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In reviewing the Chinese Zodiac and how our newly added animals might fit within the twelve year cycle, we wrote that “2014 is technically the Year of the Wood Horse"
In reviewing the Chinese Zodiac and how our newly added animals might fit within the twelve year cycle, we wrote that “2014 is technically the Year of the Wood Horse"
In reviewing the Chinese Zodiac and how our newly added animals might fit within the twelve year cycle, we wrote that “2014 is technically the Year of the Wood Horse"
Letter to Fellow Investors In last quarters letter, titled Te Year of the Alligator: Why 2014 will be the Inverse of 2013, we hypothesized that returns in global investment markets in 2014 would look quite diferent than the returns in 2013 and that assets that had been shunned (long bonds, commodities, gold equities) during the Year of the Coyote (so named for the gravity defying move in global equities) market might fnd favor with investors. We dubbed 2014 #YearofheAlligator because the extreme return divergence between risky assets and safe haven assets was quite remarkable and had created the widest Alligator Jaws (the divergence between two total return lines on a cumulative wealth chart) we had seen in many years. In reviewing the Chinese Zodiac and how our newly added animals might ft within the twelve year cycle, we wrote that 2014 is technically the Year of the Wood Horse, which predicts that the year would be full of energy, fnancial volatility and impulsiveness, a year for taking on new projects and a year focused on borrowing and spending money (think debt issuance and M&A activity) and, so far, those themes seem to be playing out as predicted. Tere has indeed been a high level of market volatility, punctuated by some truly wild swings in the highest beta segments of the market during the beginning of the second quarter. If 2014 were actually a horse, it would be a thoroughbred capable of running with California Chrome if we measured speed by the incredible pace of debt issuance, stock buybacks and M&A activity (#M&ABoom). Companies are clearly following the theme of focusing on borrowing and spending money (like it is going out of style, which it actually may be, but more on that later) this year. We also noted that horse years are typically marked by individuals holding frm to their beliefs, hence compromise is more difcult and there have been a number of conficts/wars linked to these yearswe have some concerns about tensions in the Middle East that could erupt into something more dangerous. Te frst half of 2014 has been flled with people not being willing to compromise, from U.S. politicians, to Russian and Ukrainian leaders, to religious groups all over the Middle East, with the recent fare up in Gaza being potentially the most dangerous, as it has the potential to draw a number of players into the confict. A highly levered economy hit by rising global tension and societal conficts does not sound like a recipe for stable markets. History has shown time and time again that when we reach a certain level of stress in the global fnancial system, things do break down and this time is likely to be no diferent.
Something that seems quite intuitive is that if we anticipate that there will be a period of above average volatility and risk, wouldnt it be prudent to position portfolios in such a way to try and mitigate the damage that could occur if the valuation excesses were to adjust back to normal, or the geopolitical tensions were to fare up into something more serious (#CantPredictCanPrepare)? We spent a good deal of time discussing this issue last quarter
and said that the time to actually play defense is before you really need to play defense. Tere are two key reasons for this: 1) you dont get to buy the insurance policy afer the event (the coverage has to be in place before the event occurs), and 2) the cost of insurance is signifcantly lower when everyone is still ebullient and no one thinks you need insurance. Te problem, as we discussed, comes down to timing and we wrote, so if timing is so critically important, how do we know when it is time to make a change? Tere are myriad models, indicators, calculations, rules of thumb, etc. for trying to time the markets (and none have proven to be consistently accurate in every environment) and some work better than others at diferent times. We went on to discuss the Bradley Turn Date indicator, which we found provided some useful guidance on major trend changes in the markets. Te fact that the Bradley Dates were predicated on naturally recurring cycles over many decades seemed intuitively appealing and the historical evidence was strong that overall market trends did indeed tend to reverse (or sometimes accelerate) around these dates. We talked about the major Turn Date that occurred this year on January 1 st and discussed how the reversal of the trends from 2013 would drive the transition from the #YearofheCoyote to the #YearofheAlligator as the Alligator Jaws across markets would begin to snap shut. We wrote that positive trend markets included Japanese equities, U.S. equities (NASDAQ, small and large), European equities (and the Euro), high yield bonds, MLPs and negative trend markets included Emerging markets equities and bonds (and currencies), U.S. bonds (particularly long bonds), Commodities, REITs, Gold, Gold Miners and the Yen (weakening) and we discussed how these trends should invert in the frst half of 2014. As it stands today at the end of Q2, Te #YearofheAlligator seems like a ftting descriptor, as the performance of these markets has nearly perfectly inverted from last year with Gold Miners, Gold, Commodities, REITs, Long Bonds and Emerging Markets leading and Japanese, U.S. & European equities and HY bonds trailing.
So, at the halfway point, 2014 does look very diferent from 2013 but, as we said last quarter, the fact that we were modestly more cautious coming into the year doesnt mean we cant take advantage of great opportunities and generate solid returns, we will simply have to adjust our game plan, be a little more balanced and defnitely be more Tactical to achieve our investment objectives. A couple great examples of those opportunities are that investors in long-bonds (TLT) are up 14% (on pace to match the 30%+ returns in 2011, not a high probability outcome, but certainly possible) and those who bought gold miners (GDX), and endured the wild volatility, are up a stunning 27% (or an even more stunning 39% if you bought the junior miners, GDXJ). Te challenge for most investors is that those were two of the worst performing assets last year and it took some truly independent (and contrarian) thinking to embrace the #YearofheAlligator theme and buy what the crowd was selling coming into the New Year (#WorstToFirst). If we look at the equity market in the U.S. we see a similar trend, in that the worst performing sectors from 2013, like Utilities, Healthcare and Energy, are among the leading sectors in 2014, (something we mentioned was likely to happen in our iCIO meeting in NYC in December). Interestingly, as we mentioned last quarter the troubling part of that story is that these are not the sectors that lead in robust economic expansions, but rather they are the sectors that lead during decelerating economic growth leading to Recessions. While there do not appear to be many other signs of impending Recession, we do know that markets are leading (not lagging) indicators, and that Recessions are routinely caused by Fed tightening cycles (which the end of QE may begin). Quickly, on the Fed and the potential for tightening, we mentioned in the two previous letters that Larry Jeddeloh, calculated that for every $100 Billion of QE, the S&P 500 rises 40 points, so if there is $500 Billion of QE lef, that is worth 200 S&P points in 2014 (Tat would equate to 2,050 on the index from 12/31 levels) which is looking like an increasingly good estimate as we sit at 1978 at a little past the halfway point (up from 1848 to start the year). Te one risk we see to the QE = Upside thesis is the sternly stated warning from Stanley Druckenmiller last year that if the Fed were to stop buying bonds, equity markets would go down.
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So with the Alligator Jaws across the various markets beginning to close and an increasing number of pundits and fnancial commentators describing the New Normal, that somehow it really is diferent this time, and that the Fed (and other global Central Banks) has banished the business cycle, established permanent foors under equity markets and has fgured out how to somehow manufacture growth and wealth out of debt (a feat that has never been achieved in many centuries of trying). In the last letter we discussed the seven-year cycle that seems to exist with respect to the business cycle (interesting to me that its precisely half of the 14 year innovation cycle I have written about in the past) and talked about how the peak in markets in 2000 and 2007 was followed by Recessions and larger losses in the equity markets in subsequent years. Tose two incongruous constructs of #TeNewNormal and Te Old Normal, coupled with my stumbling across an increasing number of charts and graphs that show a number of market data follow this seven-year cycle and how another peak was forming in those same areas again in 2014, led me to start attaching #NotDiferentTisTime to many of my tweets and retweets (for Twitter users, you can fnd me at @markyusko). Tis hashtag is a play on the famous Sir John Templeton quote, the four most dangerous words in investing are this time its diferent and the idea to use them as the theme of the letter prompted me to do a little research on the origin of the phrase and on Sir John as well. What I found was a very compelling outline of his investment philosophy that I decided to include in the letter to provide some context for the overall theme. In searching for my opening picture, I found the image of the hourglass with Sir Johns wisdom and it reminded me of the quote that, the more sand that passes through the hourglass, the more clearly we can see (more on this theme later). Ten, in a serious case of everything happens for a reason, I had dinner with Peter Gutrich this week (our partner and a long-time friend) and he had a laminated copy of the 1995 cover of Forbes with a dapper Sir John making the point that to beat the market, you have to start by asking the right questions (much more on this later) lying on his cofee table in Denver. Amazing serendipity given I had composed most of this letter already and had decided that Sir Johns wisdom would be the theme.
In 1993, Sir John (who is clearly one of the most successful and intrepid investors of our time) did all investors a great service by putting his personal philosophy down on paper, 16 Rules for Successful Investing (which was published in the World Monitor: Te Christian Science Monitor Monthly) in which he captured a lifetime of investment wisdom for the ages. Many of the individual tenets of the philosophy may seem obvious, or common knowledge, but taken together they represent an investing discipline that, when executed faithfully (that is the tricky part), can produce superior results over the long-term. Te challenge of executing the strategy is twofold: 1) adhering to the entire collection of Rules and 2) sticking to the discipline over time and not making exceptions when it would be easier or more expedient to do so. Sir John begins the essay with a little humor in which he says that he could sum up his message by reminding the reader of the famous advice of Will Rogers who said, Dont gamble, buy some good stock. Hold it till it goes upand then sell it. If it doesnt go up, dont buy it! He then goes on to say that there is as much wisdom in that remark as there is humor and makes the following introductory commentary before diving into the 16 Rules: Success in the stock market is based on the principle of buying low and selling high. Granted, one can make money by reversing the order, selling high and then buying low. And there is money to be made in those strange animals, options and futures. But, by and large, these are techniques for traders and speculators, not for investors. And I am writing as a professional investor, one who has enjoyed a certain degree of success as an investment counselor over the past half-century and who wishes to share with others the lessons learned during this time. What is truly remarkable about Sir Johns perspective is that his direct investment experience at the time of writing was six decades (that is some serious volume of sand through the hour glass) that spanned periods of War and Peace, Prosperity and Hardship, Bull Markets and Bear Markets and every transitional phase in between each extreme, so the applicability of his Rules is more timeless (in my opinion) given his vast experience base. So lets review the 16 Rules and discuss how they are relevant to todays
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investment environment and why they lead us to the title of this quarters letter.
