“Avoiding danger is no safer in the long run than outright exposure. The fearful are caught as often as the bold.”
It is difficult to invest for the long term. In order to do so, the key characteristic an investor must have is permanent capital. The best example of permanent capital is Berkshire Hathaway, Warren Buffett’s investment vehicle. Since Berkshire recently hit a 52-week low, in the short run, it has been a bad investment. In the long run, of course, Berkshire has been a fabulous investment.
From December 31st, 1987 to the close yesterday, Berkshire “A” shares have returned ~3,770%+. Over the same period, the SP500 has returned ~415%+. In the long run, it is obviously difficult to debate Buffett’s success as an investor. Unfortunately, very few investors can operate for the long run because of a lack of permanent capital and an unwillingness of those that provide the capital (limited partners) to suffer volatility.
Naively many investors attempt to emulate Buffett’s performance by purchasing stocks that emulate his criteria. In aggregate, studies show that cheap stocks with clean balance sheets will outperform over time if bought well. Obviously, the challenge when emulating Buffett, though, is to assess the moats of a company and barriers to entry of an industry.
As Buffett wrote in his 1992 letter to Berkshire Shareholders:
“An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.”
The challenge of finding a long term economic franchise is that very few exist, or are sustainable. At one point, the newspaper industry was a prime example of an economic franchise. The newspaper was needed, in many markets had limited competition (think the Buffalo News), and pricing of newspapers was not regulated by the government. While arguably the newspaper industry did represent franchise-like investments during periods, those investors that held these franchises in perpetuity are likely not happy today.
The key way to “avoid danger in the long run” is to remain flexible, not duration specific. I appeared on the Kudlow Report a few months back and one of the other guests was extolling on the virtues of being a long term investor and indicated that his firm has an average holding period of four years. In theory, that’s fine if you have the process and team to execute on a long term holding period. If you are investing for the long term, which for this discussion we’ll just consider beyond three years, it requires just as much work, if not more, than if you are an intraday trader.
The primary reason investing for the long term requires more work is because in the short term, assets will get mispriced. Much of this can be attributed to behavioral finance and fear. When assets get mispriced, such as in the market dislocation during the subprime debacle, it requires strong conviction in the research process to believe the fundamental story and to continue to buy, or even hold, as an investment is dramatically underwater. While many fund managers claims to be adept at buying while there is “blood in the streets”, very few actually can effectively time purchases. The world is replete with studies that show both professional and individual investors classically sell at the bottom and buy at the top.
Given the challenges with true long term investing and the reality that most cannot do it, we emphasize three investment durations in our research: TRADE (3 weeks or less), TREND (3 months or more), and TAIL (3 years or less). In theory, at least based on how we analyze timing and risk, they are all related, so a TRADE idea can become a TREND idea and so on. Thus, a rigorous daily research process is critical to our success (hence the early mornings).
Shifting to the short term, there are a number of data points from the last 24 hours that I wanted to flag as fundamental to some of Hedgeye’s key investment views:
First, the European sovereign bond markets continue to signal that the worst is yet to come for sovereign debt on the continent. Even as equity markets seem to be lightly cheering positive developments yesterday, bond yields have barely budged. In fact, Greek 10-year yields are at 16.5%, Irish are at 12.1%, Portugese are at 12.1%, Spanish are at 5.7%, and finally Italian 10-year yields are at 5.0%. Specific to Greece, civil unrest continues to accelerate as Greek trade unions are planning a 48-hour strike to protest austerity measures that will be voted on Thursday. We remain long German equities via the etf EWG and short Spanish equities via the etf EWP.
Second, Premier Wen Jiabao provided us an early view on Chinese inflation for the full year yesterday. He indicated on Hong Kong-based Cable TV that while he sees difficulties in reaching a full year inflation target of 4 percent, inflation “can still be kept below 5 percent”. This supports our view that the proactive monetary tightening that China has implemented will lead to steadily decelerating inflation in the back half of 2011 and marginal dovishness out of the People’s Bank of China. We are long Chinese equities via CAF.
Finally, New Jersey officials are purportedly in negotiations to secure a temporary $2.3BN bank loan to cover a state cash shortfall. New Jersey needs the cash to pay various bills between the start of its fiscal year on July 1st and the mid-summer bond offering. We’ve been consistently negative on State and Local level finances and this provides incremental support to the view. While many States are constitutionally obligated to balance budgets, it will be challenging and will likely require additional municipal bond issues as federal government support will be largely non-existent in fiscal 2012. Further, State and Local level austerity will be a drag on economic growth more broadly. We currently have no position in the municipal bond market.
Good luck “avoiding danger” out there today,
Daryl G. Jones
Director of Research
This note was originally published at 8am on June 23, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“Confusion now hath made his masterpiece!”
So… according to La Bernank in his Fed Presser yesterday, US Growth Slowing As Inflation Accelerates is “part temporary” … but “part longer lasting”… and while “we don’t have a precise read on why”… we are confident that the entire market should trust our forecasts for growth to re-accelerate.
