How Ignoring Variation Can Lead To Terrible Investment Decisions

"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent." -Charlie Munger

On a recent trip abroad I took some time to think about the decision of 51.9% of UK voters to leave the European Union. As I sifted through the commentary regarding the historic vote, what struck me was how wrong the "experts" got it. The consensus of public opinion experts - at least if one uses prediction markets as a proxy - was that voters would in the end decide to stay in the EU. At certain points on Thursday before the results of the vote were released, the probability of a "remain" vote implied by betting odds stood at 90 percent. Furthermore, the majority of hedge fund managers worldwide looked at the stats and also concluded that the law of averages supported their decision to position for a "remain" vote to pass. Even the billionaire hedge fund manager Leon Cooperman told an audience of Wall Street insiders on Wednesday that there was a 70 percent probability that Britain would stay inside the European Union. "I don't worry about Brexit," he added. I myself as Head of Strategy at my investment firm Logos LP also made this mistake.

How could we all have been wrong? How could we "experts" have been caught flat footed in the face of an outcome the statistical averages so clearly suggested? The chapter on mathematics from one of my favorite books on investing by Robert Hagstrom suggests an answer: the concept of variances. Most people look at averages as basic reality, giving little consideration to the possible variances. Most of us have a tendency to see the world along the bell shape curve with two equal sides, where mean, median and mode are all the same value. The reality is that things are not so neat. Things do not always fit in a symmetrical distribution and instead skew asymmetrically to one side or another. What causes a distribution to skew to left or right is variation. As variation on one side or the other side of the median increases, the sides of the bell curve are stretched either right or left.

What does this mean in the context of Brexit? Without diving too deeply into the specific reasons 51.9% of UK voters choose to leave, many voters demonstrated high variance. Research has shown that in our "modern" digital age people make up their minds too late. According to a recent report by the market research firm Opinium, 20 percent to 30 percent of voters make a final decision within a week of casting their ballots, half of them on the day of the vote. This suggests that although a majority of UK voters polled to stay within the UK many politicians and experts ignored or simply downplayed the widespread attitude of disillusionment and misunderstanding amongst the electorate. This high variance pulled the curve to form a right skew.

In a right skewed distribution, the measures of central tendency do not coincide; the median lies to the right of the mode and the mean lies to the right of the median. If the experts had been more attuned to the concept of variance they would have been able to think deeply about the characteristics of those voters who populated the right skew of the distribution. Those individual voters who were so disillusioned with the status quo (remain in the EU) that they were unable to make up their minds until the last minute. Perhaps this knowledge would have changed their predictions.

Either way the above explanation leads me to believe that our culture favors a powerful bias to neglect or ignore variation. As the result of the Brexit vote demonstrates, focusing exclusively on measures of a central tendency can lead us to make significant mistakes.

Is there a lesson for investors? The answer is yes. As suggested by Hagstrom, perhaps the most important lesson for the prudent long-term investor is to grasp the differences between the trend of the system and the trends in the system.

There is an important distinction to be made between the average return of the stock market and the performance variation of individual stocks. To illustrate the significance of this lesson one has only to consider periods in which the S&P 500 (NYSEARCA:SPY) has been stuck in a sideways pattern. Consider the following charts:

The above chart shows the S&P 500 from 1995 to present. Albeit a recent breakout which began July 1, 2016, note that from roughly December 5, 2014 the S&P 500 has gone sideways. Consider the following chart which provides a more recent snapshot:

For the vast majority of an investor's lifetime he or she will be exposed to either bull or bear markets which either go up or down. Yet at present, the investor appears to face a sideways market in which the major indexes remain range bound without a significant and sustained move higher or lower. Should investors thus conclude that stocks are a poor long-term investment?

Can history offer any insights? Consider one of the most pronounced sideways markets in history which occurred between 1975 and 1982. On October 1, 1975, the Dow Jones Industrial Average (NYSEARCA:DIA) stood at 784. Roughly 7 years later, on August 6, 1982, the Dow closed at the exact same 784. Fast forward to the present and with the market currently appearing to be stuck in a similar holding pattern, many forecasters and "experts" are concerned. They fear that in light of corporate earnings declines, weak global growth, unprecedented global monetary policy and investor complacency p/e multiples will fall leading to at worst a major correction or at best a prolonged period of low returns i.e. a sideways market.

