Category: Industry Rotation

Current Industry Ranks

Current Industry Ranks

Posted on by David Merkel

Just a short post this evening because I’m tired, and not feeling that well. Here is an Excel file containing my industry ranks for year end 2007:

Year End 2007 Industry Ranks

Remember, this can be used two ways. In the short run, the “hot industries,” the ones in the red zone, can be bought if one follows a fast turnover momentum-type strategy. For those of us with lower turnover value-type strategies, we buy industries in the green zone, but insist on quality, and attempt to analyze how transient the industry troubles are likely to be. Note that I’m not looking at all industries in the green zone — areas affected by the housing and finance sectors, for example.

One more brief note, since a couple of readers e-mailed me on this. It looks like the forced sellers of National Atlantic are done. Also, the compensation decisions for the three senior executives give them some compensation if a deal goes through. I’m not smiling on this one yet, and things could still go badly wrong. Use caution here.

Full disclosure: Long NAHC

The Nature of a Nervous Bull

The Nature of a Nervous Bull

Posted on by David Merkel

Cast your bread upon the waters,
For you will find it after many days.
2 Give a serving to seven, and also to eight,
For you do not know what evil will be on the earth.
3 If the clouds are full of rain,
They empty themselves upon the earth;
And if a tree falls to the south or the north,
In the place where the tree falls, there it shall lie.
4 He who observes the wind will not sow,
And he who regards the clouds will not reap.
5 As you do not know what is the way of the wind,[a]
Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.
6 In the morning sow your seed,
And in the evening do not withhold your hand;
For you do not know which will prosper,
Either this or that,
Or whether both alike will be good. [Eccelesiates 11:1-6, NKJV, copyright Thomas Nelson]

The point of Ecclesiastes 11:1-6 is that the farmer in Spring, much as he might be hungry, and want to eat his seed corn, instead has to cast his seed into the muddy soil, perhaps planting 7 or 8 crops, because he doesn?t know what the future may bring. If he looks at the sky, wondering if it will rain enough, or whether the winds might ruin the crops, he will never get a crop in Summer or Fall.

That?s the way that I view investing. You always have to have something going on. You can?t leave the market entirely, because it?s really tough to tell what the market might give you. Typically, across my entire set of investments I run with about 70% equity investments, and the rest cash, bonds, and the little hovel that I live in. Private equity is a modest chunk of my equity holdings, so public equities are about 60% of what I own. Domestic public equities are about 45%.

I don?t think of that as particularly bullish or bearish. Even with public equities trading at high price-to-sales ratios, my portfolio doesn?t trade at high ratios of sales, cash flow, earnings, or book value. Together with industry selection, modest valuations provide some support against bear markets.

My tendency will be if the market moves lower from here to layer in slowly using my rebalancing discipline. That?s what I did in my worst period 6/2002-9/2002, and the stocks that I held at the end were ideally positioned for the turn in the market.

So, I never get very bullish, or bearish. I see the troubles in the markets, and I avoid most problem areas, such as in housing-related areas, but I continue to plug along, doing what I do best — trying to pick good stocks and industries (and occasionally, countries.)

Second Video on the Federal Reserve

Second Video on the Federal Reserve

Posted on by David Merkel

Here’s my second video from TheStreet.com on the Federal Reserve.? This one is on where to invest from an equity standpoint.? There are two areas to look at.? Companies that benefit from:

  • Lower borrowing rates
  • Higher inflation

In the first category are healthy financials, and companies with the flexibility to borrow short-tern and buy back stock.? I highlighted insurance companies in my video, but this could apply to other financials and yield-sensitive companies, so long as they don’t face any significant fallout from housing and housing finance.

In the second category are companies that are exporters, and companies where the global prices of their products will rise in dollar terms, while their inputs stay relatively fixed.? This would include energy and most commodities.

Bonds were not a topic of discussion, but I still favor foreign, high quality and short-to-intermediate bonds for now.

