Just Ask Warren Buffett or Charlie Munger

Good Morning,
 

U.S. stocks bounced back from the most significant selloff since May, while Treasuries fell after unexpectedly strong hiring data improving confidence in the American economy, bolstering the Federal Reserve’s case for raising interest rates.

Broad-based payroll gains that topped estimates boosted sentiment among equity investors a day after stocks suffered the biggest drop in six weeks. The Bloomberg Dollar Spot Index was flat as tepid wage growth stoked concern that inflationary pressure remains weak. The hiring report supported the Federal Reserve’s stance that recent signs of labor market sluggishness are transitory, though the tepid wage gains gave fuel to arguments that weakness remains. 

On the Canadian side, Canada’s job market delivered another stellar performance in June by adding 45,300 positions, Statistics Canada said Friday.

The number, which vastly surpassed economists’ consensus expectation of 10,000 new jobs, increases the probability that the Bank of Canada (BoC) will raise interest rates at its next rate announcement on July 12.

 

Our Take
 

There are plenty of reasons to be bullish as global earnings per share are expected to grow around 11 percent this year, compared to just 2 percent growth last year. In fact, all the major economies around the globe and the companies which compose them are gaining momentum at the same time, the first such simultaneous recovery in years.

What we are looking at is a “global synchronous recovery”. This is a big change compared to recent years, when we had various regions and countries moving in and out of EPS recessions.

Furthermore, Janet Yellen's bet on pulling workers back to the labor force appears to be paying off.
The flow of people moving from outside of the labor force straight into jobs jumped in June to 4.7 million, its highest level in records that go back to 1990. Labor force participation has stabilized after a long-run decline, and the share of the population that works continues to rise moderately. And as long-hidden labor market slack gets absorbed, it could be helping to keep wage gains modest and inflation in check.

Nevertheless, there are reasons to remain cautious as central bank chiefs in the US and UK seem very sure of themselves. Mark Carney, the governor of the Bank of England and chair of the international Financial Stability Board, said this week that issues of the last financial crisis had been “fixed“.

Last week, his American counterpart, Janet Yellen said at a Q&A in London:

“Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.”

Last week, Mario Draghi, governor of the European Central Bank, sent the euro to its highest level in more than a year by proclaiming that the euro-zone economy was improving and that he was “confident” the bank’s policies working. Both the Bank of Canada and Sweden’s Riksbank have also recently suggested that their economies probably don’t need any more monetary stimulus.

The problem is that the wage increases which should go along with increasingly low unemployment are nowhere to be found. Inflation remains below central bank targets. 

In response, central banks are largely sticking to the script: The retreat in inflation is transitory, idiosyncratic even, and the slow-but-steady slog back toward the central bank's 2 percent target will probably resume.

The prevailing wisdom based on the Phillips curve is that the jobless rate is so low that wages and inflation just have to -- at some point -- really start to pick up.

So far this isn’t happening and thus as we have stated before, it may be wise to allow inflation to run above the 2% target rather than raise rates prematurely and risk undermining a still fragile global recovery.

 

Musings
 

A shorter note this week. For insights into how we are navigating this market I urge you to read our Q2 letter to our investors included below.

Nevertheless, to pick up on the themes of patience and discipline included in our letter, I wanted to briefly consider an article I read this week from Nir Kasissar in Bloomberg.

Nir reminds us that despite the reams of financial data and vast computing power to process it, investing remains a stubbornly superstitious and emotional pursuit.

As such, it should come as no surprise that the investment world has always prized “discipline” as the holy grail of personal attributes. 

As an investor, you should find a strategy and have the discipline to stick to it over the long-term. Just ask Warren Buffett or Charlie Munger.

The problem is that every style of investing -- no matter how thoughtfully constructed and ably executed -- goes through a long, agonizing period when it doesn’t work. Again just ask Warren Buffett or Charlie Munger.

Only a few years ago pundits dared to suggest that Buffett’s underperformance was evidence that perhaps he had “lost his touch”.

The longer an investing style falters, the harder it is to know whether that style is temporarily out of favor or destined for retirement. The line between discipline and foolishness becomes increasingly blurry, even to elite investors.  

Further compounding this dilemma are two issues:

1) Current markets are abnormal : Value stocks, for example, are supposed to shine during recoveries. They haven’t. Low interest rates are supposed to translate into meager returns from bonds. Sub 5% unemployment is supposed to translate into greater than 2% inflation. Again nope.

2) “Long-term” doesn’t mean the same thing anymore : In the 1960’s the average hold time for stocks was roughly six years. Today that average hold time is from six weeks to six months.

In this environment, patiently finding the line between discipline and foolishness is itself a fantastic test of discipline...



Logos LP Updates
 

June 2017 Return: -3.69%

2017 YTD (June) Return: 19.66%

Annualized Returns Since Inception March 26, 2014: 24.89%

Cumulative Return Since Inception March 26, 2014: 82.99%



Logos LP in the Media


Our Q1 2017 letter to our investors picked up by ValueWalk

Our Q2 2017 letter to our investors picked up by ValueWalk




Thought of the Week

 

"Patience is bitter, but its fruit is sweet" -Jean-Jacques Rousseau


Articles and Ideas of Interest

 

  • What history says about low volatility. For all that's being said and written about the lack of volatility in financial markets these days, you might think something unusual is going on. In fact, history suggests it's the opposite. Nice piece in Bloomberg suggesting that volatility is lower than average historical levels, but it’s at levels typical of the bottom of a quiet period between two crises. Instead of fretting about complacency, it appears that history shows us that crises occur when the VIX and realized volatility are above 20 percent, and investors typically get warned months in advance of what the headlines refer to as “shocks”...the market anticipates news events about 18 months in the future. It’s not perfect, of course, but it may be a lot better than experts and commentators. Evidence of smooth sailing over the next while?