It is no wonder that investor bearishness is at a record high. Based on research conducted by Bank of America investors ended June with the highest cash allocation on record at 5.7% on average and the lowest equity allocations in 4 years. Moreover, it looks as if investors are capitulating into bonds with an annualized year-to-date return from global government bonds at 25% in 2016, the highest return in 30 years. These three bearish indicators combined with the fact that inflows into precious metal funds hit a record during the first week of July, all point to the fact that investors are very bearish on global equities. Furthermore, Bank of America, Merrill Lynch's Bull & Bear Indicator, fell to an "extreme bear" reading of 1.6 on June 28. Is the "herd" right about the system? Should investors stay away from stocks?

In Hagstrom's book he points out that during the sideways market explained above which lasted from 1975 through 1982 Warren Buffett and Billy Ruane were both able to generate impressive returns. During this period in which the DOW gained exactly 0 percent, Buffett was able to generate a cumulative return of 676 percent and Ruane was able to generate 415 percent…

It would appear that the herd might be correct in their read about the trend of the system but dead wrong about the trends within the system. Diving deeper, Hagstrom found that over the 8-year period, only 3 percent of the 500 largest stocks on the market at that time went up in price by at least 100 percent in any one year. Yet over rolling 3 year periods, 18.6 percent of the stocks, on average, doubled. That equals 93 out of 500. But when the holding period was extended to 5 years, an average of 38 percent of the stocks went up 100 percent or more; that's 190 out of 500.

What a mistake it would have been to focus on the market average and avoid stocks altogether during this period. To have done so was to ignore the variation within the market and thus to miss out on the myriad of opportunities to generate excess returns by investing in high quality businesses.

Whether using averages to forecast the probable result of votes such as Brexit or perhaps the US presidential election or the future returns of the stock market we would do well to pay attention to the role variance plays as we distinguish between the trend of the system and the trends in the system. We may find that there is much more at stake than simply our ability to generate excess returns over the long term…

For original article published on SeekingAlpha click here. 

Cal-Maine Foods: A Tale of Two Egg Shells?

Cal-Maine Foods (NASDAQ: CALM) is the largest shell egg producer in the United States and has been a short-sellers dream lately: the stock is down nearly 26% over the past year and short interest is at an all-time high. The catalyst for this decline, in a nutshell, is the expected price decline of eggs going into late 2016 as egg prices peaked earlier in the year due to the Avian flu creating a supply shortage. The market is expecting LOSSES due these price declines, as CALM is at the mercy of a fairly volatile commodity. Is this the beginning of the end for CALM, or is this an excellent opportunity for buyers? We believe it is the latter.

It is no secret that the egg market is an extremely cyclical business and is heavily tied to the forces of supply and demand, which are outside the control of any one producer. Although this would certainly hit CALM in the short-term, the company has had a history of creating value over very long periods of time despite volatility. History provides good insight into CALM’s operations: According to the company the: “demand trend related to the popular diets faded dramatically and (egg) prices fell” in late 2004, dropping the stock nearly 25% in 6 months. However, if one were to have bought CALM stock during this time and held until today, that particular investor would have made a return of over 520% (nearly 4x in less than 12 years) excluding the dividend (which currently yields over 6% per year). This is not to say that egg prices may not be perpetually depressed over the coming months or that CALM could be in for very long periods of egg deflation, but historically speaking, and this was recently seen with the price of oil, the harder a particular commodity falls, the more vicious it will rise especially if that commodity has favorable economic tail winds like the consumption of eggs.