Rule No. 1 Invest for Maximum Total REAL Return (#InfationIsRisk)
We could not agree more that this is the most important issue facing long-term investors and is, perhaps, the most widely misunderstood (or simply disregarded) risk in investing. Sir John makes the statement that investing for maximum total real return is the only rational objective for most long-term investors and we have told Morgan Creek clients for all of our ten years of existence that Total Real Returns, the return net of infation and taxes, are the most important measuring stick over time (as opposed to focusing on some randomly generated index). We learned in our time managing large Endowment portfolios that the largest risk to investors is not volatility (standard deviation of returns) or trailing some benchmark for some short period, but rather, failing to achieve a real rate of return in excess of your spending rate over time. Any investment strategy that does not address the deleterious impact of infation on invested assets will fnd themselves in the unenviable position of having eroded the purchasing power of their assets over the long-term. Sir John says it very clearly that one of the biggest mistakes people make is putting too much money into fxed-income securities and he points to statistics that show how the value of the Dollar has been eroded by infation over the decades. He points to the fact that in 1993 a dollar only bought 35 cents of what it did in the 1970s and only 15 cents of what it bought afer WW II. Simply stated, if an investor buys a ten-year bond today and receives his principal back at the end of the decade, the purchasing power of those dollars would have been eroded by 32% over that period at the long-term average of 4% infation. In other words, you would need $147,000 to buy what $100,000 would have bought at the time of the investment. Lets assume that infation stays at the Feds target of 2% for the next decade (unlikely, but we will make the assumption), an investor would still need $122,000 to preserve purchasing power. Additionally, all of this analysis doesnt include taxes, which makes the challenge for fxed income even greater, since fxed income returns are taxed at Ordinary Income rates and equity returns at least have a chance to be taxed at lower Capital Gains rates (if employed in a long-term strategy). #RealReturns
Rule No. 2 Invest: Dont Trade or Speculate (#InvestWithoutEmotion)
Te wisdom of the second rule goes back to the Will Rogers quote in that Sir John believed that the stock market is not a casino, so investors shouldnt gamble by trading too frequently, or by trying to time the market in the short-term by attempting to capture every move, up or down, of a few points based on news fow and investor sentiment. Like gambling in a casino, the house wins over time and your profts will be consumed by transaction costs and losses associated with overtrading (the emotional reaction to noise in the markets). He says to remember the words of Wall St. Legend, Lucien Hooper, who wrote; what always impresses me is how much better the relaxed, long-term owners of stock do with their portfolios than the traders do with their switching of inventory. Te relaxed investor is usually better informed and more understanding of essential values; he is more patient and less emotional; he pays smaller capital gains taxes; he does not incur unnecessary brokerage commissions; and he avoids behaving like Cassius by thinking too much. Tere is so much investing wisdom in these lines and they so completely accurately describe the core personality traits of the best investors I have interacted with in my career. One example, in my frst job with an equity management frm (aptly named Disciplined Investment Advisors DIA), the principals had cofee mugs made to give to clients that were emblazoned with the simple phrase Invest Without Emotion (I have actually seen them on eBay selling for a healthy premium to our original cost) as their entire investment process was predicated on the fact that patient, unemotional capital would generate superior returns over the long-term. Te strategy was built around a
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proprietary methodology of buying assets at deep discounts to intrinsic value, which had very low turnover (was therefore very tax efcient and paid very low trading costs) and generated very strong long-term returns. Tere were, unfortunately, two small faws in the business model: 1) the value discipline was routinely Early, so there would be meaningful times when the strategy produced little return as the markets did not see the value that the model had uncovered, and 2) the strategy was Patient, so there were periods of time where returns would actually be negative as the model said to hold undervalued assets despite the market making them more undervalued. An example of how overtrading leads the average investor to underperformance over time can be seen in some of the client behavior at DIA when I frst joined in 1991. A large investor had just terminated us for poor relative performance over the previous three years (Value lagged Growth during the Recession and the model was buying more of the undervalued assets) and was going back to the Growth frm that they had terminated three years earlier to hire us (afer we had a great three year run coming of the downturn in 1987). You can probably guess the next part we dramatically outperformed over the next three years (yes, they then fred the Growth manager and came back to us) as valuation reverted to the mean. Te result was that the institution (a large, sophisticated investor with a professional consultant) had spent nearly a decade chasing the hot dot (hiring the best trailing return) and missed all the good performance of both frms (in fact, got all the underperformance of both frms). Tey were clearly victims of thinking too much as a clearly superior strategy would have been to have 50% of the capital with each frm and rebalance from the winner to the loser afer each period. Tey should have consistently been investing, rather than speculating on which style would have the edge in the next period (since, as Yogi Berra infamously said, making predictions is hard, especially about the future). #Discipline
Rule No. 3 Remain Flexible and Open-Minded About Types of Investment (#OneSizeDoesNotFitAll)
Sir John reminds us that there is no all-weather asset, no one kind of investment that is best in all conditions. Given the broad array of investment choices across assets classes, Stocks, Bonds, Currencies and Commodities, across geographies, U.S., Europe, Japan, Emerging Markets and across sectors, Technology, Energy, Healthcare and Financials to name a few, investors can always fnd something that is attractively valued, IF they are fexible and open-minded to looking at new ideas and strategies. Another important point he makes is that there will be times when Cash (which most investors disdain and dont even view as an acceptable asset class) will be the preferred asset, as sitting on cash enables you to take advantage of investment opportunities which reminds me of another great quote that is critical for long-term investment success, dont just do something, sit there. To that end, Jesse Livermore (a famous Wall St. investor) was quoted as saying, It was never my thinking that made the big money for me, it was always the sitting which goes to the Cassius quote above in Rule No. 2 about not thinking too much. Two other points Sir John makes here are: 1) that when a particular type of investment becomes popular that popularity will always prove temporary and, when lost, may not return for many years, and 2) that despite his admonition to be fexible across types of investments, his clients were predominantly invested in common stocks over time. A critical point to remember here is the time horizon perspective from which he is writing is a half-century. Terefore, a predominance of time over 50 years could be 35 years, which would still leave 15 years (a long time for any investor) where stocks were not the dominant (or at times, not even an attractive) asset class. With the caveat that equities may be unattractive for meaningful periods of time, Sir John highlights the long-term attractiveness of stocks vs. fxed income and cash, as he explains again that equities are the only asset of the three that can overcome the drag of infation over the long term and he says emphatically I repeat: Tere is no real safety without preserving purchasing power. #InfationistheEnemy
Te description of this Rule begins with a great line, Of course, you say, thats obvious. Well, it may be, but that isnt the way the market works and he goes on to explain that, unfortunately, just the opposite occurs in practice. In fact, all of the data on investment capital fows suggests that the line I so ofen use people love to buy what they wish they would have bought aptly describes the collective actions of investors over time and for some reason, despite it being obvious, investors do not, for the most part, heed Rule No. 4 and buy low. Te reason that Sir John posits for this anomaly is that prices are low when demand is low and investors have pulled back because people are discouraged and pessimistic. It is hard to step up and buy an asset if you have become pessimistic on the current situation or, more importantly, the future prospects for the asset class, region, sector or individual company. One of Sir Johns most of quoted lines comes from his belief that long-term investors should capitalize on the incredible opportunities created by collective pessimism as he says, Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. He goes further to say that the real problem is that yes, they tell you, buy low, sell high, but all too many of them bought high and sold low. Ten you ask: When will you buy the stock? Te usual answer: Why, afer analysts agree on a favorable outlook. Terein lies the fundamental problem. Tat behavior is (in his word) foolish, but not unexpected, as it is human nature to want to do what everyone else is doing (herd behavior) and avoid doing what is considered non-consensus. In fact, Lord Keynes famously quipped that worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally, in essence, reminding us that people are even willing to endure failure (so long as everyone else is failing along with them) rather than do something considered unconventional, even when the outcome is positive. Sir John points out that buying low requires taking an action that is in direct opposition to what everyone else is doing, to buy when everyone else is selling or has sold, to buy when things look darkest, to buy when so many experts are telling you that stocks in general, or in this particular industry, or even in this particular company, are risky right now, which history and psychology both show us is simply not human nature. Humans want to be at the center of the herd, where it is comfortable and warm, doing what everyone else is doing because that must be the right course of action, because everyone cant be wrong, can they? Te inherent problem is that if you do what everyone else is doing, you cannot, by defnition, have performance that is diferent from the crowd and, worse, when you buy what everyone is buying, you will likely be doing so afer the price has already risen and you will be buying high, not low (or vice versa, selling low, not high). Sir John quoted two legendary investors here on how to invest, Benjamin Graham who said, Buy when most people, including experts, are pessimistic, and sell when they are actively optimistic and Bernard Baruch, who was even more succinct and said simply Never follow the crowd. Sir Johns fnal two lines are elegant (and haunting) as they sum up the concept of Buy Low, So simple in concept. So difcult in execution. #LiveOutsidetheComfortZone
Rule No. 5 When Buying Stocks, Search for Bargains Among Quality Stocks (#WinnersPressWinners)
In describing what Quality is, Sir John lists characteristics like leadership in an industry, or feld, having superior management talent, a strong balance sheet, a trusted brand and high margins, pointing out that this list is incomplete and, importantly, that each attribute cannot be considered in isolation. He goes on to give two examples where threats to Quality Status could arise, saying that a company may be the low-cost producer, for example, but it is not a quality stock if its product line is falling out of favor with customers. Likewise, being the technological leader in a technological feld means little without adequate capitalization for expansion and marketing. In trying to pinpoint precisely what is Quality, we can recall the now infamous quote from Supreme Court Justice, Potter Stewart, when he ruled on an obscenity case in 1985, saying that while I shall not today
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attempt further to defne the kinds of material I understand to be embraced within that shorthand description [of obscenity], and perhaps I could never succeed in intelligibly doing so. But I know it when I see it. Every investor can point to myriad examples of both types of companies they have invested in over time, those that were quality companies and those that were not, and, more ofen than not, the examples of high quality companies have happy endings and the stories of poor quality companies do not. Te one caveat here is that the other italicized word in the Rule matters too, a lot. Te price you pay matters and, as a follow up to Rule No. 4, you cant pay any price, you have to pay bargain prices to win long term. To this point, we include a great line from Howard Marks of Oaktree that applies here, where he says that there is no investment good enough that cant be messed up by paying too much and, conversely, there is no investment bad enough that cant be fxed by paying a very low price. In essence, even Quality will not protect you from losing money if you pay an exorbitant price and, perhaps in a little disagreement with Sir John, Howard, as a great distressed investor, does believe that a really, really good bargain price can allow you to buy a less than quality asset and still make good returns. One other point here is that a Bargain does not only mean a very low price. Low prices are what are preferred in buying value, trying to buy dollar bills for 50 cents (or less if you fsh in the really depressed areas where the herd has completely abandoned particular assets, like Russia and Argentina today). But sometimes, you want to pay what is seemingly a high price because it is actually low based on future growth prospects. Tis is the essential diference between Growth and Value investing and really focuses on the life cycle of companies. Young, fast growing companies, will rarely sell at bargain prices (meaning for less than the value of their assets) because so much of their intrinsic value is in their future prospects as they take market share and build a dominant franchise or brand (thing Coca-Cola in the 1930s and Google in the 1990s). Te key to success is recognizing that an upstart business is morphing into a Quality business (before the herd sees the same thing) and buying a bargain of a diferent variety (buying $2 in the future for $1 today). A friend pointed out a critically important point to me recently, that every stock that goes up 10X was making new highs all along the way and may never have appeared as a bargain (or value) based on current metrics (most people never buy these stocks because they think they are always just about to crash). Only the most intrepid investors, who can truly remain forward-looking, will reap the rewards of investing in these diferent, but equally important, types of bargains. #PriceMatters
Rule No. 6 Buy Value, Not Market Trends or the Economic Outlook (#MarketofStocks)
Te essence of this rule is that investors should focus on buying companies, not markets, as Sir John reminds us that a wise investor knows that the stock market is really a market of stocks and while individual stocks may be pulled along momentarily by a strong bull market, ultimately it is the individual stocks that determine the market, not vice versa. He goes further to remind us that far too many investors try to, unsuccessfully, invest based on anticipating market trends, or the economic outlook and lose sight of the fact that: 1) individual companies can rise in a bear market and fall in a bull market, and 2) Bull Markets do not always correlate with economic expansions and Bear Markets do not always correlate with economic contractions. Companies rather rise and fall with their business fortunes, future prospects and, perhaps most importantly, other investors perceptions and expectations of those prospects. A good example of this phenomenon has occurred over the past fve years, as the economic expansion in the U.S. has clearly been subpar (compared both to expectations and history) while the stock market rally has been substantial. Individual companies have been able to expand proft margins through a combination of downsizing of labor costs and the application of new technologies to enhance productivity or have been the benefciary of signifcant government largesse in the form of unprecedented fscal and monetary stimulus (think extended unemployment benefts turning into revenues for Walmart). Additionally, an investor who made an investment decision to sit out of the market based on the weak outlook for economy would have missed many
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opportunities to earn outstanding returns from stocks that have capitalized on the artifcially low interest rates to issue debt to buy back stock and raise earnings per share (frighteningly, over 2/3 of earnings growth recently is from the buyback efect). Another example is that investors who decided not to invest in the China Market because of fears of the slowdown in economic growth would have missed truly amazing returns available in individual companies in the Internet, Healthcare, Retail and Alternative Energy sectors, where the incredibly bright future prospects of these businesses were being masked by the dim view of the market indexes which are dominated by the State Owned Enterprises (SOEs) where business prospects are indeed depressed for many of the SOEs as the economy shifs from Fixed Asset Investment to Consumption. Further, even within the totality of SOEs there are a growing number of these companies that are seeing the light and making meaningful changes in their strategy and have been recently, and will be in the future, great investments. #CompaniesNotEconomies
Rule No. 7 Diversify. In Stocks and Bonds, as in Much Else, Tere is Safety in Numbers (#ConcentrationMakesYouRichDiversifcationKeepsYouRich)
As proponents of the Endowment Model of investing, we are staunch advocates of Diversifcation as the optimal strategy to control risk, but also as a methodology to maximize long-term investment returns through the lowering of overall total portfolio volatility (maximize the power of compounding). As Sir John so aptly states, no matter how careful you are, you can neither predict nor control the future and bad things happen. He lists a number of external events that can cause problems for companies, from natural disasters to technological changes to regulatory changes and says that then, too, what looked like such a well-managed company may turn out to have serious internal problems that werent apparent when you bought the stock. So you diversify, by industry, by risk, and by country. I have said for many years, concentrated portfolios make you rich, diversifed portfolios keep you rich. While it is true that all large fortunes come from concentrated portfolios (business ownership, land, real estate, individual stock positions), all small portfolios also come from concentrated portfolios, that is simply what happens when you stay concentrated too long (large portfolios turn into small portfolios when the inevitable bad event occurs). While there is nothing wrong with taking concentrated positions, an investor needs to balance the inherent risk of taking that concentrated position with the potential upside and, most importantly, the investors capacity to hold on during the inevitable drawdown. One of best ways to make concentration work (and is a common characteristic of most of the assets listed in above) is to have the concentration in illiquid assets where there is no choice but to hold the asset through the periodic tough periods, essentially providing protection from the natural human reaction to sell at the bottom. Two other issues of importance here are: 1) you will make mistakes, so there is safety in numbers, and 2) by searching the globe for great ideas, you increase the likelihood of fnding more investment ideas, and perhaps even better bargains, than focusing your search in any single country. We will cover mistakes in another Rule, and the challenge for #2 is that overcoming the tendency toward Home Market Myopia (the tendency for investors to have the most money in their home market) is much more difcult than it would seem. Take today for example, everyone is so enthralled with the great Bull Market over the past 18 months in the U.S. (S&P 500 up 32% last year and up 7% so far in the 1H of 2014) that they dont even see that both Japan and the GIIPS markets are up more and, further, are more likely closer to the beginning of their Bull Markets than is the U.S. market. #EyesWideOpen
Rule No. 8 - Do Your Homework or Hire Wise Experts to Help You (#NoShortcuts)
Te primary message of this Rule is fairly straightforward, either resource it or outsource it. If you have the internal resources to do primary research and investigate investment ideas fully, then do it; if you dont, then fnd
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professional help. Te good news is that there are lots of great organizations that can help, from consultants, to primary research frms, to investment management organizations, or instead, simply allocate capital into funds managed by professionals. Sir John says very succinctly, people will tell you: Investigate before you invest. Listen to them. Study companies to learn what makes them successful. What separates the best investors from the rest is that they are constantly doing research, continually scouring original source data to isolate companies that have a distinctive edge in some element of their business that will lead to superior returns in the future. Te challenge of performing research in an increasingly global world is that it is simply hard to cover the entire landscape (physically and mentally) on your own and it is expensive (both in terms of time and resources) to get to some of the most interesting places to invest today. We have been fortunate to have team members all around the world to help us bring together a truly global perspective at our Monday Investment Meetings but even we bring in outside experts to help us really drill down on a particular market or opportunity. For example, two Mondays ago we had four of the best Indian equity managers on the planet call in to give us an update on the state of the India market in the Modi era. Our years of traveling and developing relationships allowed us to assemble this all-star group of experts and enabled our large group to beneft from their wisdom without traveling to be with them in New York, Singapore and Mumbai. We came away from the discussion much wiser on the incredible opportunity that will unfold in the coming years as the BJP transforms India and we will make much more efective investment decisions since we spent the time to #DoYourHomework.