 

  • Rising inequality may be the real risk of automation. Technological change has had more impact on earnings distribution than on demand for workers. If your main worry over automation is losing your job, history suggests you’ll probably be just fine. The bigger concern, economists David Autor and Anna Salomons reckon is how technological advances will affect earnings distribution. Interestingly, in the AI age, “being smart” will mean something completely different. HBR suggests that we will need to take our cognitive and emotional skills to a much higher level.

 

  • How to deal with North Korea? The Atlantic proposes that there are no good options. But some are better than others. For his part, Trump has tweeted that North Korea is “looking for trouble” and that he intends to “solve the problem.” For his part, Trump has also tweeted that North Korea is “looking for trouble” and that he intends to “solve the problem.” Nevertheless, the U.S. has 4 broad strategic options: 1) Prevention : crush them using a military strike 2) Turn the screws : limited targeted precision strikes and small scale attacks to debilitate 3) Decapitation : remove Kim and his inner circle and replace the leadership with a moderate regime 4) acceptance : allow nuclear ambitions and train and contain. Acceptance is how the most current crisis should and most likely will play out…

 

  • Baby boomers will live long but might not prosper. The biggest threat to the majority will be outliving their nest egg. As life expectancies continue to climb, managing longevity risk will be a key input in the portfolio management and planning for the 10,000 or so baby boomers retiring every day for the next 19 years or so. Ben Carlson suggests a few tips to stay above water. One I particularly like is try generational financial planning. Bring other trusted family members into the retirement planning process. Just don’t count on millennials buying your home. Student loans are a problem for all of us not just the young. Great piece in Businessweek suggesting that mounting student debt in the U.K., U.S. and elsewhere, might hold young people back from buying houses and saving for retirement. That would endanger economic growth and asset prices, with the effects made worse by shifting demographics. This should worry everybody.

 

  • There is a “wellness” epidemic going on. Why are so many privileged people feeling so sick? Luckily (or unluckily) there’s no shortage of cures. Wellness is a very broad idea, which is no small part of its marketing appeal. On the most basic level, it’s about making a conscious effort to attain health in both body and mind, to strive for unity and balance. This is not a new idea. But perhaps what is new is that there is something grotesque about this multi billion dollar industry’s emerging at the moment when the most basic health care is still being denied to so many in America and is at risk of being pulled away from millions more. In addition, what is perhaps most concerning about wellness’s ascendancy is that it’s happening because, in our increasingly bifurcated world, even those who do have access to pretty good (and sometimes quite excellent, if quite expensive) traditional health care are left feeling, nonetheless, incredibly unwell. Will all the high priced meditation retreats, aromatherapy, yoga, pressed juice, spiralizers and supplements really change anything? Or is history repeating itself with the resurrection of the 18th century peddler with dubious credentials, selling “snake-oil” with boisterous marketing hype often supported by pseudo-scientific evidence? Get your ashwagandha, bacopa, chaga mushrooms, colloidal silver, cordyceps mushrooms, eleuthero root, maca, selenium and zizyphus while supplies last…

 

  • Last Domino’ just fell for Canada rate hike. Canada added more than four times the number of jobs economists had expected in June, capping the best quarter since 2010 and solidifying the view the Bank of Canada will raise interest rates at its meeting next week. A series of government measures and the prospect of higher interest rates boosted listings and sparked the biggest sales decline in more than eight years last month, the Toronto Real Estate Board reported Thursday. The Toronto Real Estate Board also lowered its forecast for sales and prices. Expect prices to decline further as central banks begin to reign in easy money policies.


Our best wishes for a fulfilling week, 
 

Logos LP

Blind Spots, Power and Decision Making

Good Morning,
 

U.S. stocks steadied Friday after a three-day slide, while Treasury yields and the dollar edged lower. The week was largely dominated by crude’s tumble into bear market territory yet all three major American assets didn’t seem to care.

The S&P 500 Index finished the week virtually where it began, as rallies in health-care and tech shares offset a rout in energy producers. Small caps rallied Friday to end higher on the week.

Also of interest this week was Warren Buffet’s Berkshire Hathaway Inc., buying a 38 percent stake in Home Capital for about C$400 million ($300 million) and providing a C$2 billion credit line to backstop the Toronto-based lender.

With the deal, the billionaire investor is wading into a housing market that’s been labeled overvalued and over-leveraged, with home prices in Toronto and Vancouver soaring as household debt hits record levels.

Warren Buffett’s deal to back Home Capital Group Inc. was quickly interpreted by Toronto real estate pundits as a vote of confidence for a housing market that everyone from investors to global ratings companies say is a bubble ready to burst. Nevertheless, before getting too jubilant about Canadian real estate one should consider the terms of the deal. 

Buffett is no stranger to taking advantage of dark times to opportunistically turn need into an attractive investment (famously investing $5 billion in Goldman Sachs right after the 2008 collapse of Lehman Brothers). Securing Buffett’s participation came at a high price for the Canadian company, including giving Berkshire Hathaway a large stake at a steep discount to a recent trading average. Based on Friday’s closing price Buffett appears to have already have nearly doubled his initial $153 million investment in Home Capital’s equity, on paper...

A classic example of: “be greedy when others are fearful.”
 


Our Take

 

Weakness in energy prices were the theme of the week, yet few signs of contagion emerged leaving everything from gold to the dollar to U.S. equities to stay range bound as the traditionally slow summer season began.

As Bloomberg remarked, the bear market in crude in many ways resembles its more severe predecessors from 2014 and 2016: oil prices plummeting, non-U.S. producers floundering to keep supply at bay and concerns swirling around the impact of energy companies on high-yield bonds.