Despite these macroeconomic variables, CALM is a solid operator of capital and has a history of creating value: the company has very little debt (has more cash than LTD) while providing investors with an ROE north of 28%. Operating margins are at a healthy 14% and the company has a FCF/Sales of over 15%. Despite the volatility of egg prices, CALM has an acquisition based strategy (it is a purely market share play) and revenue has increased nearly five fold over the past ten years with book value increasing nearly 6x over that same time span. Over its latest quarter, the company grew operating income by over 19%, revenue by nearly 3% while maintaining a P/E ratio of under 6 (which, quite frankly, does not make much sense). FCF over the trailing twelve months is at an all-time high, price to sales is at a paltry 1.0, and it has an extremely healthy payout ratio of 32%. Over 1/3 of the company’s market cap is in working capital, which is means that if this price decline continues, the company is looking at a Graham-esque valuation unseen by a consumer non-cyclical company.

Do we expect CALM to recover and the price of eggs to rebound?

Although we do not play in the futures markets, we do believe that CALM provides attractive value as the owner and operator of the largest egg brand in the U.S. (Egg Land’s Best) and history suggests that egg fundamentals will eventually stabilize given long-term demand trends for eggs. For investors who are patient and can stomach the wild swings, there are very few names that offer this level of value run by quality management. We’re expecting CALM price to fall near the $35, which would be an extremely attractive opportunity for the long-term investor.

DISCLAIMER: Logos LP is long CALM.

Are markets getting frothy? Should we be more cautious? Where do we stand?

Although the May jobs report sent the Market into a bit of a tailspin, overall stock market performance has been improving since the correction in January. As all prudent investors know, good performance should never be a reason to get complacent. How should we interpret this improvement in performance?

In his seminal book "The Most Important Thing" Howard Marks reminds us that we must develop a sense for where we stand. Instead of trying to predict where the market will be in the future we must develop an ability to “take the temperature” of the market. More specifically, market cycles present the investor with a daunting challenge given that:
 
-Their ups and downs are inevitable
-They will profoundly influence our performance as investors
-They’re unpredictable as to extent and, especially timing

In the face of these challenges the investor has a few options:

1) Believe that market cycles are predictable and put more effort behind trying to predict the future

2) Accept that the future isn't knowable and simply try and ignore cycles by buying and holding high quality businesses

3) Figure out where we are in terms of each cycle and make intelligent investment decisions accordingly

Knowing where we are in the cycle doesn't imply predicting the future but what it does mean is that we can gain better insight into the probability of events occurring in the future. The challenge is developing an alertness to the behavior of market participants as well as an ability to make inferences. What are the deeper implications of what we observe around us? If a majority of people are exhibiting extreme pessimism, can we be more aggressive?

This isn't about forecasting, it is about deep reflection on present observations.

Yet what factors should we be alert to? What observations matter more than others? What signals should we watch in order to make intelligent inferences? To answer these questions, consider Marks’ poor man’s guide to market assessment included below. Listed are a number of market characteristics. For each pair, think deeply about the one you think is most descriptive of today. If you find that most of your findings are in the left hand column, then hold on to your wallet. If most are in the right then consider a more aggressive capital allocation strategy. We believe that at present the balance seems to be tilted to the the right…..

What Do You Want? Happiness And The Concept Of An Empty Mind

After reading Think and Grow Rich by Napoleon Hill, I’ve been reflecting on the notion of happiness. That feeling of fulfillment, contentment and energy. How can it be defined? How can we find it? How can we keep it?

Without offering a total answer, I believe a good starting point is the link between happiness and figuring out exactly what YOU want. What I’m talking about here is the definite knowledge of what YOU want and a burning desire to possess/achieve it. Interestingly, the prime difficulty may be the clear and precise definition of what it is one wants rather than the faith, organized planning, action and persistence needed to attain it. Ask most people what they want most in life and many will be unsure or will offer vague suggestions such as "to be happy" or "to be rich" etc. When was the last time you knew what you wanted so clearly that you could write it down or tell it to someone in great detail?

Stop and think about that for a moment.

To attain this clarity, and perhaps to maintain it, consider the concept of “an empty mind”. In our “noisy” culture the ability to empty one's mind has immense value. Imagine moments of calm unbound from schedules, emails, messages, meetings, the news and frivolous demands from friends, colleagues and acquaintances pulling your mind in multiple directions.