Ben Bernanke’s growth forecasts haven’t been sort of wrong in 2011 - they have been wrong by almost a half! So how can a country that was founded on such fiercely independent principles put up with this level of analytical incompetence from its economic Central Planner in Chief?
I don’t know. But after doing a full day of meetings with major money managers in NYC yesterday, I can tell you that Keynesian Confusion is starting to breed contempt. Dollar Debauchery was all good and fine, until people stopped getting paid.
What we do know is that economics, never mind Keynesian economics, is a social science (Mr. Krugman, that’s different than a hard science, fyi). We also know that market-based practitioners who apply math to markets make a living off of the academic dogma of Keynesian economists.
This is great for my Research and Risk Management business – but really bad for the US economy. My team and I get paid to be right. These guys at the Fed get paid what they’d be worth to an asset management firm managing Globally Interconnected Risk - not much.
Back to this morning’s Global Macro Grind…
- CURRENCY – we’ve had a bullish bias towards the US Dollar since the beginning of June; now the USD Index is breaking out above its $74.41 immediate-term TRADE line of support. This is bad for asset prices that are highly correlated (inversely) to the US Dollar.
- TREASURIES – we’ve been bullishly positioned on the long-term Treasury (TLT) side of the bond market since May. Yes, we understand that bond yields are low – but we think they are going lower – primarily because people aren’t yet Bearish Enough on US Growth.
- STOCKS – we re-shorted the SP500 (SPY) at 3:14PM EST on Tuesday, June 21st ahead of the Greek confidence vote in socialism and La Bernank walking down this forecasts for US Growth. Timing matters.
- CURRENCY – having a bullish bias towards the US Dollar (with near-term catalysts that are USD bullish – QG2 ending, a mid-July Debt Ceiling compromise) is reason enough to be bearish on Euros. But the bigger bear brewing in the FX market is Europeans behaving European on go- forward monetary policy. There’s an increasing probability that the ECB considers going for a hybrid version of Quantitative Guessing II.
- EUROCRAT BONDS – plenty of European Sovereign bonds look like the Sovereign Debt Default Cycle is just getting started. If you think this is isolated to Greece, market prices are pricing in the other side of that thought. Major risks – and they are not going away anytime soon.
- STOCKS – we are long Germany (EWG) and short Spain (EWP). Germany’s PMI (Producer Manufacturing) print slowed significantly in June (54.9 versus 57.7 in April) and we’d be unaccountable to not call that data point out for what it is – Growth Slowing, globally. Across European Equities, the only major market that has not broken its intermediate-term TREND line yet is the German DAX (7103 support), but it’s close!
- CURRENCY – since one of our Q2 Macro Theme remains “Deflating The Inflation”, we finally sold our 2-year (buy and hold!) long position in the Chinese Yuan (CYB) this week. We think Asian currencies will weaken as commodity inflation does. Don’t forget that most of these countries (China, Australia, India, etc.) have been vigilant in raising interest rates – now they can stop with that.
- CHINESE STOCKS – after being bearish on China for the last 15 months, we’ve been on the road articulating the research scenario analysis around A) Chinese Growth Slowing At A Slower Rate and B) Chinese Inflation Deflating. The research and the risk management calls are two very different things (one is research, the other timing), but we did finally buy exposure to the A-shares on June 16th and we are in the money. Despite the Keynesian Confusion, Chinese stocks were up +1.5% last night and have been up for 3 consecutive days, outperforming most of the majors in Global Equities.
- JAPANESE STOCKS – we remain long-term bears of the gigantic Keynesian Experiment in Japan and we remain short of Japanese Equities (EWJ) here. Yes Japanese stocks are down -6% YTD and, yes, they had a natural disaster. But the real long-term disaster in Japan is that the average annual GDP Growth rate since 1992 has been 0.85%. Bernanke would be less confused if he embraced Richard Koo’s economic ideas about “Balance Sheet Recessions” and what perpetuates them (cutting rates to the ZERO bound and scaring the hell out of your people).
- OIL – we remain on the other side of Goldman’s call to buy oil and see immediate-term downside in WTIC Oil to $91.22 this morning.
- GOLD – we remain long Gold (GLD) and think it will continue to perform as long as real-interest rates in America remain negative.
- COPPER – we remain respectful of Dr. Copper’s Ph.D in the antithesis of Professor Bernanke’s confusion. Bearish TREND is as bearish does.
Otherwise, in the land of nod, it’s a pretty quiet morning. We don’t see any probability of Keynesian Confusion leading to any level of American style accountability and/or change in whatever it is that they do to come up with these embarrassingly bad forecasts.
My immediate-term support and resistance ranges for Gold, Oil and the SP500 are now $1533-1555, $91.22-95.98, and 1257-1297, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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Conclusion: In the three charts below, we highlight key risks to hopeful expectations of a sustained recovery in earnings growth and a tranquil global investing environment over the long-term TAIL. In fact, when analyzed with a wide enough lens, the data suggests that equity market headwinds are significantly less “transient” than is currently anticipated by consensus.