The correlation between daily swings in the S&P 500 Index and crude has been roughly zero in the past month, the lowest since January and far below the five-year highs reached in 2016 as the oil prices bottomed near $26 before staging a rebound.

Why? Perhaps the industry’s impact on the overall market is simply low. Today, energy stocks account for less than 6 percent of the S&P 500, compared with 11 percent three years ago. Or perhaps investors see little possibility of systemic risk.

One thing is evident: that falling energy prices will likely further subdue inflation.

Treasury yields have fallen from their 2017 highs recently, with the benchmark 10-year yield trading around 2.15 percent. In March, it traded around 2.6 percent. The bond market doesn't appear to see inflation coming in the near term, and so far it's been right.

The consumer price index fell 0.1 percent in May, raising questions about whether the Fed will be able to raise rates once more this year. The next rate hike isn't fully priced in until March 2018, according to the CME Group's FedWatch tool.

In addition, Amazon’s CEO Jeff Bezos may be single handedly killing inflation. As recently pointed out on CNBC, at a time when central banks are starting to prepare for an expected rise in inflation ahead, Bezos' move to acquire Whole Foods looks to be a significant counterweight.

The entire food retailing industry is an $800 billion market and it is likely that the the supermarket wars are only just beginning. Food makes up about 14.6 percent of the consumer price index, a widely used inflation index…

In addition, this move will likely put greater pressure on other chains such as Target and Wal-Mart to lower prices. Neil Irwin for the NY Times goes so far as to say that the Amazon-Walmart showdown has come to explain the modern economy as in the short term consumers will benefit from lower prices but in the long term will have worrying implications for jobs, wages and inequality.

Interestingly, few are following the Federal Reserve’s lead to raise interest rates. In fact, inflation appears to slowing worldwide and a broad measure of rich-world monetary conditions implied by Morgan Stanley, which incorporates short-term interest rates, bond yields, share prices and other variables suggests monetary policy is becoming looser, if anything…

In this environment further tightening presents asymmetric risk to the downside. Much better to let the economy run a bit hot and raise rates than exacerbate a deflationary environment...low inflation and thus low interest rates will likely remain the “only game in town”...

 

Musings
 

This week I read an interesting piece in the Atlantic which suggested that power causes brain damage. Many leaders actually lose mental capacities - most notably for reading other people - that were essential to their rise.

Is it perhaps useful to think of power as a prescription drug which comes with side effects? After 2 decades of lab research, Dacher Keltner, a psychology professor at UC Berkeley, found that subjects under the influence of power acted as if they had suffered a traumatic brain injury—becoming more impulsive, less risk-aware, and, crucially, less adept at seeing things from other people’s point of view.

Sukhvinder Obhi, a neuroscientist at McMaster University, in Ontario, recently described something similar.

When he put the heads of the powerful and the not-so-powerful under a transcranial-magnetic-stimulation machine, he found that power, in fact, impairs a specific neural process, “mirroring,” that may be a cornerstone of empathy.

Which gives a neurological basis to what Keltner has termed the “power paradox”: Once we have power, we lose some of the capacities we needed to gain it in the first place.

These findings are concerning as we look to those in our societies who have power including perhaps ourselves.

What blind spots has our power generated in ourselves and our leaders? Do these findings help to explain current political events and leadership styles? How much do they contribute to trends in income distribution, social stratification and investment returns?

What I found most interesting and perhaps most alarming about these findings is to set them in the context of another ill which society is currently suffering from: an inability to acknowledge error.

In a wonderful piece in The Economist a few weeks ago it was posited that humanity is getting worse at owning up to its gaffes.

Few enjoy the feeling of being outed for an error but real damage can be caused when the desire to avoid reckoning leads to a refusal to grapple with contrary evidence.

People often disregard information that conflicts with their view of the world. Why? Roland Bénabou, of Princeton, and Jean Tirole, of the Toulouse School of Economics posit that: “In many ways, beliefs are like other economic goods. People spend time and resources building them, and derive value from them. Some beliefs are like consumption goods: a passion for conservation can make its owner feel good, and is a public part of his identity, like fashion. Other beliefs provide value by shaping behaviour.

Because beliefs, however, are not simply tools for making good decisions, but are treasured in their own right, new information that challenges them is unwelcome. People often engage in “motivated reasoning” to manage such challenges. Mr Bénabou classifies this into three categories. “Strategic ignorance” is when a believer avoids information offering conflicting evidence. In “reality denial” troubling evidence is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news. And lastly, in “self-signalling”, the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.”

These tendencies/biases linked to the desire to avoid acknowledging error are relatively harmless on a small scale but can cause major damage when they are widely shared or exhibited by those in power.

It is no wonder that motivated reasoning is a cognitive bias which better-educated people are especially prone. This takes us back to the research on how power can cause the brain to become more impulsive, less risk-aware, and, crucially, less adept at seeing things from other people’s point of views.

As investors, but more broadly as humans we would do well to recognize how these tendencies cross-pollinate and threaten to wreak havoc on our decision making and its outcomes.

Particularly as we accumulate success and thus power we become more vulnerable. Blinded by our own righteousness, increasingly unable to consider differing narratives, facts, perspectives, ideas and at times even reality.

What can be done to avoid these blind spots? Research finds that humility can go a long way to counter such tendencies. Yet to build humility, experiences of powerlessness may be key.

By experiencing or at minimum recounting moments of powerlessness, you maintain a connection or “groundedness” in reality.

When was the last time you felt powerless? The last time you made an error? Hold onto those moments. They may more important than you think.



