More uncertainty lies ahead. Expect increased volatility as the US election draws to a close; including executive change and possibly a change of control in Congress. December 13-14 will likely mark the Fed’s next rate hike – nearly one year since its first hike in the cycle. Although not statistically significant, a rate hike of .25% does reflect a continuation of a forward looking policy oriented toward a return to normal, meaning more rate increases will follow.
Predictably, the US dollar will strengthen versus other major global currencies, unless the Fed Chair can orchestrate a “on the count of three everybody raise rates” strategy, an unlikely event given recent comments from the central bankers of Europe, Japan, and more recently Britain. Ten-year European Government bonds yield just above 0%, while ten-year Japanese Government bonds have had consistently negative yields in the recent past. Low rates at first glance would seem to be a positive, making capital cheap and available for enterprising businesses and investors. Yet the basis for low rates has been the slack in demand and anemic macro-economic growth (or lack thereof) for the past 7 ½ years. Any rate hike will, by definition, strengthen the currency making US exports more expensive overseas, resulting in reduced demand – think of the largest US companies sending products and services overseas (agricultural products, heavy equipment, technology services, etc.) and then trim revenue and earnings by some meaningful percentage. The odds are good that the US employment situation will soften in this environment as well. The macro impact will be noticeable. The Fed appears motivated to wait until after the election to affect policy change.
Historically stock valuations are highest when rates are lowest and lowest when rates are highest. The end of the Fed’s Zero Interest Rate Policy (aka ZIRP) will undoubtedly mark the cyclical peak in equity valuations. The S&P 500 stock index currently sports a healthy 19x earnings multiple. Even if corporate earnings grow, which they haven’t for the past 6 quarters year over year, there is reason to believe the stock market will go through a simple valuation contraction.
The stagnant earnings, softening employment, and rising rates will also pressure the bond market. The highest quality debt (AAA and AA rated) is most sensitive to interest rate movements, so US Treasuries will be most at risk as rates rise. Additionally, the US Government continues to add to the supply of Treasury bonds available for purchase by running large fiscal deficits. The Sept 30 year end deficit was $580 billion, adding to the total US Treasury debt, which now registers in excess of $20 trillion. Institutional investors, in an attempt to own the most liquid and available bonds on the planet, have bought significant amounts of Treasuries over the past few years; however, the prices associated with those bonds have been pushed to excessive levels. We anticipate bond prices will decline as interest rates rise. Lower-rated bonds will fare better as long as those underlying businesses remain stable. Oddly, for investors in need of bond exposure, a shift from high quality to lower quality debt may be the optimal strategy while rates are rising.
The likelihood of an economic slowdown during the first half of 2017 is high in the absence of intelligently structured fiscal policy initiatives from the US Congress, suffice to say we are not holding our breath. Subject to the US election outcome, there remains a high degree of uncertainty on the near-term horizon.
Global Value Investment Corp, (GVIC) and its investment research and financial advisory divisions make no claims regarding our ability to time the market or exploit macro-economic trends. In fact, the firm is clearly agnostic as it relates to market trends. We focus on identifying and investing in undervalued or mispriced stocks and bonds. The firm’s investment approach takes a long-term perspective, with a willingness to invest at points when the last quoted price seems disassociated with the fundamentals of the business. We then have the patience to wait for the price/value relationship to resume. Historical experience demonstrates the firm’s portfolio allocations tend to be cash heavy at market peaks and near fully invested closer at market troughs. Today, typical portfolios hold roughly 20-25% cash, reflecting challenges in identifying undervalued stocks or bonds. If no investments meet our criteria, we strategically hold cash in reserve, believing future opportunities will present themselves at unpredictable times.
Most of our business day is spent studying company strategy and finance while seeking out undervalued and mispriced securities. We find security prices fluctuate widely in the short-term, often defying logic or not reflecting a natural ‘cause and effect’ relationship. Stock and bond quotes are simply available for the convenience of market participants. The seller of a security may not like the price, but the market does exist to provide liquidity. For investors caught in the real estate market downdraft of 2007 and beyond, the notion of liquidity can’t be overstated.
Global Value Research Company’s analysts take particular care in speaking with senior management of companies before and during our investment commitment. It is important to keep in mind that people manage businesses, and people can change. Our research process emphasizes ongoing company management communication. We think the words and actions of management and directors are critically important.