Momentum and Growth

Momentum and Growth

Posted on by David Merkel

I make no pretense to being anything more than a value manager.? It’s what I’ve done for the past fifteen years, with pretty good results.? Granted, my new methods over the past seven years attempt to incorporate industry rotation in two ways:

  • Industries where pricing power is near there nadir, such that the only direction is up, given enough time.? Strong companies in weak industries survive weak pricing cycles, and do well when the cycle turns.
  • Industries where pricing power is underdiscounted, and it will pay just to wait for future earnings to validate a higher P/E.

But no, I don’t explicitly focus on earnings growth, though I do look at forecast earnings for next year, which embeds a future ROE forecast.? I ignore growth forecasts for several reasons:

  • Growth forecasts tend to mean-revert.? Low growth companies tend to surprise on the upside, and high growth on the downside.? With a little help from pricing power, I tend to get more good surprises.
  • ROEs also tend to mean-revert.? Competition enters spaces with high ROEs and exits spaces with low ROEs.
  • It’s rare for a high growth, high P/E company to grow into its multiple.
  • Low growth, low P/E companies can be treated like high-yield bonds.? A P/E of 10 implies an earnings yield of 10%; I may not capture all of that 10% in dividends and buybacks, but a modestly good management team will find ways to deploy excess cash into other organic growth opportunities which will grow earnings in the future.? With a little good management, I can see my company with a P/E of 10 grow its intrinsic value by more than 10% in a year.

As for momentum, my rule of thumb is that momentum persists in the short run, and mean-reverts in the intermediate term.? I have to size my trading to the rest of my strategies.? Value emerges over the intermediate term, not rapidly.? The same tends to be true of industry rotation; it works with a lag, but it works.? I have to become like Marty Whitman at that point and say that often the fundamentals and price action are lousy when I buy, and for me that’s fine, because:

  • I focus on balance sheet quality,
  • Accounting integrity, and
  • Cheapness.
  • I have my rebalancing discipline standing behind me, which often has me buy more before the turn occurs.
  • I also stay reasonably well-diversified.

The turns usually do occur.? I never make a ton of money on any trade, but typically 80% of my trades make money. And, my losses are typically small, so this method works well for me.

Anyway, that’s why I embrace negative momentum and don’t explicitly embrace growth.? It can place me in the “caricature” camp for value managers, because my valuation metrics are usually lower than most.? Given my longer holding period, I’m fine with that, because low valuations tend to produce their own catalysts for change, if one has done reasonable research on the shareholder-friendliness of the corporation, and the strength of its financials.? Besides, as intrinsic value grows with companies having low valuations, there is a strong tendency for the stock to rally.? Think of PartnerRe, which has never had a high valuation; as it puts up good earnings year after year, the price of the stock keeps running.? Just another example of an underdiscounted trend in the markets.

Full disclosure: long PRE

Eight Notes on Insurance, Economics, and Value Investing

Eight Notes on Insurance, Economics, and Value Investing

Posted on by David Merkel
  1. Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”? An interesting comment to be sure.? Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.? That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.? So who would be affected?? Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.? Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
  2. Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”? Now, we weren’t talking about credit card debt, which they paid off in full every month.? They did have a home equity loan at 8.5% fixed.? My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.? Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.? My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.? Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
  3. As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.? Shoe retailers and mortgage REITs have not done well of late.? Am I predicting no recession by buying the retailers?? No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.? I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
  4. Does buying a mortgage REIT mean that I am betting on further FOMC loosening?? No.? The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.? While a FOMC loosening would probably help, I’m not counting on that.
  5. My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
  6. If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.? The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
  7. Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.? There is only so much room for shorting, which is an artificial overlay on the system.? We aren’t at the limits of shorting yet, but we are getting closer to those limits.? It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).? It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
  8. I’m thinking of doing a personal finance post on what insurance to buy.? Is that something that readers would like to read about?
October 2007 Portfolio Reshaping