Ideas from Logos LP

Huntington Ingalls Industries (NYSE: HII) 

 

Logos LP in the Media

Our 2016 Annual Letter to Shareholders Published by ValueWalk
 


Thought of the Week 

 

"It is impossible for a man to learn what he thinks he already knows." -Epictetus
 


Articles and Ideas of Interest
 

  • My algorithm is better than yours.  Just 10% of trading is regular stock picking estimates JPMorgan. The majority of equity investors today don't buy or sell stocks based on stock specific fundamentals. No wonder the world’s fastest growing hedge funds are quant funds and robots are eating money managers lunches.

 

  • Finland tests a new form of welfare. An experiment on the effect of offering the unemployed an unconditional income. Interesting piece in The Economist chronicling Mr Jarvinen who was picked at random from Finland’s unemployed (10% of the workforce) to take part in a two-year pilot study to see how getting a basic income, rather than jobless benefits, might affect incentives in the labour market. He gets €560 ($624) a month unconditionally, so he can add to his earnings without losing any of it. Finland’s national welfare body will not contact him directly before 2019 to record results. I see this happening more often in the developed world. Something to keep an eye on.

 

  • Stop fooling yourself about 8% returns. Nice piece in Gadfly suggesting that There's an amazing amount of denial going on right now. Investors are simply ignoring current market dynamics and are still expecting average annual returns of 8.6 percent, according to a Legg Mason Inc. survey of income investors released this week. Those who were employed expected more than 9 percent gains, with retirees expecting less. Actual returns have come in markedly lower of late, but hopes remain high. It is important that investors become realistic. If they're not, fund managers will try to serve their hopes and dreams, making the financial system all the more fragile for it.

 

  • The web makes it harder to read market sentiment. The internet swept away the old-school financial pundits, turning the public forum into the Wild West. Inflammatory click bait filled with extreme opinions has found its way into ordinary discourse. Not too long ago, anyone who held radical opinions about markets, individual stocks (or even politics) could freely opine about them, just as today. But it was local and contained; those with idiosyncratic opinions could only scare their friends and neighbors, one at a time, at backyard BBQs and school plays. That is no longer the case as “crash”, “hyperinflation”, “monetary debasement” are becoming more common than “value investing”, “long-term” and “prudence” ;).

 

  • The cheapest generation. Why millennials aren’t buying cars or houses and what that means for the economy. Younger generations simply haven’t started spending yet….But what if this assumption is simply wrong? What if Millennials’ aversion to car-buying isn’t a temporary side effect of the recession, but part of a permanent generational shift in tastes and spending habits? It’s a question that applies not only to cars, but to several other traditional categories of big spending—most notably, housing. And its answer has large implications for the future shape of the economy—and for the speed of recovery. After all the old are eating the young. Around the world, a generational divide is worsening.

 

  • The older we get, the person we spend the most time with is the one we see in the mirror. QZ reports that time with friends, colleagues, siblings, and children diminishes over the course of a lifetime. One doesn’t have to be alone to be lonely. More than half of the lonely respondents in the UCSF study lived with a partner. To feel connected to others, it seems, the number of hours spent on relationships is less important than the quality of the relationship itself.

 

Our best wishes for a fulfilling week,  

Logos LP

(NYSE: HII): Defense Contractor With Significant Upside

Huntington Ingalls Industries (NYSE: HII) is a defense contractor for the U.S. Navy, and spun-off from Northrop Grumman in 2011. The company is the largest military shipbuilder in the U.S., with over 70% market share in the construction, repair and maintenance of nuclear-powered ships, amphibious assault ships, ballistic missile submarines and other high-grade ships built at the Newport News and Ingalls port, the largest shipbuilding ports in the U.S. It also provides ancillary products and services to the U.S. Navy, including information technology solutions, professional services and business support services for U.S. Navy missions. The U.S. government makes up roughly make roughly 97% of the company’s revenues while 3% is focused on commercial clients in the oil & gas and nuclear markets. 

HII has seen moderate sales growth since being public but has a strong operating profile over the past 7 years: gross margins have grown roughly 53%, free cash flow has nearly quadrupled, book value per share has grown over 50%, and return on invested capital has grown from 8.30% in 2012 to 21.35% in 2017, with the last 4 year average being in the mid-to-high double digits. The company also has tailwinds that we believe are quite significant going into 2030: HII has a backlog of over $20 billion (and growing – they recently won another $3 billion contract from the Navy) of which 50% has already been committed. The Navy is in desperate need of an overhaul, with new ships and vessels required sooner rather than later and government budgets dedicated to fulfill their cause. Moreover, given this pent up demand, a number of legacy ships are under a replacement cycle and current competitors Lockheed Martin and General Dynamics (who they have a partnership with HII for specific services) have cost the U.S. Navy far too much under the troubled Littoral Combat Ship program, creating new shipbuilding demand for HII. Further, with President Trump’s renewed focus and vow to build 350 ships for the U.S. Navy in addition to the Navy’s request for 12 new vessels in fiscal 2018 and depot maintenance funds beyond that, there is little doubt that HII will be the sole beneficiary presenting the company with very predictable revenue streams. 

Without question HII has proven that it can be a successful operator under the right conditions and upper management is very homegrown (their new strategic sourcing VP spent years building ships for the company). Further, there has been considerable insider buying over the most recent quarter, with a senior VP purchasing over 4100 shares in the company in May. The company has a payout ratio of 19% (considerable room to increase dividends) and has a stated policy to return a substantial amount of cash to shareholders by 2020 via buybacks and dividends from the significant free cash flow it generates. Despite creating a perfect storm for shareholders, HII faces considerable risks and volatility being tied to U.S. government budgets. A gridlocked Congress (likely under the Trump administration), reduction in committed vessels, waning demand from the U.S. Navy, reduction in maintenance funds, and an overall reduction in government spending will all create a significant reduction in the short-term price of the stock (which has already happened). However, we believe that the short-term risks do not outweigh these important tailwinds. The company is always on the lookout for strategic acquisitions to bolster their add-on services (their recent acquisition of Camber Corporation allows HII to enter into mission based software, systems engineering, data analytics and simulations for the Navy and other federal government agencies) which will support strategic growth initiatives and free-cash flow goals for shareholders.