Shareholders, or the equity owners of a business, elect a Board of Directors to represent them in the operation of the business. Directors assume a fiduciary responsibility to act in the best interest of the equity constituency and are legally accountable to shareholders. Company Directors and Officers are in a unique position to access and understand the inner workings of the company, its financial condition, and the success of strategic plans and initiatives. By way of illustration, our research team recently reviewed a business with $10 billion in sales. The company provided an income statement (profit and loss statement) with fewer than 20 lines of financial data. It’s difficult to make an intelligent investment decision with so little information. Indeed, the company has an internal income statement detailed with hundreds of lines of statistical data. Officers and Directors have access to a significant level of information that is unavailable to shareholders and investors. Having access to this information qualifies them to be “insiders” and thus subjects them to various buy/sell rules and restrictions. Yet at certain times these insiders can buy or sell shares in the company, and our researchers watch that buy/sell activity closely. In fact, we often question why insiders a) don’t make more purchases given their intimate knowledge of the business, and b) don’t own a larger amount of stock – and in many cases directors don’t own a single share of company stock.
We believe every company’s Officers and Directors should own stock in the company. We also believe that stock should be purchased by Officers and Directors in open market transactions. Directors receive cash compensation for serving as shareholder representatives on the Board; we believe some amount of their compensation should also be reserved to purchase company stock. Having Directors feel the same financial impact as those by whom they were elected is good policy, aligning interests more clearly. We encourage every board to adopt policies requiring its Directors to buy and own shares as long as they serve on the board. We believe this will engender better behavior and outcomes for all shareholders. Finally, we think it is entirely appropriate and desirable for Officers and Directors to make open market purchases of stock after earnings announcements and/or periods of inexplicable share price declines; what better message to send to market participants with limited access to financial and strategic data than a stock purchase with one’s own money?
From Our Library:
The firm’s investment research team’s ongoing education involves weekly readings during which we discuss books with particularly valuable investment thinking or perspective. We are now reading Margin of Safety by Seth Klarman. He wrote this book in the late `80s, but the ideas remain timeless. The following few excerpts are relevant to our current letter.
Today institutional investors dominate the financial markets, accounting for roughly three-fourths of stock exchange trading volume. All investors are affected by what the institutions do, owing to the impact of their enormous financial clout on security prices. Understanding their behavior is helpful in understanding why certain securities are overvalued while others are bargain priced and may enable investors to identify areas of potential opportunity.
If the behavior of institutional investors weren’t so horrifying, it might actually be humorous. Hundreds of billions of other people’s hard-earned dollars are routinely whipped from investment to investment based on little or no in-depth research or analysis. The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance. Indeed, the short-term, relative-performance orientation of many money managers has made “institutional investor” a contradiction in terms.
You probably would not choose to dine at a restaurant whose chef always ate elsewhere. You should be no more satisfied with a money manager who does not eat his or her own cooking. It is worth noting that few institutional money managers invest their own money along with their clients’ funds. Economist Paul Rosenstein-Rodan has pointed to the “tremble factor” in understanding human motivation. “In the building practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know.” Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived.
Although our outlook remains cautious, we are actually quite enthusiastic – almost giddy – about the prospect of an increase in the number of potentially undervalued securities available in the event of greater price variability, which we foresee. The firm’s clients have historically embraced a long-term investment horizon, recognizing superior results are achieved over time through careful and diligent security analysis and portfolio management.
We continue to be mindful of emerging information security risks. We designated a Chief Information Security Officer who is charged with overseeing the protection of our network, technology, and client data. We also retain a third party consultant to monitor our network and provide redundant data backup on a daily basis, while our network is monitored 24/7. In addition, our Chief Compliance Officer is perpetually reviewing internal processes and holding regular firm meetings to discuss issues such as business continuity, identity theft, and money laundering. Needless to say, we stay busy.
If you’ve had a change in your investment objectives or portfolio restrictions please let us know so we can make the appropriate adjustments.
As always, we take seriously the trust and confidence placed in us and dedicate ourselves to investment excellence.
Very best wishes,
Your Investment Research and Advisory Team
Global Value Investment Corp.