this goal requires research and discipline. By research, I mean finding investments that have enough underlying value to sustain themselves during down markets, while having the cash-flow growth opportunities to keep pace with the market in up markets. Discipline means investing assets over time to avoid the natural (and unprofitable) tendency to invest only  when the market sentiment is high and selling when it's low.

Prospective clients often ask where the market is going in the next year to decide whether or not to invest. Per above, my answer always is, "Since we're investing over time, you shouldn't be overly concerned about the next few months. Furthermore, we're investing defensively. Let's ease in." This approach has worked for our clients (and ourselves - since we are invested alongside them) since we started Hurley Capital in 2003 and we're hopeful to keep up the good work going forward.

How are we 'easing in' now? You can look at all of current composite client holdings on our Q1 Investor Letter.

Follow Up On A Prior Investment: Annaly Capital Management

In my Q107 Investor Letter, posted on my website (hurleycapital.com), I talked about why we bought Annaly Capital. Herewith is a paragraph I've just deleted from my upcoming Q307 Investor Letter about the circumstances surrounding our sale of Annaly in August:

As described in our First Quarter 2007 Investor Letter, we thought Annaly Capital would be a great investment to take advantage of difficulty in the housing and mortgage markets and potentially a lower short-term interest rate. Annaly is the most conservative player in the mortgage investing space, investing exclusively in government-backed AAA-rated mortgages using leverage of 9-11x their equity on hand. As the turmoil in the mortgage market unfolded, all mortgages and mortgage products of ALL credit qualities were marked down. Like The Three Little Pigs, first the subprime players fell, then Thornburg Mortgage, who invests in only AAA mortgages, though no government-backed lost 1/3 of its book value and our judgment was while it was unlikely that the big, bad, wolf would blow down Annaly’s brick house, the risk (Thornburg is still down 50% from its June 2007 levels) outweighed the reward (20-30%) by enough to warrant exiting the investment at a small loss. While Annaly’s stock has recovered to its springtime highs, we’re in the risk mitigation business and believe the decision was an appropriate execution of our investment mandate

Catching Up

I haven't posted for a while as I've been short-staffed in the office. That said, I'll be prolific this week/next week as we'll be issuing our quarterly newsletter on our website (www.hurleycapital.com) shortly. I've got lots of newsletters there going back to the beginning of my firm. If you like the newsletter, you can subscribe to it online on our web site.

Furthermore, as I've been told that my letter was too negative considering the market-beating returns at below market volatility, I'm including a paragraph that will not appear in the newsletter on one that got away, in my mind for the right reasons. I'm a big believer in the concept that Nassim Taleb covers in his book "Fooled By Randomness", where the ends don't qualify the means. Which is to say, if a trade doesn't work out but it was done for the right reasons, then it's ok. There's certainly reason for review and introspection, but not necessarily reason for doing things differently the next time. -- See next post on Annaly Capital Management.

Market Volatility Creates Investment Opportunity

Volatility creates investment opportunity, even for value-oriented, low turnover investors like me. While many financial-related company stocks were "taken to the woodshed" (read: went down a lot) last week for their connection to the subprime malaise and its knock-on effects, many others seemingly unconnected fundamentally, went for a ride of their own. Moments like these allow discerning investors to take advantage of product put on sale temporarily.

In his 2005 Annual Report, Frank K. Martin, CFA, founder of Martin Capital Management likened these moments of market disarray (and opportunity) to being Larry Bird standing on the free throw line to take a foul shot to win at the buzzer. While to the outsider, it must have seemed that Bird was under immense pressure, for Bird, he'd been preparing for this moment his whole life, taking tens of thousands of free throws in practices and other games.

Take a look at charts of small cap software companies like JDA Software, Interwoven, Captaris, Actuate and Progress Software and you'll see companies that dropped around 10% early in the week only to recover towards the end of the week. Nothing fundamental happened with these companies to cause the volatility, rather, I think they were companies owned by a fund, or funds, that just needed to sell some positions and these not-so liquid names felt the brunt of the pain. Rumored troubled funds at Goldman Sachs and Rennaissance owned large positions in some or all of the above stocks as of March 31, 2007, according to SEC filings.

Knowing how discern when a falling stock price is representative of a loss of underlying value or external sources (such as distressed sellers) requires an in-depth knowledge of the stocks, and industries, involved. As the disclaimer in tiny type on the bottom of many car commercials reads: "Professional Driver - Don't Try This At Home".

FedEx Hits Truckers While They're Down

Yesterday morning FedEx (FDX) announced a 25% reduction in fuel surcharges on its less-than-truckload (LTL) and freight services. Clearly FedEx sees this as a great opportunity to use their growing international business to grab market share by taking advantage of a weak domestic trucking market to further squeeze their competition, including Arkansas Best (ABFS), Conway (CNW), and Yellow Roadway (YRCW). With many truckers continuing to see year-over-year volume reductions, price reductions kick out another leg of the profitability stool for these companies. On many first quarter earnings calls, the saving grace for LTL truckload providers was a stable price environment despite reduced volumes. Managements trumpeted how consolidation in the LTL industry has made pricing more rational among competitors and profitability should therefore remain stable. To make matters worse for investors in these truckers, they are still trading at premium P/E multiples (while the denominator - earnings - are at risk).