HII has remarkable free-cash flow generating capabilities, which is due to the company’s superior economic and pricing power that it faces as a market leader. As new ships get built and maintained, the company will realize significant depreciation in the early years (before the ships are delivered), with depreciation coming down in future years despite growth in revenue due to maintenance and add-ons. This means that the company has very sticky (and growing revenue) on fleets that are worth less tomorrow than they are today, increasing the rate of change of free cash flow every year. In 2012, the company faced a depreciation expense of $206 million with net income at $261 million. As of last year, depreciation was $163 million with net income at $573 million. Free cash flow grew from $168 million in 2010 to $560 million in 2017, while free cash flow per share grew from $0.98/share in 2011 to $13.29/share as of 2016. Not only does this reflect a favorable economic environment for the company, but in comparison to its peers, it is a better operator of capital with a much cheaper valuation. The company has a free cash flow yield that is 40% greater than General Dynamics, while the company’s price to sales ratio is 1.2x, which is on the low-end of defense contractors: General Dynamics, Lockheed Martin and Northrop Grumman have price to sales ratios of 1.7x, 1.8x and 2.0x, respectively. HII is significantly smaller than the other defense contractors (GD = ~$51bn market cap; LMT = ~$81bn market cap; NOC = ~$44bn market cap) and if it were to reach a similar valuation to its peers (i.e. 1.8x sales, which we deem fair value) this would value the company at $12.652bn in market cap, giving the company 47% upside. We believe that, despite the volatile nature of defense stocks, this company should be worth at least 1x its backlog in the next 10 years, giving us a roughly $20 billion valuation and a price target of $434.70/share.

LOGOS LP is LONG: HII

Political Risk and "Expert" Bearishness

Good Morning,
 

Significant movement for U.S. stocks last Friday closing mixed due to pressure from this year's best-performing sector: technology.

                               

The Nasdaq composite hit a record high at the open before closing 1.8 percent lower. Shares of Apple, Facebook, Amazon, Netflix and Google-parent Alphabet all fell more than 3 percent.


The tech-heavy index also posted its worst weekly performance of the year. The S&P 500 closed 0.1 percent lower, erasing earlier gains, with information technology dropping more than 2.5 percent. Big tech was slammed as investors took profits from the group, which some fear has become a massive market bubble.

 

These concerns were bolstered by a report released by Goldman Sachs on the top five outperforming mega-cap names in tech with some warnings on valuations and concerns that their volatility has become extraordinarily low. In fact, the stocks had become closely correlated to safe haven plays, like bonds and utilities.

 

Meanwhile, the Dow Jones industrial average rose about 90 points, notching a record close as out of favor financials and industrials led.

 

Also this week we saw another unfortunate chapter of Donald Trump’s Presidency unfold. Hiding in plain sight in former FBI Director James Comey’s testimony Thursday before the Senate Intelligence Committee was a potentially major new avenue for special counsel Robert Mueller’s investigation of Russia-related crimes: the possibility that President Donald Trump committed a federal crime by lying to Comey about his connections to Russia and activities on his 2013 visit there.



Our Take
 

“Big tech” could be vulnerable in the near term as investors rotate into other groups that have lagged such as financials and energy yet the long-term earnings growth story remains intact. If anything this rotation is evidence of a healthy market alive to the issue of valuations supported by sound fundamentals (almost 40 percent of fund managers think that global equity markets are overvalued, the highest level since January of 2000. And 80 percent see U.S. markets as the most overvalued in the world).

Interestingly, looking back at the year 2000, all five companies have eight times more cash than the big tech stocks had in the bubble.

 

As for the Trump show, this week what became more clear is that the self-inflicted wounds of what appears to be an undisciplined presidency are increasingly likely to blow its chances of passing any of the anticipated economic stimulus measures. The trifecta of tax reform, repatriation and infrastructure investment could put the U.S. on very strong footing for the next several decades but this opportunity seems to be slipping away.

 

Barry Ritholtz in an interesting piece for Bloomberg, suggests that the president is becoming radioactive. He is having problems hiring outside counsel: four top law firms have reportedly turned him down. Resignations are mounting. Diplomats are revolting. Hundreds of key positions have gone unfilled as people increasingly perceive working for Trump as a career killer.

 

What now appears increasingly likely is not a dismantling of the Trump administration from the outside. But an implosion from within. Furthermore, although there may be no serious collusion with the Russians, there is now certain to be a wide-ranging independent investigation into all things Trump. This investigation will likely make governing even more difficult than it already is...

 

But, some may say, stocks are up, so how bad can it be? It’s true that while Wall Street has lost some of its initial excitement about Trumponomics the market is still sitting close to all time record highs as investors and businesses don’t seem to be pricing in the risk of disastrous policy.

 

Or aren’t they? Interestingly, in a recent research note put out by FactSet the initial excitement does not appear to be translating into stronger performance for most measures of the real economy so far in the first half of 2017. Even the initial surveys suggesting optimism have retreated somewhat as the equity markets have flattened out as progress on reforms has stalled in Washington D.C.

 

Business and consumer surveys initially reflected optimism, but we have seen small retreats in sentiment measures for both in the second quarter. *Note that the sentiment indicators may have pulled back recently, but they still remain elevated and near longer-term highs.

 

Perhaps the big money, which classically tends to equate wealth with virtue, is beginning to consider (even Ray Dalio is starting to break a sweat as Trump consistently chooses conflict over cooperation) the potential risks posed by this increasingly self-destructive Presidency….