Rule No. 9 Aggressively Monitor Your Investments (#WatchTeBasket)
Andrew Carnegie famously said, Concentrate your energies, your thoughts and your capital. Te wise man puts all his eggs in one basket and watches the basket closely and while he might debate how much concentration is optimal (see Rule No. 7), Sir John would agree vigorously with the advice to concentrate your energies and thoughts on watching the basket. Todays conventional wisdom, that a passive, buy and hold strategy is optimal, was not quite what Sir John had in mind. His position on Aggressive Monitoring was driven by the need for investors to expect and react to change. No bull market is permanent. No bear market is permanent. And there are no stocks that you can buy and forget. Te pace of change is too great. Being relaxed, as Hooper advised, doesnt mean being complacent. An example of change that he talks about is the continual turnover in the benchmark indices as companies go out of business, are acquired or get displaced by another company that fts the benchmark criteria better as the world changes (e.g., Yahoo replacing Woolworth in the S&P 500 as the index upgraded to include more new economy companies). Te natural life cycle of businesses demands that investors monitor, and react to, the transitions between the various phases from development, to growth and expansion, to maturity and then decline. Tere will be opportunities across all stages, on both the long side and the short side, but aggressive monitoring of the companies that you own in your portfolio will mitigate the damage that can be done as the prospects for a once great business erode. Sir John sums up his view on the monitoring by saying, remember, no investment is forever. #ChangeHappens
Rule No. 10 Dont Panic (#KeepCalmAndCarryOn)
Invariably, all investors will fnd themselves in a position where they did not heed the corollary to Rule No. 4, to sell when everyone else is buying, and Sir John reminds us that we will be caught in a market crash such as we had in 1987. Tere you are, facing a 15% loss in a single day. Maybe more. He advises us not to panic, not to rush out and sell. At the risk of stating the obvious, he reminds us the time to sell is before the crash, not afer. Te only thing that has changed afer a sudden downdraf in the overall market is that all security prices are lower, so the
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right response is to calmly study your portfolio and make a determination whether the rationale from which you made the original purchase remains intact and, if so, then hold tight (or even buy more, if you have liquidity with which to react to the opportunity). Te only reason to sell a security in a Bear Market is to make room to buy something that is more attractive. To this point, I was with one of my favorite Asian managers last week (who has compounded client assets at 15% for 23 years) who said that you make the bulk of your excess returns in Bear Markets if you remain disciplined, dont sell into the panic and actually deploy any excess liquidity you might have to purchase great companies at true bargain prices. Te key is, as Rudyard Kipling shared with us in his classic poem, IF, that if you can keep your head, while all those around you are losing theirs you will generate consistently superior returns over the long-term. #StayintheStore
Rule No. 11 Learn From Your Mistakes (#FocusOnTeNextPlay)
An old English Proverb tells us the man who makes no mistakes, usually makes nothing at all and Sir John tells us that the only way to avoid mistakes is not to invest, which is the biggest mistake of all. Te investment business is about taking positions in anticipation of future events that are, by defnition, unknowable and every investor will make some good decisions and some bad decisions, some mistakes. Tere are myriad reasons for making investment mistakes, including poor quality data, faulty analysis, bad investment process and judgment error and any of these reasons (and others) can knock your investment of track and lead to losses. Te most important thing to do when you make a mistake is to forgive yourself for your errors, dont become discouraged, and certainly dont try to recoup your losses by taking bigger risks. Te ability to maintain composure and focus, to stick to your discipline, to move forward without dwelling on the past are all characteristics that separate great investors from average investors. Coach K says it best, great players always focus on the next play, while average players always focus on the last play. In one sense, great investors actually welcome mistakes because they understand that their job is to take risks, to move out beyond the comfort zone, they know that they will miss 100% of the shots they dont take and are not afraid to miss a few, in order to learn what is most efective in each new environment. Sir John also said that you must turn each mistake into a learning experience. Determine exactly what went wrong and how you can avoid the same mistake in the future. Te investor who says, Tis time is diferent, when in fact its virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing. Te title of this letter stems from those four critical words and speaks to the importance of recognizing that the investment landscape moves through a repeatable cycle of peaks and valleys and convincing oneself that somehow the next cycle will be diferent will be very costly indeed. #LearnFromMistakes
Rule No. 12 Begin With a Prayer (#HopeIsNotAnInvestmentStrategy)
Sir John shares his personal perspective that if you begin with a prayer, you can think more clearly and will make fewer mistakes. Whether it is prayer, meditation, or spending some time in solitude, anything that clears the mind will help you make more efcient and efective decisions, which is likely to lead to fewer mistakes. Similarly, Michael Steinhardt, one of the most successful investors of our time, said to always trust your intuition, which he described as being more than just a hunch, but rather resembling a hidden supercomputer in the mind that youre not even aware is there. Intuition is most available to us when we quiet the mind and any means with which we can achieve that centered state will help us be better investors. Importantly, the one thing that this statement is not referring to is the construct that we should pray for good results and hope for some divine intervention in our investments. As I have been known to say on occasion, hope is not an investment strategy, it is, rather, a
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four-letter word. #QuiettheMind
Rule No. 13 Outperforming the Market is a Difcult Task (#HoneYourEdge)
Te market, or rather the indexes that approximate the market, have a number of advantages over even the best investors: 1) they pay no transactions costs, 2) they have no expenses related to research and 3) they are always fully invested as they do not have to keep cash available to pay out to redeeming investors. Sir John contends that the ability to consistently outperform the market is a tremendously difcult task given the inherent advantages of the benchmarks and further that any investment company that consistently outperforms the market is actually doing a much better job than you might think. And if it not only consistently outperforms the market, but does so by a signifcant degree, it is doing a superb job. Given the huge amount of resources that are dedicated across the investment management industry in the attempt to outperform the market, it is a little surprising that there are not more frms that have a consistent edge. Terefore, when you fnd an individual, or frm, with real Edge, the ability to generate Alpha above the market, you should make them a cornerstone of your portfolio. One thing we know about Alpha is that it is a zero sum game and for every winner (returns above the average), there must be, by defnition, a loser (returns below the average). Tere are also some that say that there is a huge degree of luck involved with investment success. In fact, Michael Mauboussian wrote a fascinating book on this subject recently, Te Success Equation: Untangling Skill and Luck in Business, Sports and Investing. Michael is a great writer, and the book makes a lot of great points, but I still side with Tomas Jeferson on this particular point when he said, I am a great believer in luck, and I fnd the harder I work, the more I have of it. #DoTeWork
Rule No. 14 An Investor Who Has All the Answers Doesnt Even Understand All the Questions (#KnowWhatYouDontKnow)
In a famous press conference many years ago, then Secretary of State, Henry Kissinger, asked the group of reporters assembled do you have questions for my answers? In investing, Sir John points out that, a cocksure approach to investing will lead, probably sooner than later, to disappointment if not outright disaster. Te problem we face is that even if we have the discipline to stick to small set of unchanging investment principles, we do not have the luxury of applying those principles to an unchanging investment environment. Tere are changes to government policies, both fscal and monetary, changes to the regulatory environment, changes to the liquidity of the markets, changes to the makeup of the investors in the markets and myriad other changes that we must adapt to in real time in order to be successful as investors. Markets, he says, are in a constant state of change, and the wise investor recognizes that success is a process of continually seeking answers to new questions. Maintaining a rigid approach to the markets is a sure way to lose money over time and stubbornness and arrogance are character traits that will mete out disproportionately high penalties to those investors who believe, incorrectly, that they are right, despite direct evidence to the contrary in the form of investment losses. As Mark Twain was fond of saying, it's not what we dont know that hurts us, it's what we know for sure, that just aint so. To this point, when I was in college I noticed a phenomenon that is similar to Sir Johns perspective. When I would take an exam, how I felt right afer taking the test was inversely proportional to my ultimate results. If I felt like I did poorly, I ofen did surprisingly well, as I understood the material and the exam questions while maintaining a healthy respect for what I might not know. On the fip side, when I believed I aced the test, I ofen ended up having done poorly as it turned out that I didnt even know what I didnt know and didnt maintain that degree of respect for understanding the questions. Investing is about the future and hence one cannot possibly have all the answers, but we can continually strive to keep asking the right questions, which is what distinguishes the great
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investors from the rest. One of the best examples of this point is refected on the Forbes cover (and elsewhere in this letter) that those who want to invest where the outlook is good are clearly asking the wrong question and have little hope of outperforming the market and they would be better to go. #WhereIsItMostMiserable
Rule No. 15 Teres No Free Lunch (#GetWhatYouPayFor)
If investing was simple, then everyone would be wealthy and there would be no need for professional managers or advisors and there would be no need for following a disciplined, repeatable, process. In that world, we could simply buy companies that make the things we know and like and follow tips from friends and colleagues without doing our own work. Sir John would admonish that both of these things need a Never in front of them. First, he says to never invest on Sentiment. Te company that gave you your frst job, or built your frst car, or sponsored a favorite television show may be a fne company. But that doesnt mean its stock is a fne investment. Even if the corporation is truly excellent, prices of its shares may be too high. Remember the words of Howard Marks here that there is no investment good enough that cant be made unattractive by paying too much. Second, he says to never invest solely on a tip. You would be surprised how many investors, people who are well educated and successful, do exactly this. Unfortunately, there is something psychologically compelling about a tip. Its very nature suggests inside information, a way to turn a fast proft. When something sounds too good to be true, it always is, and something important to always keep in mind is that if the opportunity was so great, why is that person sharing it with you? An investor should always consider the source of any investment idea, but the level of scrutiny that should be applied to a tip, something usually ofered for free, should be extremely high, as the saying you get what you pay for clearly applies here. #NoTips
Rule No. 16 Do Not Be Fearful or Negative Too Ofen (#BeOptimistic)
Te fnal Rule is very simple, but critically important for long-term investors, Sir John implores do not be fearful or negative too ofen, for 100 years optimists have carried the day in U.S. stocks. Tere will be times when a cautious stance will be warranted, even necessary, to preserve capital and put yourself in position to fght another day, but, on average, equities rise the majority of the time and it doesnt pay to be fearful of, or negative on, the markets for extended periods of time. Even in the darkest times for the averages, there will be opportunities and a fexible approach (see Rule No. 3) will enable an investor to proft from other asset classes, sectors or geographies. Sir John also reminds us that there will, of course, be corrections, perhaps even crashes, but, over time, our studies indicate stocks do go up and up and up. Importantly, part of this continuous ascent is money illusion, or the efect of infation increasing the nominal value of everything, which naturally fows into equity values. However, there is additional real growth that comes from innovation and the creation of new wealth from secular forces such as globalization, urbanization and demographic growth. Healthy skepticism about valuations when assets seem to have moved beyond levels supported by their fundamentals is critical, but excess negativity will prompt inaction and will result in too many missed opportunities over time. Interestingly, when Sir John wrote this treatise in 1993 he made a fnal comment that seemingly could have been written today despite all the current gloom about the economy, and about the future, more people will have more money than ever before in history. And much of it will be invested in stocks. And throughout this wonderful time, the basic rules of building wealth by investing in stocks will hold true. In this century or the next its still buy low, sell high. We agree wholeheartedly with these sentiments on a global basis and see tremendous opportunities in many areas, which we will cover in the Market Outlook section below. Tat said, we also believe that there is growing evidence that the U.S. economy, and markets, are heading toward another cyclical peak and we should heed Sir Johns most famous
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words, now updated for the Twittersphere, that it is #NotDiferentTisTime.
While Sir John is right that we should not be fearful, or negative, too ofen, at the appropriate time it makes good economic sense to be cautious when the weight of the evidence warrants such caution. It is always challenging to get the timing right on precisely when to be cautious, and two important quotes apply here, you cant predict, you can prepare, from Howard Marks, and preparedness averts perils, from the Chinese idiom yu bi w hun. Over the next few paragraphs we will review the mounting evidence that perhaps now is one of those times to be a little fearful and begin to prepare for a diferent investment environment than we have experienced over the past fve years. I have talked about a core Investment Rule that I have followed over the course of my career that if I hear something once, I remember it, if I hear it twice, I write it down, and if I hear it three times, I do something about it. Last quarter I discussed how in looking at the positioning of three great investors (Julian Robertson, George Soros and Seth Klarman), they all said that they were close to neutral or net short in their portfolios, or had substantial cash positions, and I wrote hear it thrice. Maybe they do ring a bell at the top. Maybe these guys are Early (Julian, like Bufet, began de-risking in 2007 and many questioned both of them then) but I am going with my Rule and we will begin to lower exposure in our Funds at the margin. We did modestly lower exposure in the Funds, however, Q2 turned out not to be the period when playing defense was rewarded, so on the margin we could have done a little better had we stayed more net long. As we have said, the timing of these transitions is very difcult (Julian and Warren were a year early in 2007), but as we mentioned last quarter, the magnitude, and more importantly, the speed of the correction when this type of event occurs, means it is far better to be early than late. We wrote that the average Recession related Bear Market correction in the U.S. has been (38.6%), so when valuations fnally reach the extreme and the earnings prospects for companies become impaired by a slowing economy, the adjustment, like a collapsing sand pile, is swif and meaningful. Te best plan of action, like when dealing with alligators, is to be far away from the pile when things begin to go wrong. Remember how the math works here. If you started with a dollar and went to cash now and the bear market does come, you still have the dollar. If you stay for the last 15% upside (Jeremy Grantham now saying the Bubble will peak at 2250) and then get caught in the downdraf, you end up with 71 cents (1.15 x 0.614). Te other problem is that it is human nature that once a belief is formed (and worse, once we have committed capital to an idea, or theme) we tend to reject all evidence that is contrary to our belief when it would clearly be better to use that information to help us avoid negative outcomes. So lets review the evidence and see if it really is diferent this time.