When our minds are brimming with external stimulus we often lose track of who we really are and what we truly cherish as we drift away from the meaningful and tether to the meaningless. Thoughts become clouded, incomplete and ephemeral as each is quickly superseded by the next. Judgment becomes heavily influenced by external stimulus and most importantly independence and knowledge of self is compromised. Consider the concept of an empty mind in order to connect with what YOU desire most. Cleanse, disconnect, simplify, streamline and reduce. You are your thoughts. All people become who they are because of their dominating thoughts and desires.

“Without a doubt, the most common weakness of all human beings is the habit of leaving their minds open to the negative influence of other people.” –Napoleon Hill

The good news is that you have absolute control over one thing in this world….and that is your thoughts. Reclaim them…as perhaps happiness isn’t a goal but simply an indication that you are living your life in accordance with what YOU as an individual desire most.

Renasant Corp.: An Upcoming Regional Powerhouse

Renasant Corp. (NASDAQ: RNST) is a regional bank operating in Mississippi that is successfully taking advantage of both a unique resurgence in the state as well as in the American South. The bank holding company provides traditional banking services to the southeast, including industrial and commercial loans, residential mortgages, consumer deposits and wealth management services. The company recently closed the acquisition of KeyWorth Bank to expand its presence in Georgia and is looking to drastically enhance its wealth management footprint within the southern U.S. The real story, however, is two fold; the possibility that RNST is a proxy for an improving southern U.S. as well as RNST's ability to capture market share within its core divisions.

Mississippi has become a 'new economy' as traditional industries have given way to new markets within the state, creating a plethora of opportunity for business expansion (see Figure 1). Gone are the days of natural resource and government as the major drivers of employment and in are the days of new professional services, business services, health care and information. Moreover, unemployment in certain regions within the state are dropping to record lows while the annual percent change of incomes within the state is growing faster than the national level (see Figure 2). 

Figure 1

Figure 2

Despite these macroeconomic catalysts, Renasant has been a prudent allocator of capital within the financial markets within which it operates as it has been able to appropriately capture revenue growth within its home state (see Figure 3). The company has a very healthy ROE near 8% while increasing book value per share by 25% over the last three years. Unlike other major diversified banks like GS, WFC, C or BAC, Renasant is trading at a slight premium (1.3 times book) which reflects the positive catalysts within the state in addition to southeast service expansion. Over the past 5 years, operating cash flow has more than doubled while operating income year-over-year has increased by 36.58%, which is very strong for a regional bank. Revenue growth over the last quarter has increased by over 47% and the 10 year average of revenue growth has surpassed 11%, which reflects the quality and prudence of management as it has been able to weather the financial crisis in a sustainable fashion. The more impressive metric, however, has been the bank's cash flow from sales which is at a remarkable 65.06%, which is almost double from last year. The reason why this is important is because this level of conversion allows the financial institution to have an abundant purse to continue its expansion within the southeastern U.S. while being able to take advantage of the economic turnaround happening within the state of Mississippi. In light of the bearish sentiment still present both with the U.S. and globally, it is impressive to see a financial institution with this kind of cash flow generation avoiding the typical excuses of a low interest rate environment we keep hearing from the bigger banks. 

Figure 3

Figure 4

Source: finbox.io

There are certainly some headwinds facing the company, especially since RNST has performed so well and the market is starting to price in the southern U.S. region's improving economic picture. At 27.6x EV/LTM EBITDA, the company is not exorbitantly expensive (unlike peers HOMB and PNFP at 87.3x and 43.1x, respectively) but the company has compounded at over 20% per year for last 5 years and begging the question whether the ship has sailed. Moreover, just like any financial institution, the macroeconomic picture is a major variable bearing on future revenue and ROE growth and some are wondering whether we are starting to enter into peak unemployment and economic growth. However, there are reasons to believe this is not the case as U.S. GDP is expected to outpace Mississippi's growth.

Figure 5

Overall, we believe RNST below $30 creates a unique opportunity to participate in a growing regional bank in a very unique economic situation. Prudent and competent management, strong economic growth, low loan loss provisions, increasing cash flows and operating income combined with growing ROE (grew 6% from last quarter) should propel RNST towards becoming a financial institution worth north of $2 billion in market capitalization.