 

Musings
 

On a not so unrelated topic, I came across two notable bearish "expert" perspectives on the American economy this week. Good old gurus Bill Gross, manager of the Janus Henderson Global Unconstrained Bond Fund, and Paul Singer, founder of hedge fund Elliott Management Corp. Speaking last week at the Bloomberg Invest New York summit on Wednesday.

 

They’re message: a crash is coming. Their argument: The Federal Reserve flooded the U.S. economy with cheap money after the 2008 financial crisis by holding interest rates near zero and beefing up its balance sheet. Corporations and individuals responded by bingeing on debt and risk assets -- as the Fed encouraged them to do so.

 

Now we’ve heard this argument many times before. In fact we’ve basically heard it every year since 2013. Should we be worried as these two investors are considered by many to be two of the greats having both superbly navigated the 2008 financial crisis?

 

There is no doubt that debt levels should be watched closely yet what is the data telling us?

As shown in the chart above, after over eight years, the nominal outstanding amount of U.S. consumer debt which includes mortgages eclipsed its $12.6 trillion peak from Q4 2008. While the $12.7 trillion current outstanding amount of consumer debt has made a new high, consumer debt has seen zero growth in the last nine years compared to a near doubling of debt in the five or so years that preceded the prior peak.

 

The consumer loan delinquency rate is at a 30 year low.

And this chart paints a positive picture of where the consumer stands regarding paying off their loans:

Nir Kaissar for Bloomberg reminds us that Gross's and Singer’s investment realms -- high-grade bonds and multistrategy hedge funds, respectively -- have been two the biggest laggards since the financial crisis. The S&P 500 has returned 18 percent annually from March 2009 through May, including dividends. By contrast, the HFRI Fund Weighted Composite Index -- a collection of various hedge fund strategies -- has returned 6.2 percent annually, and the Bloomberg Barclays U.S. Aggregate Bond Index has returned 4.2 percent annually.

 

Thus, a market meltdown would perhaps be the best thing that could happen to Gross and Singer. Should we therefore brush off such warnings?  

 

The answer is no. Although the consumer’s balance sheet appears to be healthy, vigilance is necessary as signs are now emerging in the credit markets that leverage is on the rise with a surge in corporate debt issuance that has steadily pushed investment-grade corporate leverage to a new peak for this cycle, as measured by debt-to-equity ratios. The ratio for companies in investment-grade indexes is around 2.8 times and 4.2 times for those on high-yield indexes.


Even though the ratios are near historic highs, market volatility as measured by the VIX is near a record low. Yes, the VIX is often criticized as a good measure of stock market volatility, but the divergence between leverage and VIX isn’t sustainable. We may be looking at a reversion to the mean as volatility is bound to pick up as investors and markets come to realize that low volatility and rising leverage may no longer be a suitable marriage.

 

Nevertheless, none of this suggests a 2008 style meltdown. What is likely is simply for the market to hang around its current level for years, waiting for earnings to catch up with stock prices as there are compelling reasons that companies will remain incredibly profitable for the foreseeable future. Thus, what vigilance in the face of such warnings should mean is what it has always meant to the prudent long term investor: buy right and hold on. You’re never going to get a perfect all-clear or get-out-now signal from the markets and this time is no different.



Logos LP Updates


May 2017 Return: 3.68%

2017 YTD (May) Return: 23.36%

Trailing Twelve Month Return: 31.01%

Annualized Returns Since Inception March 26, 2014: 28.471%

Cumulative Return Since Inception March 26, 2014: 92.53%


*All returns are reported unlevered


Thought of the Week

 

"Simplicity is not the goal. It is the by-product of a good idea and modest expectations.” -Paul Rand
 


Articles and Ideas of Interest
 

  • 6 Long-Term Economic and Investment Themes. Good list from Gary Shilling. 1) Huge fiscal stimulus, primarily infrastructure and military related 2) Globalization that shifted manufacturing from West to Asia is largely completed 3) Worldwide aging of populations 4) The long-promised Asian Century of global leadership is unlikely to come to pass due to the completion of globalization, the slow shift from export led domestic spending driven economies, government and cultural restraints, aging and falling populations 5) Disinflation with chronic deflation likely, especially as services follow goods in price retreats 6) The bond rally of a lifetime continues

 

  • Stop being positive and just cultivate neutrality for existential cool. Do we believe in the superiority of optimism? Culturally, we’re obsessed with positivity—our corporations measure worker glee, nations create happiness indices, and the media daily touts the health and social benefits of optimism. Thus, the good answer is to see the glass half full. Otherwise, you risk revealing a bad attitude. But are things so mutually exclusive? Is the glass not in a state of perpetual change? Can neutrality set us free? Can it help us see something more like the truth, what’s happening, instead of experiencing circumstances in relation to expectations and desires? The pressure to succeed—or to define success conventionally—can be subverted with neutrality. Things can go just so or totally awry once you understand that all things are fine, their upsides and downsides to be determined.

 

  • Mary Meeker’s 2017 internet trends report. In the most anticipated slide deck of the year Kleiner Perkins Caufield & Byers partner Mary Meeker looks at trends in digital and beyond. Of great interest is her coverage of interactive games as the motherlode of tech product innovation + modern learning (slides 113-150). Interesting concepts as we debate whether machines will replace most roles performed by humans. Such research supports that rising engagement in digital games is preparing us for the merger of man with machine.

 

  • Leverage: Gaining disproportionate strength. Wonderful explanation of the concept of leverage. Anyone who has ever haggled at a market or with a salesperson will understand the principle of using leverage in a negotiation. The trick is to declare their product or service to be so flawed and worthless that you are doing them a favor by buying it. Subsequently, the next step is usually to offer a low price which they counter with a slightly higher one that is still much lower than the asking price.