We have written in past letters about evidence that suggested that there was a natural seven-year cycle in the markets where excesses that had built up were corrected. We have seen this cycle play out over the decades in three-year periods around 1973, 1980, 1987, 1994, 2001 and 2008 with each exhibiting similar boom/bust outcomes. Looking at a great deal of various data series, it appears that this cyclical pattern is repeating with 2014 looking eerily similar to 2000 and 2007 (with some similarities to earlier periods as well, but looking back two dec- ades is a good amount of sand through the hourglass). We will start with the big picture data on the economy and work our way down to the equity market and funds. If we just look at GDP in isolation, the recent negative (2.1%) reading for Q1 is the lowest reading (by far) since 2008 and has actually only been exceeded in the past few decades in the depths of meaningful Recessions like 1975, 1981, 1983, 1991 and 2008. Many want to say that it was all weather related, but we have had plenty of cold winters in the U.S. over the years (by my recollection, my frst winter in Chicago in 1985 seemingly made the Polar Vortex seem a like a little tempest in a teacup) and GDP held up just fne, so perhaps there was more to the setback than just a deep freeze. Te frst estimate of the Q2 reading just came in at 4% (with a big inventory component that will likely be revised lower) and given that the bounce was not as big as expected (the collection of those supposedly deferred sales was not huge) it has been interesting to
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hear the narrative on where the Recovery (Math: -2 & +4 needs a pair of 5s to get to the Fed 3% estimate for the year no chance). If we take a peek at the Bufett Ratio (reportedly his favorite indicator of value in the markets), the Market Cap of the S&P 500 over the GDP, we see that today's 125 reading is now uncomfortably above the 120 reading from 2007 and beginning to approach the crazy reading of 153 from 2000. Tere are some who want to make adjustments for the globalization of U.S. companies as they get a larger percentage of their revenues from overseas, which could have some merit, but the adjustment would be modest and the primary point that we are right on cycle remains. Looking at Tobins Q (created by Nobel Laureate James Tobin of Yale), the ratio of the actual value of the assets of the companies in the market over their replacement value, we have only been higher in 2000 and 1968 (the Nify 50 bubble, 7 years prior to 1975). If we transition over to equity markets and valuations, we see the same patterns. Looking at the most simplistic valuation indicator, the current level of the markets as a percentage above (or below) the running regression of the long-term growth trend, we see that the current value of 84% (above the trend line) has only been exceeded twice in over 100 years, 88% in 2007 and 149% in 2000 (we just exceeded the 81% level in 1929). Clearly there is a lot of room between 84% and 149%, so some might argue this trend can continue for a while longer. On the fip side, if the valuation were to return to the trend line, the S&P 500 would fall to 1050 (from 1930 today) and if it were to correct down to the level at the end of historical Bear Markets, it would fall all the way to 500. Looking at traditional P/E ratios and, more importantly, the Shiller P/E ratio (which adjusts the E for the trailing ten year average), we see similar data and todays value of 26.2 is in the 98 th percentile all time and has only been exceeded (wait for it) in 2000 and 1929.
Turning our attention to investor behavior, we see additional evidence of the same trends, the same seven-year cycle and the same levels of extreme optimism and confdence. Tere are a number of ways to measure investor confdence (as a group) and we can look at a handful of the most ofen discussed indicators here. Te American Association of Individual Investors allocation to equities (as a percentage of their total assets) is the highest it has been since 2007 and was only surpassed in 2000. Similarly, their allocation to cash is the lowest it has been since the Tech Bubble in 2000. Te Investors Intelligence survey of Bulls and Bears has the second lowest reading of Bears in history at 23%, it was only lower in summer of 2000, and the percentage of Bulls has reached a level that it has only seen once in its history at 62%, the last time, of course, October 2007. Another indicator of investor confdence (or perhaps Financial Repression has worked and the Fed has forced everyone out of cash) is the ratio of Money Market assets to total mutual fund assets, which has reached a low level only seen twice before in 2001 and 2007. Te investment professionals running the mutual funds are equally bullish as the cash levels in mutual funds has only been lower in two months, January 2000 and April 2007, in both cases about six months before the eventual market top. Te most ofen talked about indicator of fnancial excess is the about of margin debt outstanding and there is some very interesting data that emerges from close inspection. Te frst abnormal peak in margin debt occurred in March of 2000, which was followed by a market top in August of 2000 and a Recession in March of 2001. Te next peak in margin debt occurred in July 2007, which was followed by a market top in October of 2007 and a Recession in December of 2007. Te most recent peak in margin debt occurred in February and we are now waiting to see if the market top and Recession follow a similar pattern.
If we examine corporate behavior, we also see the same seven-year trends and exaggerated behavior that would make the case for another cyclical wave getting ready to crest. Given the artifcially low interest rate environment, companies have been issuing record amounts of debt (high yield issuance is at an all-time high) and using much of those proceeds (in many instances) to buy back stock. One might ask the logical question of why are they buying their stock today afer a trebling of the S&P 500 over the past fve years (i.e., why didnt they buy when prices were 60% cheaper?), but they are indeed buying near record amounts of stock. Te trouble with that level of activity is
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the last time we saw this level of activity (when they actually set the record) in buybacks was in October of 2007. Today, interestingly, the same number, 380 of the 500 S&P companies, are doing buybacks and the $160B level hit in June was getting close to the record $180B from 2007. Te other activity at the corporate level is occurring in the deal-making arena with the rapid acceleration of corporate M&A. Tere has been an explosion in mergers and acquisitions activity in 2014 as total deal volume has eclipsed $1 Trillion for only the second time in history. Yes, the frst time was in 2007 with $1.1T and we will clearly surpass the record this year. When we look out beyond the U.S., global deal volume is $2.1T, again second only to 2007, and the U.S. proportion of total deals has reached 48%, the highest level since 1999. One other interesting data point is that deals completed by Financial Sponsors (LBOs) has never been higher and with nearly $200B spent across 536 deals which is a 91% increase over 2013. Perhaps the only time we have witnessed more froth in the M&A market was when AOL purchased Time Warner for an all-time record $164B in January 2000. Tat purchase price ultimately valued AOL stock at $226B. Now, for the rest of the story Te combined frm had to take a write-of of $99B (yes, you read that right) two years later and afer a contentious nine-year relationship Time Warner regained control and spun out AOL for $20B in 2009. Today, the market cap of AOL is $3B, for a cumulative loss of (98.7%). Perhaps in what may (or may not) turn out to be another signature moment for M&A in 2014 (coincidently at the same time as the peak in margin debt), Facebooks recent purchase of WhatsApp for $19.1B prompts comparisons to some of the 2000s era deals given the nearly invisible revenues and earnings and the talk of future revenue per registered user elicits memories of eyeballs and page views that never did materialize the way the spreadsheet forecasts predicted. Finally, the rapid increase in IPOs in 2014 has, again, prompted comparisons to 2000, as we have not seen this level of IPO activity since that vintage. More worrisome than the increase in IPO volume is the quality of those companies going public as the percentage of money-losing companies going public matches the levels during the Tech Bubble. All of this selling by corporate insiders (LBOs, VCs and management teams) has prompted me to include another hashtag in a number of Tweets, #InsidersDontSellAtBottoms (their decision to sell begs the question of why are the people with the most knowledge of the business so anxious to sell).
So there we have it, a compendium of source data that paints a picture of a very cyclical pattern of economic activity, investor and corporate behavior following a stable seven-year pattern. Sir John would have us examine the mistakes we made in 2000 and 2007 to not take money of the table, to not follow outstanding investors like Robertson, Bufett and Klarman in preparing their portfolios for the cyclical shif, for not taking the information content of individual investors pouring in (buying what they wish they would have bought) and insiders selling through IPOs and M&A (happily fulflling the excess demand created by the individuals by creating new supply), and to ask ourselves why is it diferent this time? He has told us that those are the most dangerous, and most costly, words in investing and we would be wise to heed his advice to systematically and proactively examine all the evidence on the current environment to make sure we dont make the same mistake again this time. Tere are many who say that it truly is diferent this time because of the commitment of Central Banks to QE and that the excess liquidity and low interest rates have changed the rules of the game. We remain skeptical of that conclusion, not only because QE will go away in the U.S. in October (interesting timing given the history of volatility in that month), but, mostly, because debt does not equal wealth. If it was as simple as printing money to create wealth then everyone would do it and all the paper would get simultaneously devalued (oh wait, that is exactly what is happening, #CurrencyWars).
We wrote last quarter that markets are cyclical and tend to follow natural patterns over time. Our job is to be ever vigilant in adjusting portfolios to capitalize on the opportunities in each environment. Te cycles have shrunk over the decades and the complexity has been increased due to higher levels of central bank intervention, but the keys to
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success remain Discipline, a fundamentally sound investment Process and a Tactical implementation that capitalizes on the MCCM network and takes advantage of the collective experience of the team and those words seem to take on an even greater sense of urgency ninety days later as we look at the mounting evidence of another cyclical peak. Could a series of events unfold that pushes the timing of the cycle out beyond the historical seven years? Clearly that is a possibility and there does appear to be a cabal of central bankers trying to do just that through negative interest rates in Europe, Abenomics stimulus in Japan and chatter about new programs (like equity or REIT purchases) at the Fed. Tere are also many market participants who desperately want to believe that this time its diferent as they need to make 7% to 8% returns to meet their future liabilities and the 0-3-5 Conundrum (expected future real returns from this point for cash, bonds and stocks) is very inconvenient, so they are twisting Rule No. 12 and praying for an outcome that is not supported by the math. #HopeIsNotAnInvestmentStrategy and just because you need a particular return doesnt mean that the markets must oblige. To achieve those types of returns will require a very diferent approach going forward, one that is more opportunistic, capitalizes on both the long and short side of the traditional markets and captures the illiquidity premium from private investments. #WeCantPredictWeCanPrepare clearly applies as we cannot be certain of the timing of when the current cycle will end but we do know that it will end. As we said last quarter, #GravityBites. We also quoted Seth Klarman who said that when the cycle does end (as all cycles eventually do), Few will be ready. Few will be prepared, so we can end this section with one last hashtag and channel the Boy Scouts, we can #BePrepared.
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Second Quarter Review
In thinking about the results of Q2, it makes sense to repeat some of the commentary from our last letter on Te Kindleberger Cycle to provide some perspective on where we believe that we are in the Cycle and why the continual repetition of this Cycle over time is the basis for our view that it is #NotDiferentTisTime. As we described, the process follows a readily observable pattern, Insiders begin selling, as they believe valuations have become too high. Tat selling pressure (and ultimately some external event) triggers the frst stage, Crisis where prices begin to fall, slowly at frst, and then more rapidly, ultimately ending in a cathartic wave of Revulsion in the second stage, where the Masses sell. Te cycle then enters the third stage, Displacement, where there is a period of digestion and then meaningful restructuring which triggers the Insiders to begin buying again. As prices begin to rise, a new Narrative is created to explain why this period will be the New Normal (think Personal Computing, Internet Technology or U.S. Energy Renaissance) and we enter the fourth stage, the Boom where there is a period of robust growth, strong equity returns and participants cease to recall the events of the last Crisis. As the Masses follow the Insiders and everyone begins to buy again, we reach stage fve, Euphoria where the excess liquidity and risk seeking behavior of investors pushes prices to extremes again, which prompts the Insiders to sell and the Cycle repeats. We noted that we believed that we had entered the Euphoria stage in Q1 as valuations in some sectors (Biotech, Cloud, Internet) of the market had reached ebullient levels and we expected to see the beginnings of the selling cycle. Almost on cue, there was a huge surge in capital markets activity, the Insiders started selling in waves, as IPOs, secondary issues, convertible bond issues and M&A transactions began to spike. Concurrently, we began to see some small cracks in the host highly valued names and downside volatility spiked in Biotech, Internet Technology and Cloud causing some acute pain in the early part of the quarter. Interestingly, the #BuyTeDip crowd came to the rescue and as earnings numbers came in a little better than lowered expectations, global equity markets actually performed quite well during the period. An important point is that this strong performance only accelerated the pace of Insiders Selling and (we believe) moved us closer to the beginning of the next leg down in Te Kindleberger Cycle. Two points here are worth noting: 1) the number of money losing companies issuing IPOs was only higher in the Tech Bubble in 2000, and 2) in the most recent month, there was a huge surge in IPO activity (to rival 2000 and 2007) and, worryingly, the majority of them closed below their ofering prices. Pinpointing precisely where we are in the Cycle is difcult, but it does appear that a number of factors are lining up that may make that determination easier in the coming months. So lets move on to the core of this section of the letter, providing an analysis of the events that occurred in the capital markets during the quarter and providing some commentary on how our views on opportunities in the various market segments played out during the period.
Global equities reverted back to their winning ways (albeit Central Bank liquidity induced) in Q2, with the S&P 500 jumping 5.2%, EAFE rising 4.1% and EM surging 6.6%. We wrote last quarter that at the crescendo of the January sell-of, it was right as things were beginning to accelerate downwards when Ben and Janet did their best Sonny and Cher impersonation singing I Got You Babe during Bens swansong meeting and reminded investors that they had their back with the new, and improved, Yellen Put. Te markets were soothed by the sounds of our Economic Pied Pipers and Risk-On was back in vogue. Q2 started very similarly to Q1 and during the frst ten days of April the S&P 500 was down (4%), and many high beta names were down well into the double digits, so it was clear that Ms. Yellen had to break out the sequin gown and long wig and croon another verse of I Got You Babe. Tose melodious words were all the markets needed to hear to resume their inexorable march upwards. From the trough, the S&P 500 was up a robust 8% while the NASDAQ
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 1 8 Second Quarter 2014 was up nearly 11%, heady stuf given the multiple negative surprises on U.S. GDP (Q1 was revised down twice to a stunning (2.9%) decline vs. expectations of a 1.5% increase) and the disappointing EPS growth. Unsurprisingly, that is, unsurprising afer so many quarters of multiple expansion driving equity returns, the bulk of the market advance came from a rise in the P/E ratio, which now stands at levels we have not seen since the Tech Bubble in 2000 (the forward P/E of the S&P is now 16.4). We have noted in previous letters that even though the valuation levels of the U.S. Equity market are around 2 standard deviations above normal, that there was nothing prohibiting them from rising further to 2.5 (or even 3), but that eventually there would be mean reversion (Jeremy Grantham calls mean reversion one of the most reliable forces in the Universe alongside gravity). One thing to always keep in mind is that any data series must spend as much time below the average as above the average (that is a simple mathematical identity) and the sum of the area above the curve must equal the sum of the area below the curve (another identity). In other words, the higher the rise, the bigger the fall. Te Fed, and other Central Banks, may be able to delay the inevitable adjustment through the provision of excess liquidity, but at some point the easing will stop and valuations will adjust. In essence, stimulus simply pulls forward future returns in the same way that debt pulls forward future consumption (I borrow today to buy something I cant aford, but later I must service/pay back the debt instead of buying something else).