Position: Short US Equities (SPY).
We get called out a lot for coming off as short-term in nature. While there is certainly some merit to that claim (our style of managing risk acutely focuses on timing), we don’t necessarily agree with it in its entirety. In fact, we focus a great deal of our research on the longest of long-term trends (refer to our firm’s Sovereign Debt Dichotomy and Housing Headwinds presentations for key examples of our longer-term work), and, within the context of these bigger picture themes, we manage risk around the Duration Mismatch that’s typically ever-present in the world of investing.
Timing is everything. I believe a famous investor once said:
“It ain’t what you buy, but rather when you buy it that matters.”
To that tune, we think by the end of 2Q11 we will be able to confirm that the peak in corporate earnings for this cycle was actually in 1Q11. Including our own, many charts have been circulated around the street about peak corporate profits, but that hasn’t actually mattered until, well, now. To quickly rehash our out-of-consensus view, we think the stench of Jobless Stagflation starts to show up in the 2Q11 earnings season in the form of sequentially deteriorating corporate earnings growth on a go-forward basis. For more color on this topic, refer to the following reports:
- 5/18/11: “Eye on Earnings: Growth Slows as Inflation Accelerates”
- 5/22/11: “Early Look: The Last Stand of the Equity Bulls”
This stance is strongly supported by the fact that corporate profits are what we’d consider extremely stretched on a historic basis. Using BEA data, we were able to back our way into corporate EBITDA margins on a national level, as well as corporate EBITDA as a share of the overall economy. From a standard deviation perspective, both metrics are currently residing in rarefied air (2.3x and 2x, respectively). From a more quantified stance, 95% of observations fall within 2x standard deviations of the mean; thus, mean reversion in both series is likely over the longer-term. That’s not a bullish data point for long-term investors. It is, however, a “game on” challenge to risk managers. Be it boom/bust, bubble/burst, or expansion/contraction – alpha is always there to be captured.
The final chart we’d like to show you is borrowed from Carmen Reinhart and Kenneth Rogoff’s oft-cited, long-term work on sovereign debt. The illustration lucidly expounds upon a simple concept that we’ve been beating the drum on since late 2009: we are in the early stages of the global sovereign debt default cycle. As the chart repeatedly shows throughout the last 200-plus years, the sovereign debt woes of fiscally imprudent countries like Greece rarely (if ever) get better without first getting a lot worse. Moreover, when the cycle peaks, it’s typically a global phenomenon with 35-50% of countries in some form of default or restructuring.
While global financial markets will more than likely cheer on and celebrate any/all attempts to kick the proverbial “can” down the road, we continue to remind investors of a simple point we began making over 18 months ago: be very afraid of Europe’s periphery – especially if you are a long-term investor.
FINL’s comp of +6.5% came in just above the Street’s +5.7%, but below our proprietary blended rate that suggested comps of +8% during the quarter (our index is based on what FINL SHOULD have reported based on its mix and weighting in footwear and apparel relative to the reported NPD/SportscanINFO numbers). This is the second time in the last four quarters that FINL came in short of the blended rate with comps coming in only 30bps above last quarter – far different than FL’s margin of outperformance of at least 200bps relative to the index over the last three quarters.
We believe this suggests FL is likely gaining share in the industry. This isn’t a zero sum game and it’s not time to hit the panic button on FINL. Athletic footwear sales continue to be strong and the pipeline in the near-term suggests this momentum is likely to continue, but the reality is that these two retailers are growing at different rates. A factor to keep in mind here is that 1-point of comp equates to something quite different for each retailer. In fact, a 1-point change in comp at FL equates to just over a 4-point change in comp for FINL on an absolute dollar basis. Therefore, even if we were to assume that FL is capturing the entire difference, it’s not a 1-for-1 exchange, but rather FL would gain roughly a 40bps benefit to comp if this were indeed the case.
Some additional highlights of the quarter were the strength of FINL’s e-commerce business up over 55% and better than expected product margins more than offsetting the drag from toning. It’s worth noting that CEO Glen Lyon mentioned that the industry was the most “rational” he’s experienced in his 10-years with the company, which is good for margins – at least in the near-term. While apparel sales were up +3.3% during the quarter, they came in below industry trends and remain a continued area of focus for the company. All in, with Q2 marking the easiest comp of the year for FINL and both occupancy and product margins coming in better than expected and likely to persist at least through the next quarter, we’re shaking out at $0.41 for Q2 and $1.57 for the year above current Street estimates of $0.39 and $1.53 respectively.
While industry trends continue to benefit the FINL business, we see FL as the greater beneficiary of these trends over the intermediate-term. With continued progress in merchandising (particularly in apparel) and marketing (specifically e-commerce) in addition to the Foot Locker’s leading position in the industry, which affords the retailer access to exclusive product in all the key categories, FL remains one of our top long ideas here headed into the 2H. We’re at $0.16 for the quarter vs. Street at $0.13 with FINL results giving us further confidence in our above the Street estimates.
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