 

  • Passive investing is worse than...the misuse of antibiotics. The FT argues that the passive investment industry has become an oligopoly, with three large managers “drawing on seemingly limitless economies of scale” and amassing assets “simply by slashing costs” — both things, surely, that a blue-blooded capitalist would think is a sign of progress. Passive investing erodes competitive forces, because companies in the same sector end up with the same investor base and thus could pricing mechanisms break down?

 

  • Is the Canadian economy finally smooth sailing? Canada’s labor market continued surprising in May, with a greater-than-expected 54,500 jobs gain that also finally came with signs of a pick-up in wages. The employment gain -- the third biggest one-month increase in the past five years -- was driven by the addition of 77,000 new full-time jobs, which offset falling part-time employment. Economists had forecast a 15,000 increase in employment. The employment gains bode well for the continuation of the country’s expansion, which is the fastest among the Group of Seven, as Canada emerges from the oil price collapse and benefits from a soaring real estate market. It also could raise pressure on the Bank of Canada, which has been citing worries about slack in the economy for being cautious, to increase rates sooner. Certain funds are even becoming bullish on Canadian stocks seeing oil prices recovering. Nevertheless, it is doubtful that the bank of Canada will raise interest rates any time soon. Vulnerabilities remain. What should be watched closely is the impressive growth of Home Equity Lines Of Credit (HELOCs). A recent report from the Financial Consumer Agency of Canada explored this growth and found that “HELOCs offer relatively low interest rates and convenient access to large amounts of revolving credit, which may encourage some consumers to use their home equity to fund a lifestyle they cannot afford.” Keep an eye on the temperature of the market...

 

Our best wishes for a fulfilling week, 
 

Logos LP

How To Make Better Decisions

Good Morning,
 

U.S. stocks limped into the weekend on a sluggish final day of trading, while the dollar fluctuated with oil as investors assessed data showing the U.S. economy on solid footing.

 

The S&P 500 Index moved between gains and losses before closing higher by less than a point -- good enough for a seventh straight gain and fresh record in trading 25 percent below the 30-day average.

 

The U.S. economy’s first quarter GDP came in this Friday and it wasn’t so miserable after all, as consumption contributed more to growth and business investment was even stronger than thought.



Our Take
 

The S&P 500 and Nasdaq indexes both hit record highs this week, and the Dow flirted with its own all-time high. Investors seem to be signalling that everything is honky-dory even as the political headlines remain concerning. Tax and healthcare reform appear to be even further out of reach as the investigations into the Trump administration (now Jared Kushner under scrutiny) deepen.

 

But are these headlines so concerning? In the short-term political events can trigger short term buying opportunities but research has shown that political crises rarely have a lasting impact on markets. There is an abundance of liquidity in this market with a lot of cheap money chasing a returns. This is no doubt one factor contributing to the rally, but more importantly investors are focusing on the strengthening economy, signs from the central bank that interest rates will continue to rise, and the best quarter of corporate-earnings growth in five years.

 

Furthermore, there still exists a record amount of bearishness. The S&P 500 Index has climbed 7.9 percent since January, including its biggest gain since April in the just-completed week. At the same time, short interest as a proportion of total shares outstanding has also expanded, rising by 0.3 percentage point to 3.9 percent. Never before has an equity advance as big as this year’s occurred simultaneously with more short sales, according to exchange data compiled by Bloomberg that goes back to 2008.


There is no euphoria!

 

Bloomberg this week reported that investors are pulling money out of stocks after the initial rush to buy faded along with the optimism over Trump’s pro-growth policy. They have withdrawn $20 billion from exchange-traded funds and mutual funds this quarter, reversing about one third of the inflows seen between November and March, according to data compiled by Bloomberg and Investment Company Institute.  

 

Bullish bets are also shrinking in the futures market. Net long positions in S&P 500 contracts held by large speculators fell in seven of the last eight weeks and were closer to turning net short than any time since December, data compiled by Commodity Futures Trading Commission show.

 

The challenge for short sellers is how long they can stay solvent before being forced to buy back the shares that they have borrowed and sold. And the pressure to cover is building. The potential for a swift melt up is increasing…..


 

Musings
 

Last weekend I was on vacation and had the opportunity to read a wonderful book “Charlie Munger: The Complete Investor” by Tren Griffin. Munger is one of the world’s most successful investors better known as Warren Buffett’s partner at Berkshire Hathaway.

 

What is most interesting about Munger is not his success as an investor but the way he thinks and keeps his emotions under control.

 

The book offers a great overview of Munger’s ideas and methods which can help us make better decisions, be happier and live a more fulfilling life. Why? Because investing, like life is about decision making. Everyday we are faced with a spectrum of possible decisions which will set us along one path or another.

 

As such, misjudgement can wreak havoc upon the outcomes of our lives.

 

What is the psychology of human misjudgement?

 

Humans have developed simple rules of thumb called heuristics, which enable them to efficiently make decisions. Heuristics are essential as without them humans would be unable to process the vast amount of information they face on a daily basis.

 

The problem is that these shortcuts can sometimes result in tendencies to do certain things that are dysfunctional.

 

The upside is that we can learn to identify these dysfunctional tendencies and overcome them. This is the key to better decision making. What are some of the most common of these tendencies? There are over 20 explained in the book but these are those that stood out most:

 

  1. Liking/Loving Tendency

    1. People tend to ignore or deny the faults of people they love and also tend to distort the facts to facilitate love.

  2. Inconsistency-Avoidance Tendency

    1. People are reluctant to change even when they have been given new information that conflicts with what they already believe. The desire to resist any change in a given conclusion or belief is particularly strong if a person has invested a lot of effort in reaching that conclusion or belief.