Diving deeper into the individual market performances for Q2, we see some interesting developments related to trends that we commented on last quarter. First, in the U.S. equity market, the liquidity driven equity ramp continues, as the S&P 500 has not come close to touching (let alone breaking through) the 200-day moving average since November of 2012. Second, we wrote that an interesting development that will likely be talked a lot in the next quarterly letter is the rotation from Growth toward Value by investors in the U.S. equity market, but little did we know that the rotation would be extremely short lived as the animal spirits sparked by Janets crooning would push investors back toward growth (as if the dramatic drop in March/April never occurred). To that end, the R3000 Growth and Value indices had identical 4.9% returns for the quarter despite the Value index having a huge 400 basis point lead afer the April sell of in growth stocks. Looking a little more closely at the sector components, small-caps continued to lag (they trailed large-caps in Q1 for the frst time in a long time), rising only 2.1% and micro-caps actually had negative returns during the quarter, falling (1.4%). Given the very high valuations of the small-cap sector, where the P/E was rapidly approaching triple digits, the recent weakness bears careful monitoring as a potential canary in the coal mine. Te small caps have been the leaders in the U.S. equity market for a number of years, serving as the head of the liquidity fed, momentum monster since the turn in 2009. But, as my high school wrestling coach used to say, where the head goes, the body follows so if the head of the market continues downward, we could see a rapid shif in momentum in the quarters ahead.
Two other aspects of the U.S. equity markets we commented on last quarter were the opportunities on the short side and the prospects for the markets given the continued tailwind of QE. We wrote as we enter the second quarter of 2014, that negative momentum is accelerating in the most over-valued segments of the market and the return opportunities on the short side have been nearly as attractive as they were in 2000 and shorting names in biotech, social media and cloud was a tremendous source of returns for managers in April and the frst part of May. Te ETFs for these sectors, IBB, SOCL and SKYY fell (10%), (20%) and (10%) respectively in the frst half of the quarter, but then made a dramatic reversal in mid-May, surging for the balance of the quarter back into positive territory and then falling again in recent weeks to end fat over the past three months. With respect to the overall market, we also wrote that we continue to believe that there is modest downside risk
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 1 9 Second Quarter 2014 to the U.S. equity market as a whole and that a loss similar to the (9%) drop in 2000 is possible. Tat said, there are some arguments against this outcome, namely that bull markets rarely end with a steep yield curve (no sign of short rate increases until at least 2015) and historically every $100 billion of QE has translated into 40 S&P 500 points (calculated by Larry Jeddeloh at TIS), so with around $600 billion scheduled for 2014, that would translate into 240 points up upside to 2090, or a gain of 13%. Interestingly, while the S&P 500 was behind schedule afer Q1 by that calculation, the strong returns of Q2 put the index almost exactly in line with this prospective outcome at 1960, up 110 points and 6% (plus 1% of dividends yields the 7.1% YTD total return) for the frst half. Tere are a number of other methodologies for forecasting returns for the year related to earnings growth and anticipated changes in valuations relative to interest rates (mostly pointing to low single digit returns), but Larrys Law of 40 points per $100B has been the best predictor of the S&P since 2009. Te efcacy of this relationship does beg an important question, what happens to the market when QE ends in October? Stan Druckenmiller has a simple answer that he shared on Bloomberg TV last November, the market will go down, but we will have to see what the next two quarters bring.
Generally speaking, international equity markets were quite strong in the second quarter as the trends from Q1 reversed. Japan had an outstanding quarter as we highlighted was likely in our Around the World with Yusko Webinar, Te Abe-san Also Rises: Te Continuing case for Japan (for a copy of the materials from the webinar, please email IR@morgancreekcap.com). Investors shook of the difcult performance of Q1 and focused on the rapidly escalating profts from Japan Inc. and the MSCI Japan Index surged 6.7%. Japanese small-caps fared even better as the Mothers Index jumped an incredible 17.6% during the period. Even more astonishing is that the return was made up of a (17%) decline in the frst half of the quarter followed by a 42% surge of the bottom in mid-May. Even without additional monetary stimulus from the BOJ, and without any further depreciation of the Yen, investors are beginning to understand the incredible earnings power of the top companies in Japan and the growth opportunities as they capitalize on supplying goods and services to support the dynamic growth in consumption in Asia and Africa. European performance was also the reverse of Q1 as the Core was strong and the Periphery weak (with the exception of Spain which surged another 7.2%). In the Core, stalwarts Germany and France were modestly higher, up 1.7% each, while the UK and Belgium were the standouts in Q2, up 6.1% and 5.1% respectively. Te GIIPS had a rough quarter (afer their stunning results in Q1 where Greece was up18.1%, Italy was up 14.6%, Ireland was up14%, Portugal was up 9.7%, Spain was up 4.8%) as the GIIP countries fell (10.8%), (9.0%), (0.1%) and (2.6%) and only Spain managed to continue its winning ways as noted above. We just updated our thesis on the GIIPS last week in our Around the World with Yusko Webinar, Peripheral Europe: When PIIGS Fly (again, if you would like a copy of the materials from the webinar, please email IR@morgancreekcap.com) and we continue to see signifcantly more upside in Peripheral countries vs. the Core countries given their superior valuations. Te European Recovery continues apace (and actually appears to be gaining some momentum) as the ECB has begun to expand their balance sheet again and has cut interest rates to below zero to stimulate lending. We noted last quarter how Q1 was a very good one for the GIIPS banks. However, Q2 was a very diferent story, as Alpha Bank and Piraeus Bank in Greece shed (5%) and (18%) respectively, Bank of Ireland plummeted (30%), (mirror image of its Q1 gain) and Bankia in Spain fell (8%), essentially giving back all their gains for 2014. Concerns about the upcoming Stress Test and some recent troubles with a bank holding company in Portugal created selling pressure across the fnancial services sector. Curiously, the data on the European recovery continues to gain momentum, so we would expect to see continued strong performance from cyclical and fnancial
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 0 Second Quarter 2014 services frms in the GIIPS region.
Perhaps the most surprising move in Q2 was the acceleration of the momentum in Emerging Markets, particularly given the universal gloom & doom forecasts at the beginning of the year by market prognosticators everywhere. Coming into 2014, there was near unanimity in the belief that the Fed Taper would crush growth, and hence profts and stock prices, in EM, with some pundits proclaiming that the EM run was over and the next decade belonged to the Developed Markets (despite the presence of the Killer Ds of poor Demographics, huge Debt burdens and Defationary threats). We wrote in the last letter that all of this was a reminder of another Soros quote that the worse a situation becomes, the less it takes to turn it around and the greater the upside that we felt applied to these markets as they had all taken steps to prepare for a non-QE world (hiring new Central Bank heads, raising interest rates or instituting more fscal discipline) and we thought that they were very attractively priced afer the corrections. Apparently, global investors got the memo and the MSCI EM Index outperformed all the Developed Markets indices, rising 6.6%. Digging a little deeper, there was some truly outstanding performance in various regions and individual countries. Te BRICs all surged with returns of 7.5%, 10.7%, 12.7% and 5.5%, respectively, as positive developments such as settling of the Ukraine/Russia tension and the huge election result in India (the pro-business BJP party gaining a supermajority for new PM Modi) pushed those markets to double-digit gains. We commented in April that we will talk more about the Russian situation in the Market Outlook section as the events unfolding there seem to be creating a compelling opportunity to buy assets at prices that will look like fantastic bargains in a few years and global investors again agreed that despite the turmoil, the assets were too cheap to pass up. China posted a solid quarter afer many quarters of sub-par performance as some economic data surprised to the upside and rumors of PBOC easing drew capital back into the market. We commented last quarter that one interesting development to watch is whether the SOEs in China can enhance their governance policies and unlock value for shareholders and there could be an interesting opportunity to mine the listed SOEs for un -lockable value in some of the largest commercial enterprises in the world that are the owners of some really spectacular assets. Interestingly, and while one quarter does not a trend make, there was some very strong performance in PetroChina, CNOOC and China Minsheng bank that rose 15%, 18% and 10%, respectively. Tat said, we continue to believe that New China (Internet, Retail, Consumer, Healthcare and Clean Energy) will be the very best place to fnd growth opportunities and extract superior returns and Q2 saw our favorite name in this theme, Vipshop, continue to surge on rising revenues and profts, jumping another 25%, taking the total return to an amazing 145% CYTD and an astounding 550% since we began talking about VIPS a year ago.
Q2 also turned out quite positively for the Not So Fragile Five as Brazil, India, Indonesia, South Africa and Turkey surged 7.5%, 12.7%, 0.4%, 4.5% and 15.1%, respectively, to bring CYTD gains to surprising levels of 10.5%, 21.9%, 21.7%, 9.5% and 20.6%, respectively. Tere were, again, no prognosticators predicting that these countries would produce outstanding returns for investors coming into 2014 and, in fact, January was a very difcult period as these markets returned (10.6%), (3.8%), 4.3%, (10.0%) and (13.3%), respectively (which makes the big CYTD returns even more impressive). We actually discussed in a previous letter a concept called the Templeton Misery Index (I tweeted about this in January as well) coming into the year based on the idea that Sir John was right in saying that People are always asking me where is the outlook good, but thats the wrong question. Te right question is: Where is the outlook the most miserable? History has shown that it is where there is Maximum Pessimism that Bull Markets begin and great long-term returns can be found. Te Fragile Five were all quite miserable on the TMI scale in January as were countries like Tailand, Taiwan and the Philippines, which have also
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 1 Second Quarter 2014 generated strong returns, up 15.6%, 11.5% and 19.9% CYTD. Sir John said Bull Markets are born on Pessimism, grow on Skepticism and there is still plenty of skepticism on EM, so we should expect to see continued solid returns in the quarters ahead (albeit with some material volatility). Another one of our favorite areas over the past year has been the Frontier Markets (for a full presentation on the case for Frontier Markets from a recent Webinar contact IR@morgancreekcap.com), which continued their surge, rising a robust 11.9% (and a huge 20.2% for the CYTD), well ahead of all the other global equity markets. Te MSCI Index number masks the historical variability across these markets (which is why we focus on allocating to great country/stock pickers), but Q2 was pretty strong across the board with countries like Argentina surging 18.6%, Nigeria & Ukraine recouping all their Q1 losses, rising 17% and 26.4%, respectively, and Pakistan rising another 8.5% on top of similar gains in Q1. We continue to focus on the signifcant tailwinds related to Demographics, Growth and Low Debt that will drive these market returns higher for many years to come. An area we highlighted last quarter was the opportunity in the GCC countries as they continue to beneft from young, growing populations, current account surpluses and tremendous wealth generation capacity as they covert their petro-dollars into commercial and consumer enterprises, and while these markets took a breather in Q2, markets in Saudi Arabia, UAE and Qatar are up 11.5%, 15.2% and 14.5%, respectively, for the year.
Contrary to 100% of the economists surveyed by Bloomberg (67 out of 67 predicted rising rates) to begin the year, global interest rates did not rise and global fxed income markets generated solid returns in Q2. Interest rates continued their inexorable decline as signs of Defation began to rear their ugly head (so much so in Europe as to prompt Super Mario to push interest rates below zero) and global GDP growth continued to fall short of expectations (with the most stunning development being the negative (2.9) print in the U.S.). For the quarter the Barclays Aggregate Index rose 2%, the JPMorgan Global Bond Index jumped even more, rising 2.8% as unexpected Dollar weakness helped domestic investors, the ML HY Index posted another solid quarter, up 2.6% and the rebound in EM Debt accelerated as the JPMorgan Index surged 4.6%. While all of these returns were solid, the biggest surprise in the bond markets in 2014 continues to be long Treasuries, which surged another 4.7% and now stand well ahead of equities for the CYTD, up a stunning 12.0%. We wrote in the Q4 letter so while we continue to believe that traditional fxed income will generate negative returns for the next fve years (or more), there could be a short-term opportunity to hide in long Treasuries if the markets get queasy from QE withdrawal in 2014. Tis Variant Perception was beyond contrarian as it was in direct contrast to all of the pundits and market observers who were certain that rates had to rise. Our view was based simply on the observation that every time the Fed had withdrawn stimulus in the past few years, rates had actually fallen (not risen as everyone predicted) and that there was a predictable trend in bond yields that created an opportunity to proft from the Fed signaling that they are going to stop buying bonds at some point in 2014. While we did add some exposure to long bonds in our tactical allocations, we clearly should have made a much larger allocation given the historical pattern of returns during previous QE cycles. Te good news on this front is that the Source on this trade, Van Hoisington, spoke at our iCIO Event in May and reiterated his view that Long Bonds continue to be undervalued and that the negative surprise in Q1 GDP nearly guarantees lower interest rates since long rates should approximate Nominal GDP which will struggle to make 2% for 2014. Given that prospective outlook for growth and rates, we will continue recommend that investors divest from traditional, low duration, fxed income as investors are nearly guaranteed a dismal real return over the next decade. While it is possible that we will follow the Japanese path and we will have another decade of declining interest rates that will drive bond yields lower (and returns modestly higher), but low duration fxed
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 2 Second Quarter 2014 income is a terrible risk/reward even in that scenario as the opportunity cost relative to strategies like direct lending, distressed debt, EM bonds and other hybrid approaches (converts & preferreds) is simply too high to justify holding traditional bonds.