As discussed in my April 27th post, one of the keys in my investment process is to invest in industries with the wind behind their back and truckers have the wind squarely in their face. For industries with the wind in their face, while the primary risk is the expected bad results, the really important secondary risk  is the unexpected even worse developments -- such as increased competition or further fundamental deterioration.

My managed account clients and I are short Arkansas Best Corp.

Understanding Sentiment/Valuation Disconnects

On days like today, when the market is down a bunch, I usually get some client calls that go like this:
Client: Hey Chuck. What's going on with the market?
CG: It seems to be going down.
Client: Well, what do you think?
CG: I dunno. I've picked out a bunch of value-oriented investments which I think ought to do well in most market environments, are reasonably priced, and together form a conservative portfolio. I've got some nifty ideas for new investments, that I'd love to buy if the market keeps coming down like this.
Client: So you're not worried.
CG: I'm always worried. That's my job. To be worried for you, so you don't have to worry.
Client: Ok

While it's been written a million different ways, by all sorts of value investors, I try to tell clients that stock prices go up and down, but behind each ticker is a company that we can ascribe a value to. While this value is subject to change due to macro-factors (such as interest rate fluctuations and economic growth here and abroad) and micro-factors (such as competition and corporate management changes), what happens in the stock market today or tomorrow rarely effects this value.

Market movements are changes in sentiment. Does today's down market or this year's up market mean:
- that domestic trucking tonnages are rising? No.
- that Korean mobile phone churn/ARPU is changing? No.
- that Wal*Mart is suddenly reversing it's plans to reduce growth spending and buyback $15B of stock? No.
- that Chesapeake Energy is having less success drilling for Natural Gas - or, more importantly, that domestic natural gas supply/demand trends are changing? I don't think so.

Stock buying and selling opportunities are created by this disconnect between sentiment and individual company valuation/trends. Knowing how to take advantage of this discrepancy is one key to making money in stock investing.

I'm A Thief!

I admit it. I steal.

In this case, I steal investment ideas. Like the Value Investors Club and Value Investor Insight, there is a long history of investors sharing ideas and proselytizing prospective investors.

Typically, I'll troll through 13-F's of some of my favorite investors such as Fairholme Fund or Southeastern Asset Management to see if they've bought anything recently, if it's in a sector I'm currently interested in, and if the stock has moved a bunch since they've purchased. If I'm still interested, then I'll start doing the research: going through the SEC filings, listening to the conference calls, doing some basic valuation work, looking at other institutional or inside holders, etc. The vast majority of this work yields no investments as I either am not comfortable with or don't understand the investment thesis.

Last week, I attended the Ira Sohn Research Conference here in NYC to hear some of the best hedge fund, mutual fund and private equity fund investors talk about some of their favorite ideas.
I attended this conference last year and didn't invest in any of the ideas, but found the conference worthwhile nonetheless as it's great to hear how presenters discussed their ideas and get a glimpse into their thought process. More than one investor presented an idea they've been in for five years without success yet. As they would readily admit, being early sometimes means being wrong.

I haven't posted in a while as I'd expected to write about one of the investments touted in the conference that may turn into an investment for me and my clients. It is the sort of investment that usually (stress USUALLY) works, which is - proven management, good valuation, and catalyst for growth. I hope to be ready to present it in my next post.

Yes, I stole it. But, hey, all clients care about is results, not originality.

What's The Point Of A Money Manager?

I give a few presentations a month about how to choose an investment advisor or tips on mutual fund selection and during these presentations I talk about what I do -- value-oriented, conservative money management. There's often someone in the crowd who asks, " What's the point of a money manager?. After all, most underperform the market anyways. Why don't I just invest in the index and let it ride?"

I typically answer that indexing is easier said than done, requiring steadfastness in volatile markets. When the market hits new highs, like now, can you resist the urge to take money off the table? Or, when the market plummets, do you have the fortitude to stick it out? Can you resist the urge to follow stock tip(s)?

Don Schreiber of WBI Investments of Little Silver, NJ, put it best in an interview in the April 2007 issue of Investment Advisor magazine, "Buy-and-hold doesn't work for individual investors. It works from a statistical standpoint, but people fail trying to buy-and-hold the markets, because the markets will hand them more risk and volatility than they're willing to tolerate... When I look at my statement, and I had a million dollars, and now I have $700,000, I know logically, I should do something about that. It's not emotional, it's not fear and greed, it's a logical step I should take to guard my own assets."

Furthermore, once the buy-and-hold methodology is given up, stats show that individual mutual fund investors underperform mutual funds at large:

That said, an investor doesn't necessarily need to give up performance to get good financial advisory help. There are advisors with market-beating returns, net of fees, with volatility below market levels. I encourage people to continue to ask the tough questions and do the due diligence. Feel free to email me with questions/comments.