  3. Kantian Fairness Tendency

    1. Humans will often act irrationally to punish people who are not fair. In other words they may act irrationally when presented with a situation that they feel is unfair. Some would rather lose money in an investment than see another person benefit from “perceived” unfairness.

  4. Envy/Jealousy Tendency

    1. Very primal emotions are triggered when humans see someone with something they don’t have often causing dysfunctional thoughts and actions. In this world of abundance there is nothing but unhappiness to be gained from envy.

  5. Reciprocation Tendency

    1. The urge to reciprocate favors and disfavors is so strong that people will feel uncomfortable until they can extinguish the debt.

  6. Simple, Pain-Avoiding Denial

    1. People hate to hear bad news or anything inconsistent with their existing opinions and conclusions. If something is painful people will work to even deny the reality.

  7. Excessive Self-Regard Tendency

    1. People tend to vastly overestimate their own capabilities. The most effective way to reduce risk in any situation is to genuinely know what you are doing.

  8. Deprival Super-Reaction Tendency

    1. Loss aversion- we irrationally avoid risk when we face the potential for gain, but irrationally seek risk when there is a potential for loss.

  9. Social Proof Tendency

    1. Humans have a natural tendency to follow a herd of other humans. We view a behaviour as more correct to the degree we see others performing it. This is how bubbles form. The herd is rarely correct.

  10. Authority-Misinfluence Tendency

    1. People tend to follow people who they believe are authorities or have the right credentials. Especially when they face risk, uncertainty or ignorance.

 

Think independently!



Thought of the Week
 

"The best thing a human being can do is help another human being know more.” - Charlie Munger


Articles and Ideas of Interest

 

  • The meaning of life in a world without work. As technology renders jobs obsolete, what will keep us busy? Sapiens author Yuval Noah Harari examines ‘the useless class’ and a new quest for purpose. Could playing virtual reality games be the answer? But what about truth? What about reality? Do we really want to live in a world in which billions of people are immersed in fantasies, pursuing make-believe goals and obeying imaginary laws? Well, like it or not, Harari suggests that may be the world we have been living in for thousands of years already...

 

  • Why you should learn to say no more often. The NYT suggests that humans are social animals who thrive on reciprocity. It’s in our nature to be socially obliging, and the word no feels like a confrontation that threatens a potential bond. But when we dole out an easy yes instead of a difficult no we tend to overcommit our time, energy and finances. Do you have the ability to communicate ‘no’ and reflect that you are actually in the driver’s seat of your own life?

 

  • The cryptocurrency mania may just be starting. Practically this entire week on CNBC the top 5 most popular articles were bitcoin related with bitcoin more than doubling in price this year alone and its closest rival Ether up over 2,300 percent! Yes 2,300 percent. There are a few theories for why the currencies have been rallying so much the most convincing being that bitcoin has been getting support from certain governments and investors and that the ethereum blockchain has been getting serious backing by major corporations wishing to use the technology for smart contract applications. I have no interest in trading currency or speculating on its price action but what worries me about products like Ether is that they can be cloned. The people buying Ether are buying a specific blockchain while the technology underlying it is what is most valuable. Cryptocurrencies are proliferating with new currencies being launched at record speeds. Canada-based Kik's cryptocurrency, Kin just launched this week which is also based on the ethereum blockchain. If I were to invest in a crypto currency I would look at bitcoin and take 1% or less of what I own, buy bitcoin with it, and then forget about it for at least the next five years; ideally the next decade. The way I see it you will either lose 1% of your net worth or make incredibly large sums. You can find the ways to buy it here.

 

  • Toronto homeowners are suddenly in a rush to sell. Toronto’s hot housing market has entered a new phase: jittery. After a double whammy of government intervention and the near-collapse of Home Capital Group Inc., sellers are rushing to list their homes to avoid missing out on the recent price gains. The new dynamic has buyers rethinking purchases and sellers asking why they aren’t attracting the bidding wars their neighbors saw just a few weeks ago in Canada’s largest city. Interestingly, a Canadian regulator this week said it disciplined two mortgage brokers who funneled business to Home Capital Group Inc., marking the first disclosure of action taken against dealers who submitted fraudulent loan applications to the embattled mortgage lender. The Financial Services Commission of Ontario conducted its own review into Home Capital in relation to the company severing ties in 2015 with 45 brokers who used falsified client income on applications. This is a big deal….this means that many Canadians may be delinquent or be under real stress in affording their home since who knows what they put down as income. According to Equifax, mortgage fraud jumped 52 percent last year from 2011, showing the issue may only be growing. House of cards? No wonder a recent Manulife study indicated that a mere 10% hike to mortgage payments would sink almost ¾ of Canadian homeowners. Robert Shiller for the NYT reminds us how tales of “flippers” led to the last housing bubble.

 

  • The phrase “late capitalism” is suddenly everywhere. The Atlantic suggests that “Late capitalism,” in its current usage, is a catchall phrase for the indignities and absurdities of our contemporary economy, with its yawning inequality (new research suggests that your financial fate is sealed by the time you turn 25) and super-powered corporations (new research also suggests that employers often implicitly, and sometimes explicitly, act to prevent the forces of competition from enabling workers to earn what a competitive market would dictate, and from working where they would prefer to work) and shrinking middle class. Interesting read chronicling the perverse ways our “developed” economy is progressing. What do growth and productivity even mean in an economy that has moved from manufacturing (whose products can be counted) to services (which can't be)? Do economies driven by information and software need new metrics for progress? And what, if anything, can an economy at the technological frontier do to make living standards rise faster?

 

Our best wishes for a fulfilling week, 
 

Logos LP