One of the most stunning developments in Q2 was the acceleration of the return to yield assets, REITs and MLPs. We wrote last quarter that these assets might enjoy a tailwind, but we had no idea that it would turn into a gale force wind driving REITs up another 7% (on top of the 9.9% in Q1) and MLPs up an amazing 14.2% to push these two assets classes to eye-popping returns of 17.6% and 16.3% for the CYTD. Te magnitude of this move caught us completely of guard as we expected some pause that refreshes afer such a strong run in Q1 for REITs and Q4 for MLPs. While we did write in the Q4 letter (and repeated it last quarter as well) that one scenario that could play out is that the Lower for Longer crew, led now by QEeen Janet Yellen, actually creates some new twist for QEternity (like buying stocks or REITs) that drives rates so low the Dollar replaces the Yen as the Carry Trade currency of choice, we concluded (incorrectly) that Janets lack of any announcement to replace QE, coupled with the incessant calls for rising rates by all the commentators, would deter further capital fows into these assets, which made us unduly cautious on the near term prospects for the yield trade. Clearly the average investor was unfazed by the threat of higher rates and was simply desperate to escape the penalty of Financial Repression, which has pushed yields to zero in traditional savings vehicles. While this was a meaningful missed opportunity, and we should have done a better job recognizing the shif in momentum in these sectors as interest rates continued to fall, we have beneftted from exposure to energy and other real assets in other segments of our portfolios.
Performance in hedge funds has been mixed, with some of the Event Driven strategies producing solid returns, while the Macro/CTA strategies continue to struggle and Equity Long/Short falls somewhere in between. As we observed last quarter, the average returns do mask some very strong performance from Activist Funds and a few specialty funds in Healthcare and China, but overall it was a tough relative quarter for hedge funds overall afer making up some ground in Q1. In the ZIRP (Zero Interest Rate Policy) world, the ability to generate signifcant returns in arbitrage and relative value strategies has been challenging and the artifcially low rate environment looks likely to be in place until at least 2015 (we will take the over on that timeframe as well). Looking at the indices, the HFRX Absolute Return Index was up 0.5%, the HFRX Event Driven Index was up 1.6% and the HFRX Multi -Strategy Index was up 1.8% (slightly behind fxed income) and the HFRX Macro/CTA Index managed a small positive return, up 0.3% for the quarter. For the CYTD, these indices are up 1.8%, 4.4%, 3.7% and (0.7%), respectively, and while these returns are roughly in-line with traditional fxed income returns, there is still beneft to shifing from bonds toward Absolute Return strategies since they have a positive correlation to interest rates (they have foating rate elements) whereas bonds have negative correlation (rates rise, bonds lose money), so there is an added hedging beneft to holding A/R rather than fxed income in the current environment.
Equity Long/Short hedge fund strategies struggled in Q2 as the double whammy of volatility on the long side in the frst half of the quarter was concentrated more directly in the growth names held by many managers and the snapback rally during the second half of the quarter exacted losses on the short side. Te short squeezes were particularly acute in the most overvalued segments, like biotech, social media and cloud, creating an investment environment that felt (disconcertingly) a lot like dj vu all over again back to 2013. While Long/Short Funds didnt lose money, they werent able to extract the dual alpha from longs and shorts that we anticipated coming into the year. To that end, the HFR Equity Hedge Index was fat and the HFRX Equity Directional Index rose 1.7%. As we discussed last quarter, the one drawback of the HF indices is that the very best managers do not report, so
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 3 Second Quarter 2014 many investors who have exposure to those Funds will experience very diferent results. Te best performing area within Long/Short this year has been the HFRX Technology/Healthcare Index which rallied 1.4% during the quarter, 7.7% CYTD, as many specialty managers have been able to capitalize on both the long and the short side of the market volatility to generate above market returns.
Despite the big rally in commodities prices in Q1, we wrote last quarter that there continues to be a lot of negativity about commodities in the marketplace related to Chinas plans to transition from Fixed Asset Investment to Consumption and the purported end of the Commodity Super Cycle. We also said that we would continue to side with Jeremy Grantham on his point that population growth rates are outstripping our capabilities to produce commodities in sufcient volumes (and, more importantly, at reasonable prices), so we would expect there to be outstanding opportunities in the commodity space for years to come. Returns in the commodities markets were highly varied (and highly volatile) in Q2 and there was a clear demarcation between the Energy & Metals on the plus side and the Ags on the minus side. Afer a dramatic rebound from the dreadful performance in 2013 in sof commodities in Q1, the bears were out again in the Ag space in Q2, as grain prices collapsed (giving back all their Q1 gains) and cofee slipped from its peak (but is still up a huge 54% for the year). Te pain in the grains was acute as corn fell (14.3%), wheat dropped (17.6%) and cofee slipped (3.9%), but more concerning was that the underlying tenor of the markets shifed to be quite negative during the period. We may not be at the point of maximum pessimism yet, but we are probably closing in on that level, so there could be some interesting opportunities in the upside in these markets soon. Te metals markets were also very volatile, falling for the frst two months of the quarter, before fnding a bid and surging quite nicely in June, with gold rising 1.8%, silver up 4.9% and copper up a surprising 4.6% (surprising given all the negative stories about fading China growth and demand). In nearly a mirror image of the Ags space, sentiment in the metals markets is quite strong. In fact, the underlying trends in the stocks of metals related businesses (Alcoa, Freeport-McMoRan, Southern Copper & Barrick Gold to name a few) and have begun to break out all over the place. Te gold miners deserve a little special attention here, as they have been incredibly strong (but very volatile) in 2014 (as the Year of the Alligator model predicted) with GDX and GDXJ up 12% and 17%, respectively, for Q2 and up 24% and 36% for the CYTD through this week. Te good news is that while these moves seem large, given the total decimation in the gold miners since 2011, GDX is still down (57%) and GDXJ is still down (70%) from the peak three years ago, while the S&P 500 is up 60%. Te chart of these three securities makes one of the widest Alligator Jaws we have seen in a long time so there is likely much more room to run in this emerging trend.
Overall, the frst half of 2014 has been quite volatile and very challenging for investors. Te average balanced portfolio (stocks/bonds/cash) investor is lagging again as traditional bonds have produced very little return and many investors de-risked their equity portfolios during the drawdown in April and missed the strong rally in Q2. Hedge funds have struggled to keep pace as shorts were a real drag in Q2, so investors with high allocations to alternatives are feeling wrong-footed again as well. Tere were very few investors (actually none that we are aware of, unfortunately including us) that put together an #AlligatorPortfolio (would have been heavy in long bonds, Ags, gold, gold miners, long Yen and short equities in Japan, Europe & U.S.) which would have produced a double-digit return over the past six months (and would have held up much better than a traditional portfolio in July as well). We mentioned last quarter an interesting statistic that is that there have been 17 years where the S&P 500 has returned more than 25% and the average return in the follow- ing year has been just 6% (which is right about where the equity markets are trending afer the frst third). Te range of outcomes is quite interesting, however, as 6 of the years were negative and 6 of the years
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 4 Second Quarter 2014 produced double-digit returns again, with the remaining 5 years closer to the average. At the end of Q1 it appeared the 6% number was highly likely, at the end of Q2, it looked like we were headed to the upper end of the range and as we sit here today at the end of July, the 6% number is looking pretty likely again. We have a big unknown ahead with the Mid- Term election and volatility is historically higher around these events, so it could be an exciting second half. We will be back in 90 days, on the eve of that big event, with thoughts on what transpired in Q3. One thing we know will write a lot about next quarter is how the Alibaba IPO will likely make this a #SeptemberToRemember.
Market Outlook
If the theme of this letter is correct and it really is #NotDiferentTisTime, and markets really do follow predictable cycles, then doing a Market Outlook should be pretty simple. Just go back to the last few times we were at this point in the cycle, see what did well over the next few quarters and voil, market forecast. Tere is an elegant simplicity in this idea in that economies and markets are large, complex organisms that are comprised of many sectors and segments, which have shown to exhibit highly cyclical behavior over time. Yes, there is an added layer of complexity due to the processes of Creative Destruction and Destructive Creation, insofar as new industries and companies are formed over time and those new areas will take some share of the collective capital and wealth allocation from those that fade away (think transfer of wealth from buggy whip manufacturers to Henry Ford). But, overall there has been a relatively consistent pattern of ebbs and fows across asset classes, geographies, sectors and industries over time and proactive, tactical, investors could formulate a solid, core market outlook from those historical patterns. Tere is also a compelling contrarian element to this thesis as the average investor simply looks at the very recent past as extrapolates that current return patterns will persist in the near term (e.g., the institution I discussed above who was consistently chasing the hot dot of recent performance). What we know from the data is that the most recent performance in an asset class, or market, is most ofen a nearly perfect inverse of the short-term future (this is the primary thesis behind last quarters title Te Year of the Alligator: Why 2014 Will be the Inverse of 2013) as mean reversion tends to kick in an move prices that have gone toward one extreme, back to the mean (and subsequently to the other extreme). Tis movement actually takes time, hence the cycles. Te key to overcoming this wealth- reducing tendency is to look farther back in time in order to compose a view on how the near term future is likely to look. Mark Twain said, history doesnt repeat, but it rhymes, which certainly applies, but the better quote for this issue is from Winston Churchill when he said, the farther back you can look, the farther forward you are likely to see. In other words, history does indeed repeat, but you have to look back far enough to see the elements of the environment that are likely to be most prominent in the next portion of the cycle (think fashion waves over 20 years) #LookBackToSeeAhead.
Another factor at work is that the current environment prompts some reaction by market participants (central bankers change interest rates, governments change fscal policies, companies change prices, etc.), which impacts the environment in a Refexive way (for more on Refexivity, we recommend Te Alchemy of Finance by George Soros) and catalyzes the cycle. An example. Tey (never been sure who they are) say that the cure for high prices, is high prices, as the rising price of an asset prompts competition to develop to capture the higher proft margins, which increases supply, which sates incremental demand, which leads to lower prices. Tis refexive cycle played out perfectly in the iron ore market over the past few years (and created lots of cyclical opportunities to proft on both the long and short side) as growing demand in China swamped current supply, so smart business owners raised prices (the time to be long since proft margins exploded) to
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 5 Second Quarter 2014 try and control demand, which led to lots of new investment in new capacity which has come on line recently leading to rapidly falling prices (the time to be short as margins collapsed due to high fxed costs), which leads to high-cost capacity being shuttered, prices stabilize, demand resumes, and the cycle starts anew (this point in the iron ore cycle could favor some. We can substitute any good, or service, into this example and fnd the cyclical pattern repeated over and over again throughout history and the best investors, I have found, are great students of history and have lived through multiple cycles themselves in order to gain experience, and perspective, on how a particular cycle is likely to play out. Te best way to summarize the phenomenon comes from the Good Book itself, in Ecclesiastes 1:9, what has been is what will be, and what has been done is what will be done, and there is nothing new under the sun. Even on the time horizon of millennia, it is #NotDiferentTisTime.
One of the things we talked about last quarter was how it was relatively easier (still not easy) to produce long-term forecasts (as opposed to short-term and intermediate-term forecasts) as we wrote these longer-term forecasts are moderately easier to compile because they can be more quantitative (less emotional) and they beneft from the natural cyclicality of markets and the concept of mean-reversion. Longer-term forecasts can comport to one of the most important Rules in that they can be created without emotion, as they tend to lean more on the observed data rather than opinion and conjecture. It is much easier to see when a data series of price, yield or valuation is at an extreme over a long period of time than to try and guess the incremental change over a very short period of time. Tat said, unfortunately, (once again) the latest long-term forecasts from GMO show that the bulk of the traditional asset classes are overvalued today and the expectations for returns for the rest of the decade are likely to be well below the long-term averages. Running through their 7 Year forecasts, they expect the following compound annual returns: Large-cap U.S. equities 0.5%, Small-cap U.S. equities (3.0%), High Quality U.S. equities 4.4%, Large-cap International equities 2.9%, Small-cap International equities 2.7%, Emerging Markets equities 5.8%, U.S. Bonds 2.2%, International Bonds (0.4%), EM Debt 3.8%, Cash 1.8%, Timber (proxy for Commodities) 7.6%. To be clear (for anyone who looks at the GMO chart and sees that the numbers dont match), I have restated these returns in Nominal terms (GMO forecasts in Real terms net of a 2.2% infation forecast) since most investors think in nominal terms. Terefore, one caveat to these numbers is that if infation turns out to be higher than 2.2% over the whole period the expected returns expectations would rise an equal amount (we will take the under on that given infation is hovering around 1.3% today and would need a similar period above 3.1% to get to 2.2%, but it is an important caveat). So with these long- term forecasts, the 0-3-5 Conundrum rears its ugly head again with cash paying 0%, a diversifed portfolio of Bonds (some U.S., some Global and some EMD & HY) is likely to get 3% and a diversifed portfolio of equities (some Quality U.S., some International, overweight Japan & GIIPS and some EM) investors are likely to get 5% over the next seven to ten years. Broken record time, but any way you want, 10/30/60, 0/60/40, 0/0/100, 0/100/0, you just cant get to a 7% to 8% return (unless you buy 100% bonds AND 100% stocks, so modest leverage might be the right answer actually)but investors, of all kinds, NEED, 7% to 8% to meet their liabilities, so there must another solution, right? We think there are a couple solutions. Both require meaningful efort, skill, discipline and patience to achieve, but they do exist. Te frst is to fnd managers who can add meaningful alpha on top of the market beta forecasts. Te issue here is that Alpha is a zero-sum game (not everyone can be above average, #NotLakeWobegon) and history shows that fnding Alpha in quantities to cover the gap is difcult. Second, investors can lean on more skill- based investment strategies (vs. market-based traditional strategies) like hedge funds, private investments and tactical strategies that seek to exploit the Alpha opportunities that are foregone by those
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 6 Second Quarter 2014 investors who stay with the passive 60/40 model. Tere are opportunities in both but investors need to focus on allocating to #SpecialSituationsSpecialPeople.