October 2007 Portfolio Reshaping

Posted on by David Merkel

The reshaping file can be found here. In order to stay in compliance with the Bloomberg data license, I only include numeric fields that I have calculated. My ranking method ranks the companies in my portfolio, and all replacement candidates by several variables:

  1. Relative Strength (lower is better, double weight)
  2. Trailing P/E
  3. This year’s P/E
  4. Next year’s P/E
  5. Price-to-book (double weight)
  6. Price-to-sales (double weight — financials are counted as average)
  7. Dividend Yield
  8. Net Operating Accruals (a measure of accounting integrity — double weight — financials are counted as average)

I rank the companies on all of the criteria, weight the ranks, and calculate a grand rank. I look for the company that I own that has the middle rank for all of my currently owned companies, and I sell a few companies that I own below that, and buy some new companies near the top of the list. Here are my actions:

Sales

  • Sara Lee
  • Dow Chemical
  • DTE Energy

Purchases

  • Redwood Trust [RWT]
  • Gehl Corp [GEHL]
  • Shoe Carnival [SCVL]
  • Charlotte Russe Holding [CHIC]

Future Sale

One reinsurer — could be Flagstone, PartnerRe, or Aspen Holdings.

Rationale

I have enough reinsurance names going into earnings. If you need more of an example of how well they will do this quarter, then look no further than PartnerRe’s solid earnings report this evening. On the other sales, DTE Energy and Dow Chemical were solely for valuation reasons. Sara Lee is another matter; my confidence that they can turn around the company is reduced, and valuation is not compelling.

As for purchases, on the shoe retailers, there were a bevy of cheap names, but Shoe Carnival and Charlotte Russe seemed to have the most consistent operations, and low debt. Gehl seems to be in a good industry, small agricultural machinery is in demand, and valuations are modest. Finally, Redwood Trust seems to be well-run as mortgage REITs go. Asset quality is good and leverage is moderate. Also, the debt is all from securitizations, so it is non-recourse to the company; the most that can happen is that the assets in the securitizations depreciate to the degree that their residual interests are worthless.

One other shift that is unintentional here, is that my portfolio becomes more small cap in nature. I am selling away larger companies, and buying smaller ones. That is an accident of the process, but occurring because there are some genuinely cheap companies to buy. Time will tell as to whether these are good purchases, but most of what I like in investments are lining up here.

Full disclosure: long PRE AHL FSR CHIC SCVL RWT GEHL

Industry Ranks October 2007

Industry Ranks October 2007

Posted on by David Merkel

Here are my Industry Ranks October 2007 for the current portfolio reshaping.? Remember that my ranks can be used two ways.? If you are a value guy like me, you pick from the bottom quartile, the green zone, for out-of-favor industries.? I further filter that by striking out industries that in my subjective opinion, still have more pain to take.? That’s why housing, housing finance, and housing related names are absent.

If you are a growth or momentum player, pick from the top of the list, because in the short run, momentum tends to persist.? In the intermediate term momentum tends to mean revert.? I play for the latter of those two momentum effects, because I am not much of a trader, and I think the effect is more reliable, and tax-effective.

Later today, I’ll post my final list of additions to the candidates list for the portfolio reshaping, after running an industry screen.? Then over the next three days, I’ll get to work on the reshaping.

The Next Portfolio Reshaping Starts

The Next Portfolio Reshaping Starts

Posted on by David Merkel

Every 3-4 months, I do a comprehensive review of my portfolio, comparing all of my current companies to a set of potential buy candidates.? The buy candidates come from all sorts of sources, and I do my best to forget who gave them to me, so that I can approach them fresh.? Here are the candidates:

ACH ADP AHN AIB AIG AKR AMGN APA ARP ATI BBD BBV BJS BK BLL BMA BMO BP BTU BWA CAH CCK CCRT CENX CHT CMI CNQ CNX CODI COF COG CPA CPL CR CRI CRK CS CTL CVH CVX CW CXW DDS DEI DFS DRC DSX DVN ECA EIX EMC EOG EPD EQ EXP FCX FLR FLS FRX FWLT GFI GLYT GNI GOL GOLD GR GSB GSF HCC HD HDL HGRD HLX HSR IBCP IM IMOS INFY IR IRE ITU IVN JCI JCP JEC JNJ JOYG JRT JWA KBW KEG KFT KMP LM LMT LNT LOW LSI MBT MBWM MDR MEOH MER MI MMC MOS MPG MRO MU MVO NBR NC NCI NEM NOV NTRS OXY PBR PBT PCH PCL PCZ PG PMD PNC POPEZ POT PPC PTI PXP QTM R RAIL RDY REXI RHI RIO RRD RS RTP RWT RYN SAN SBR SDA SE SGR SGY SII SKX STD STT STX STZ SVVS SYNT T TBSI TD TEN TEVA TEX TLM TRS TSO TTM TWIN UBS UFS UG UHT USB USG USTR VCP VIP VIV VSL VZ WDC WFC WHG WLL XTO XTXI

Alphabet soup, I’ll tell ya.? Here’s where we go from here:

  • Update my industry models.
  • Run a screen off of the results of the industry models to pick up a few more ideas.
  • Scrub the quantitative data for errors.
  • Run my ranking system.
  • Fundamentally analyze the top buy candidates to find a few good buys.
  • Look at the bottom of my current companies in the rankings to decide what I sell to fund the buys.

And, if you have a company you’d like to toss into the mix, let me know.? I’ll toss it in.? This process should complete sometime in the week that begins on 21st, because I need to finish up preparations for a speech that I am giving on the 15th.

Many tickers mentioned, but I own none of them.

Cautious Optimism on Relative Performance

Cautious Optimism on Relative Performance

Posted on by David Merkel

There are times when I feel “in sync” with the markets, and times when I don’t.? Example: for the four months from June 2002 to September 2002, my broad market portfolio lost 32.5% of its value.? Needless to say, I questioned my sanity while BBB bonds traded at 400 basis points over Treasuries.? (Yes, I had those to worry about also, I was managing several billion in corporate and other bonds at the time.)


So what did I do? I kept doing what I always do.? If I found a trade that improved the fundamentals of the portfolio, I did it.? I kept following my discipline, even though it hurt.? In late September, I scraped together my spare cash and invested it into the portfolio. On October 7th, we hit bottom for both the equity and credit markets.? (After the European financial regulators were done making their financial companies sell US stocks, in order to preserve their solvency.) ? Over the next 15 months, I had my best period of outperformance ever.? Including the four-month drawdown (worst in my life), the full nineteen month period gave me a 26% return, which was pretty good for that time period.

In general, the time to give up on a strategy is not when it is hitting you hard and negative.? Instead, look for the fundamental reasons why your strategy isn’t working, and ask how long lasting those factors are, and whether/when they might reverse.? If after that analysis, you realize that the factors are long lasting, and unlikely to reverse anytime soon, then change.? But if they are likely to be transitory, it is time to maintain the discipline and press on.? It will not feel good at the time to do so, but it will likely pay off.? I experienced this while doing small cap value in the 90s, managing corporate bonds 2001-2003, and with my broad market equity strategy 2000-2007.? Things always hurt the worst near bottom turning points, and vice-versa in top formation.

The third quarter did not work so well for me.? Part of it was value investing being out of style.? With all of the new growth investors over at RealMoney, it is interesting to hear them perk up and crow a bit.? They’ve suffered enough over the past seven years.? But as for me, my sector rotation discipline covers some of that, while staying in a value framework.? In the last few weeks, I might be seeing a turn in my relative performance.? At least, it feels that way.? Ideas are working for the reasons that I would expect.? So, I am guardedly optimistic on relative performance.? But what would you expect?? I’ve been through worse, and bounced back, so I keep doing what I do.

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