Lets take a look at a couple of truly Special Situations to get a sense of where we see opportunity that is #OfTeBeatenPath. Te frst is Saudi Arabia (whose stock market has been closed to foreign investors up to this point), which made an announcement on July 22 nd saying that they will begin the process to allow outside investors to buy and sell shares directly beginning in 2015 (you could buy, and we have bought, shares indirectly through the use of Participating-Notes issued by a Broker Dealer with operations in Saudi). We have liked Saudi for a while and actually wrote last quarter that Saudi Arabia is an outstanding place to invest today as the oil wealth has created a booming consumer culture that has created signifcant opportunities in banking, fnancial services, retail, real estate and other sectors. Te returns for intrepid investors in the region have been very strong, in part because of the sheer challenge of investing (foreign investors must use P-Notes, a derivative contract that grants exposure to the Saudi equity market through a fnancial services counterparty) and partly because of the strong Current Account and Fiscal situations, which have led to strong earnings. Te opening of the Saudi market to foreign investors should serve as a signifcant catalyst to move the market higher as capital fowing in from global institutional managers is likely to equate to a signifcant portion of the current Saudi market cap. For perspective (and to see why this is a big deal), the Saudi market has a market cap of $550 Billion, twice the size of Turkey, larger than UAE, Qatar and Kuwait combined, and about the same size as the South African and Russian markets. Additionally, opening the market removes the primary hurdle that has historically prevented MSCI from including Saudi in their Indexes. Te inclusion in the MSCI Emerging Markets Index could attract as much as many tens of $billions of foreign capital into the market (i.e., should Saudi account for around 4% of the Index as MSCI has guided). Tis capital infow presents a compelling Beta opportunity, especially for investors that can access the market before it ofcially opens to foreign investors. Tis re-rating phenomenon was demonstrated by the moves of Qatar and UAE afer MSCI announced their inclusion into the MSCI Emerging Markets Index in June 2013, both markets increased by 45% over the next 12 months until they were added to the index this June. Te Saudi Baby Boom generation is even more pronounced than the U.S. and European versions, which created quite a Demographic dividend and consumption boom over the past three decades. (#HereComesTeKingdom).
Te second Special Situations opportunity is even further out on the non-traditional spectrum, #Bitcoin. So what exactly is Bitcoin, and why all the hype, and why would we actually include it as a potential investment opportunity? Lets start with a high-level overview from the WSJ, currently, Bitcoin serves as an alternative currency, a commodity, and money transfer system. Over time, its underlying framework (called the Bitcoin protocol) may develop into a global ledger and information transfer system along with applications that are unforeseeable at this point in time. Tis protean nature explains, in part, why the IRS categorized Bitcoin as property while FinCEN treated the technology like a traditional fat currency. So there you have it, clear as mud, right? Te creators, and early adopters, believe it is an alternative currency that will ultimately replace traditional currencies, as Bitcoin has a built in mechanism (only a specifed number of Bitcoins are created over time) that prevents the devaluation of the currency by central bank printing. Te IRS takes the alternative view that it is simply another commodity that can be speculated in and therefore is subject to taxation as the value rises over time. Te detractors (and there are some high profle ones) contend there is nothing new here and it is simply a payment mechanism with little intrinsic value. To quote Mr. Bufets argument against Bitcoin, he says the following, "a check is a way of transmitting money, too. Are checks worth a whole
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 7 Second Quarter 2014 lot of money just because they can transmit money? Are money orders? Te idea that Bitcoin has some huge intrinsic value is just a joke in my view." No minced words here. We would ofer some thoughts on Bitcoin as a truly disruptive technology and as an interesting investment opportunity. Bitcoin is in the early stages of mainstreaming today as some of the most prominent venture capital frms (remember David Hornick of August Ventures Bitcoin was one of their top fve investment sectors at our iCIO event in May) are funding startups that will actually seek to provide Bitcoin to the masses. Additionally, over the past several months there have been an increasing number of examples of integration between Bitcoin and the fnancial services industry. For example, the CEO of eBay recently made headlines by claiming that PayPal is eventually going to have to integrate digital currencies, such as Bitcoin, into their payment platform. Likewise, the increased integration has led to substantive conversations in the government about regulation (why would we need regulation if this wasnt going to be a prominent asset?). To this end, in early July, the New York Department of Financial Services became the frst state to propose regulations on virtual currencies. According to the agency head, Benjamin Lawsky, if virtual currencies remain a virtual Wild West for narcotrafckers and other criminals, they would threaten our countrys national security. While this is clearly an extreme stance (Ben is known for his penchant for grandstanding, future political ofce maybe), regulation of how an alternative currency would integrate in the system is warranted, but what are the ramifcations of a broader adoption. Historically, early adopters of Bitcoin supported it because it was disconnected from the infrastructure represented by government and everything else (some might call these the conspiracy theorists). One thing history has shown is that truly disruptive technologies always come from the fringe (#LiveOutsideTeComfortZone). Take PCs and the Internet; Steve Jobs was a hippie; no big technology company in the 1980s thought the Internet was going to be relevant. Bitcoin didn't come from a JP Morgan or PayPal. It is from the fringe. Imple- menting regulatory safeguards to protect consumers, businesses, and entrepreneurs that work with virtual currencies will be instrumental in bringing Bitcoin into more of the mainstream which makes it an attractive theme to keep an eye on going forward. On the investing front, Bitcoin is so widely discussed given its meteoric price increase in 2013 when it went from $14 to start the year to $1,140 in early December (an 8,100% return, one of the few things better than Vipshop). Te price has fallen back to $585 today and the volatility has been huge, but there does appear to be some increasing stability in the past few months. Tere are a number of hedge funds starting to take advantage of the Bitcoin phenomenon (one even backed by the notorious Winklevoss twins of Facebook fame) and we have chosen to wait and see how these Funds develop over time. It is likely that we will be hearing more about Bitcoin in the quarters and years ahead and we will continue to look for opportunities to explore the best means to capitalize on the trend (thanks to Kyle Engle and Frank Tanner for pulling all this great information together and for keeping tabs on the Bitcoin space for the team) #TrueInnovationAlwaysSoundsCrazy.
Coming into #TeYearofheAlligator we had six key regional investment themes that we presented in our frst Around the World Webinar in January, Argentina, Greece, Spain, India, China and Japan where we thought intrepid investors could earn excess returns. Tere were diferent reasons for why we felt that each market was an attractive opportunity at the time ranging from the likelihood of an eventual settlement of the sovereign debt issues in Argentina (which came to a head this week), to stronger than expected recoveries in Greece and Spain (which has indeed transpired), to the potential for a game- changing election outcome in India (amazingly, the BJP government won a super-majority), to signifcant reforms in China (ongoing, but meaningful progress has been made and markets beginning to acknowledge) and the continuation of Abenomics in Japan (real progress was made in Q2 and markets turned up nicely afer a rough Q1). As we look back
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 8 Second Quarter 2014 over the six months since that Webinar, the results in these markets have been fairly robust, as an equal weighted basket of ETFs (ARGT, GREK, EWP, EPI, FXI, DXJ) has returned 15%, nearly double the 8% returns of the All Country World Index. One small point to make is that an equally weighted basket probably understates the returns somewhat as a couple of the ETFs are small and are not that representative of the total opportunity set, but they provide an easy way to do a quick calculation of the solid performance in those markets this year. Going forward from here, we still like these regions and will highlight some of the more interesting opportunities that we see in each one as we go through the Market Outlook (#ATWWY).
One tried and true approach to earning excess returns over the long-term is to continually allocate capital to areas where there has been a dislocation in prices due to an external shock or misperception by investors about some aspect of the asset class, region or sector. We identifed a few of these opportunities in our Q4 letter and said there were still some places where these types of assets could be found like Russian oil companies, Indian cyclical companies and Spanish and Greek Banks. Russian assets were sufering from the Putin Discount, Indian assets were sufering from the uncertainty around the outcome of the election and assets in the GIIPS countries were struggling with continuing perceptions of economic woes (despite direct evidence to the contrary in the form of higher PMIs and GDP growth). Te biggest challenge to buying really cheap assets is overcoming the human tendency of herding behavior, so your frst response is to sell because everyone else is selling. Sir John talked about this ofen as he said that people always wanted to know what area he thought was doing the best and he turned that around saying it was the wrong question and people should be asking where is the most miserable. I started tweeting last January about the #TempletonMiseryIndex (my less than quantitative perception of which countries looked the most miserable and, therefore, were the best places to look for bargains) and talked about places like Russia, India, Greece and Spain, as well as Tailand and Turkey, as being places where long-term focused investors could fnd great opportunities.
Tat said, another challenge of looking for distressed assets is that you can be early (the euphemism for wrong) and, ofen, those assets can get cheaper if there are further shocks to the system (Russian issues in Ukraine/Crimea and now the Separatists shooting down the plane) or there can be a change in perception of the opportunity that changes capital fows (Greek banks being tarred with same brush as highly overleveraged European banks that have not restructured and recapitalized). We discussed this particular risk in the Q4 letter as well saying, the challenge with many of these assets is that they reside in places perceived to be risky and, in some cases, are exposed to short-term risks. While cheap assets can get cheaper, if you buy a high quality asset at a good price and the price declines due to market sentiment, or short-term capital fows, your loss is more likely to be temporal rather than permanent. Te key word in the last sentence is quality and Sir John says defnitively in Rule No. 5 that investors should search for bargains in quality companies. As we discussed above, quality can be defned in many ways, owning great assets, having proprietary technology, having a clean balance sheet among others, and we have found that buying these types of assets when they go on sale is a winning strategy. India has seen both extremes of this activity in 2014. Te misery for investors increased dramatically in January when the Fed threats of Tapering caused investors to shun all countries with high current account defcits (regardless of the direction of those defcits or the rate of change, it was simply about level and negative was bad). Cheap assets got cheaper. Ten, nearly as suddenly, sentiment began to turn as investors saw the progress made by the new Central Bank Governor, Rajan, on controlling the current account and, more importantly, it became apparent that Mr. Modi was indeed going to be the next Prime Minister. Suddenly cheap assets got less cheap and there were considerable returns to be made, IF you had invested
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 2 9 Second Quarter 2014 before the turn. Te Greek banks had a very diferent run in 2014 as investors began to pile into these stocks in Q1 and actually drove the Greek market to one of the best returns in the world for the quarter. However, sentiment changed again in Q2 as fears over the new Stress Tests in Europe might show that banks needed more capital, but what was missing from the analysis was that the Greek banks had already done there restructuring, they had already taken the painful steps of restructuring. Cheap assets got cheaper again. Russia has been on a similar roller coaster as the big drop in March turned out to be a great buying opportunity (an example is we bought QIWI, a mobile payments company afer the drop and sold it a number of weeks later 70% higher than where we bought it) that, unfortunately, turned out to be short- lived as the tragic incident around the Malaysian Airlines jetliner prompted additional sanctions against Russia which prompted investors to sell Russian shares again. Really cheap assets went back to silly cheap levels. We see tremendous opportunities in all three of these markets and will continue to search for quality bargains in these bargain basement markets (#MiseryLovesGoodCompanies).
Our intro slide for the Argentina section of the presentation was titled Dont cry, its me Argentina and showed a cartoon of president Cristina Kirchner flling her purse full of money from a YPF gas pump (the national Oil company) at a Repsol flling station (the Spanish company that was supposedly a partner with YPF). Te juxtaposition of a positive view on the Argentine market with a picture of a corrupt leader who showed a blatant disregard for property rights in her decision to re-Nationalize Repsols stake in YPF might cause cognitive dissonance for some. However, the opportunity in Argentina was created precisely by the terrible track record of the current government as the fact that she would be gone in 2015 began to creep into global investors collective consciousness. Te situation could not have been much more miserable as Argentina was forced to devalue their currency dramatically, there were fears of a default on their sovereign debt (if the hedge funds that had held-out and didnt agreed to the London Club restructuring a few years ago were not paid, then they could not pay other bondholders), infation was spiraling out of control (back over 40% at one point), economic growth was collapsing and companies could not get access to credit with the government bond troubles, what a perfect time to invest Tose who were able to #BeGreedyWhenOthersAreFearful have enjoyed really spectacular returns over the past six months as the positives associated with the resolution of the debt issues and new leadership have helped push prices of the bonds, and equities, up dramatically. Tat is the good news, but the better news is that this festa may just be getting started as the high likelihood of an ultimately favorable resolution to the debt issues should lead to the opening of the global capital markets to Argentine companies. With better access to credit, Argentina should see an acceleration of growth, and profts, which should lead to higher share prices in the coming quarters and years. Add the really good news that Argentina has the worlds third largest shale oil & gas reserves (behind China and the U.S.) that are ripe for exploration and production and this could be a bull market to ride for many years (#BullsDontOnlyRunInSpain).
Looking at Europe, we continue to see incremental progress toward recovery and we wrote last quarter that one of the most positive developments was that capital is fowing into the region (from investors, private equity funds, corporations looking to expand and the slow resumption of bank lending. Our favorite opportunities continue to be in the GIIPS markets where we anticipate additional signifcant upside (albeit with some volatility) over the balance of the year and into 2015. In Q2 we got a taste of some of that expected volatility as Greece and Ireland shed (8%), Portugal dropped (6%), Italy eased (2%) and only Spain managed a gain, rising 5%. July actually turned out to be another difcult month for the GIIPS markets as problems with the holding company of Banco Espirito Santo ignited fears of a larger problem for the fnancial sector in Europe and further losses pushed Portugal, Ireland and Greece into negative
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 0 Second Quarter 2014 territory for the year, down around (4%). While Spain and Italy were not immune from the turmoil, these markets did hold up a little better and are still up around 7% for the CYTD. We clearly did not foresee the problems in Portugal, but we believe this is an isolated incident and will not have a major contagion efect on the other countries long-term. Te biggest surprise to us was the reaction by the Greek banks, which fell in lock step despite having restructured and recapitalized. We see very signifcant gains on the horizon for these assets, as the huge consolidation down to four major banks will drive higher proft margins going forward. We also wrote last quarter that one tremendous upside surprise could also emerge if Super Mario Draghi fnally fnds a way to perform a Euro based form of QE (currently prohibited, but he is working on it), which would ignite a serious fre under the European equity markets, and #SuperMario lived up to his name by cutting interest rates into negative territory, essentially making people pay to keep cash in the bank, and inched the Eurozone another step closer to a full-fedged QE program. Should the ECB start expanding their balance sheet again, that will provide a brisk tailwind for European assets and the GIIPS countries in particular which are much more leveraged to the upside, as they are starting from a lower base (#PIIGSCanFly).
I met with one of our favorite managers from London recently and we had some great discussions on a number of unique global opportunities, but he also shared some variant perceptions on potential risks that he saw across various markets that could cause some real pain for investors. Many of you will recall that this is a manager who spent 2013 net short 40%, yet still managed to produce an 18% return (truly an astonishing feat given the huge upward moves in global equities) and he came into 2014 still 40% net short, and again is somehow up in line with the ACWI, up 5% vs. 6%, despite being short when the markets are rising. One of the reasons he is doing so well this year is he has a huge (around 60% of his gross exposure) position in government bonds (long Treasuries and Bunds) as he continues to see a larger risk of Defation than Infation in the developed markets, particularly in Europe. Tree very interesting things came out of our discussion, 1) his favorite idea (and largest position) is our favorite idea and largest position, Vipshop, 2) he still thinks banks in Southern Europe are going to be fantastic investments over the long-term and has six of his top ten positions in banks in Spain and Italy and 3) he told me that he was having a hard time coming up with a reason not to sell all his other longs and go to 90% net short as he had grave concerns about valuations and the potential for a meaningful correction back to fair value. As of June, he had bumped up net short to 46%, but had not gone all-in on his short hypothesis. Given his large weighting to government bonds and very unique positioning, we expect he will perform very well in the recent uptick in volatility (#VariantPerception).
When it comes to Japan, our confdence in the long- term story remains strong, but we discussed last quarter some of the challenges in the short term; negative foreign capital fows, slower than expected changes in local investor allocations (individuals and the large pensions like GPIF) and, most notably the BOJs reluctance to put additional QQE into the system. We wrote that their steely resolve to wait for the GDP data from Q2 to measure the impact of the sales tax increase before making any further commitments to QE is admirable, even it is tough on the NAV of our investments short-term. Avoiding a policy mistake is critical and we are willing to take the long-view on capitalizing on the Japan revitalization and we continue to believe that they are making the right decision given that the impact of the sales tax increase has not been nearly as bad as was originally feared. Tere continue to be positive signs on the economic front, from faster than expected GDP growth, much higher than anticipated EPS growth, strong retail sales fgures and solid progress on the infation (or rather, beat defation) front. While there are many skeptics out there, we are reminded of Sir Johns second most quoted line bull markets are born
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 1 Second Quarter 2014 on pessimism, grow on skepticism, mature on optimism and die on euphoria, so with the very high level of Japan-doubters, we wrote last quarter (and reiterate here) that we are confdent that Abenomics is on course, that the PM has the conviction, political will and support to achieve the 3 rd arrow of reforms and that it will simply take a little time to reverse the efects of the unusually long Bear market. Q2 performance in the Japan markets was solid overall with the Nikkei up right in line with the S&P 500 and Japanese equities actually surged ahead in July on continued strong earnings. As Japanese corporate earnings are growing much faster than the rest of the developed world, we expect to see continued relative strength of the Japan markets vs. the U.S. and Europe in the second half of 2014. One important point here is that the performance has been uneven within the Japanese market and in true #YearofheAlligator fashion what was hot in 2013, in not in 2014, and vice versa (the turn happened precisely on the Bradley Turn date on January 1 st ). Te banks (SMFG, MTU, MFG, Resona, Shinsei) have been particularly weak (down as much as (20%) in some cases), while the Zombie companies (Sony, Panasonic, Sharp, Toshiba) have been much stronger than the indices (most are actually up vs. down (5%) for the NKY), contrary to the pundits calling for them to fade into the sunset. We actually would expect to see this trend reverse again with the Bradley Turn date that just occurred on July 16 th and it could make for some excellent opportunities for those willing to pay attention to Sir Johns Rule No. 5, to search for bargains in the quality companies. Te last point on Japan is that we continue to see a much weaker Yen over the long-term and have written that we believe that Japan has no choice but to pursue a weaker Yen (to diminish the value of the massive debt they have accumulated) and we agree with my friend Hugh Sloane when he said to me in November of 2012, the Yen will be weaker for the rest of your life. In the near-term, it is clearly possible that the Yen will continue to be seen as a safe-haven currency and could remain stronger than expected if global volatility continues, but in the end we trust in gravity and expect a much weaker Yen over the coming years. Hemingway wrote a famous book on a group of friends that goes to Spain to run with the bulls and we have co-opted that title for our Japan theme this year (#TeAbeSanAlsoRises).
In thinking about Emerging Markets, lets look back to look forward. At the end of January the cacophony of talking heads declaring the death of Emerging Markets was deafening and, to be fair, while their arguments may not have seemed so compelling to those of us on the other side of the theme, the fact that nearly all the EMs were crashing in unison on fears of the Fed Taper (afer a pretty poor showing in 2013) was testing the resolve of even the most steadfast bulls (ourselves included). It was a pretty scary time for EM investors. Te leader for the month was India, only down (4%), while the MSCI EM Index was down (6.5%), China was down (6.7%), Brazil was down (12%) and Russia was down (10%) and Turkey was the laggard, down (14%). It took real courage to step up and follow Rule No. 4 and be a buyer when everyone else was selling. In fact, I was invited to give a presentation to the Board of one of our clients in late January and made the case for why it was the time to be adding to EM exposure, not reducing exposure as they had heard from a large investment bank earlier in the week (that actually gave me a extra nudge of confdence, as perhaps the best contrarian indicator of all is what large investment bank research groups recommend). One never can be sure about timing, and catching falling knives is something we try to steer clear from generally speaking (we would rather let the knife hit the ground and then go pick it up by the handle, even if we miss the absolute bottom, we keep all our fngers), but there was something very illogical about the regions with the highest growth and the cheapest assets continuing to underperform the markets with lower growth and signifcantly higher valuations. In one of the most abrupt turns in recent memory, the emerging markets actually fnished the frst quarter up 3% (better than the S&P 500 return of 1.8%) and some of the turns were even more dramatic, India surged to an 8.2% gain for the quarter,
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 2 Second Quarter 2014 Turkey got back to up 5.8% and Brazil moved back into the black, up 2.8%. China continued to struggle with slowing growth fears and fnished down (5.9%) and Russia got hammered by the Crimea situation and fnished down (14.8%). We wrote last quarter that there are a large number of people who believe that these gains will turn out to be ephemeral (read, dead cat bounces) and that nothing has really been solved in most instances, so volatility is likely to return and investors would be wise not to pay attention to the Siren song of these dangerous shores, and we presented a case for why we did not think that would be the result. Even though we were a little early on our positive call on EM, it has turned out to be quite a good year for these markets through July, both on a relative basis compared to the MSCI World index return of 4.5%, and on an absolute basis, with the EM Index up 8.2%, Brazil up 12.6%, India surging 23.3%, China up a respectable 7.4%, and only Russia lagging, down (13.7%). Looking at some of the other markets, results are even better with Indonesia up 31.6%, Turkey up 25.3% (but remember the Taper was going to kill the Fragile Five), Saudi up 21.8%, Argentina soaring 33.4% and UAE besting the whole group, up a stunning 38%. Despite these gaudy numbers, we still see real value in a number of these markets and expect continued strong performance. Clearly, there will be continued volatility and there is continued geopolitical risk in places like Russia (although Ukraine equities are up 41% this year, so Sir Johns strategy of investing when there is Maximum Pessimism wins again), continued risk of unrest in the Middle East, risks of policy errors in places like India and China as the new leaderships try to implement huge Reform agendas and the normal perils of investing in less liquid markets where incremental capital fows can play a larger than normal role in moving prices. I noted in the last letter that I had a little debate with a fellow panelist at a conference in April as she made the comment that the Emerging Markets story was over, as in her view it was simply a resources play and the commodity super-cycle had ended (Jeremy Grantham will take the other side of that argument for me). Lets just say, with all due respect, we beg to difer, on both points, and we see continue to see tremendous opportunities in these markets going forward and would make EM a core allocation in any equity portfolio (#BuildYourHouseWithBRICsPlus).
Just a quick note on Frontier Markets which continue to be a focus area and have been of particular interest in structuring our portfolios. We wrote last time that the Middle East and Africa have massive growth potential, huge natural resource wealth, young populations and rapidly developing capital markets which have produced (and should continue to produce) outstanding returns in recent years and these factors create compelling investment opportunities. As we have said on a number of occasions in the past the Frontier Markets are traveling the well worn path of Emerging Markets twenty years ago and we would anticipate that global capital will continue to fow toward these regions as return expectations in the developed world continue to moderate. Te Financial Repression of the Central Banks in the developed world is forcing investors to deal with the 0-3-5 Conundrum and one of the ways to overcome the challenge is to allocate capital to areas where the Demographic and Debt profle favor growth and will allow for continued wealth creation, as opposed to the wealth redistribution that will occur in the developed world (#EmergingMarkets2.0).
We started 2014 with a highly diferentiated view on the direction of interest rates and the opportunities in long-duration bonds based on our belief that Sir John was right and it wasnt diferent this time. In the two previous cycles where the Fed ended QE (for brief periods before they had to bring it back) interest rates were projected to rise, but instead fell dramatically. Owners of long duration bonds made very strong returns in both instances. As the New Year began we saw that the consensus was, once again, of the belief that somehow it would be diferent this time and we wrote last quarter that the consensus has proven to have all collected on the wrong side of the boat and the extreme level of consensus (100% of Bloomberg
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 3 Second Quarter 2014 surveyed economists believed interest rates would rise in the U.S. in 2014) was one of the better buy signals in recent memory. In direct opposition to the consensus view, long-bonds have surged in the frst seven months of the 2014 and returns now exceed 14%. In our December Market Outlook presentation, we put together a slide that showed that it appeared that interest rates looked to be setting up for a fall similar to the drop from 3.65% to 1.8% on the 10-year during 2011 and that a similar drop this time would take 10-year yields from 3% to 1.6%. If that magnitude of rate compression were to occur, the returns for long-bond owners would be very compelling and might approach the 30%+ returns of 2011. When we made the comparison and put the 30% number on paper it prompted signifcant negative feedback and only our favorite bond manager, Van Hoisington, thought we had any prayer of being right. A little past the halfway point, that return doesnt seem quite as much of an outlier and while we are not declaring victory as there is too much of the game lef to play yet this year, we are pointing out that the construct that GDP growth will surprise to the upside (meaning >3% for the year) is looking much less likely afer the horrible Q1 number and without robust economic growth we fnd little reason for interest rates to move higher, given the low rate of infation. We remain of the view that it will continue to pay to have a variant perception on interest rates and that rates in the developed world are likely to be #LowerForLonger.
We dont spend that much time talking about private investments in this quarterly letter, but there are always some interesting developments that we can weave into the Market Outlook segment of the letter given that our views on a particular market, equities, fxed income or commodities could easily have applicability in the private markets as well as the public markets. I hit on this construct last quarter in discussing Utica Shale and how there was a tremendous private-to-public arbitrage opportunity that was available to investors who were willing to bear some illiquidity. Similar arguments can be made today about how traditional fxed income investors are giving up very meaningful return potential, in exchange for liquidity, by buying bonds instead of making investments in private lending Funds. Private equity investors enjoy the same type of excess return potential by taking stakes in private businesses at lower multiples of earnings and EBITDA that their publically traded counterparts (actually not true in all markets as some of the large LBO Funds are paying crazy, read 2000 & 2007-esque multiples for businesses today since available leverage is at new all- time highs) and will generate far superior returns over the coming decade relative to public stocks. Additionally, there are myriad opportunities around the globe to provide growth capital to rapidly growing businesses participating in the Middle-Classifcation of the Developing World where we anticipate compound annual returns could approach the high teens (or better with some good fortune). As we have been saying for a few years, ever since the Global Financial Crisis and the beginning of the Era of Financial Repression, investors have shown a distinct preference for liquidity in their portfolios and that has created a windfall opportunity to liquidity providers to capture excess returns above the long-term average 5% illiquidity premium that has historically been available to private investors. At the risk of over- emphasis of the point, I will repeat again that we believe that investors should double their exposure to private investment strategies today, which means if you have a long-term target of 10%, move to 20% and if you have a 20% comfort zone, go to 40%. Just reading these numbers likely makes some uncomfortable, but one thing I have learned in my investing career is that I have made the best returns when I am doing things that make me uncomfortable. In fact, I have been tweeting lately that investors should focus today on the theme #LiveOutsideYourComfortZone as we expect traditional asset classes (those where people feel most comfortable investing) are likely to deliver subpar returns in the next decade.
As part of the #YearofheAlligator theme, we entered
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 4 Second Quarter 2014 2014 with a very favorable view on commodities, particularly the Agricultural commodities, which had one of their worst years in 2013. We had a contrarian view on interest rates, and therefore the Dollar, and we were in the minority with the view that commodities could regain momentum. In Q1, did they ever, and we wrote last quarter that, these markets really have been the surprise of the year as Ags have surged, metals have been solid and energy has been stubbornly high (despite all the forecasts for collapsing Oil and Gas prices). However, Q2 was less kind to commodities as the Dollar did stage a late inning rally and many commodities have now given back all their early gains. We actually see signs that those markets are frming again and expect that we could see some meaningful gains in the Ags (Corn, Wheat, Soybeans are all at meaningful lows and look to be basing) again in the second half. Oil has been relatively stable around $100 for WTI, while NatGas has been very volatile. Afer spending a couple days in Texas with some private energy managers and a few energy hedge funds, I came away very excited about the investment opportunities in energy. Te smartest managers of the actual hydrocarbons are forecasting a steady, but upwardly sloping, price curve for both Oil and NatGas as they see a continued boom in the U.S. (thanks to the technological revolution of horizontal drilling and fracking), being ofset by a continuing decline in OPEC and Non-OPEC global supply (geopolitical concerns and corruption), leading to a fairly well-matched supply/demand balance. Te one caveat to that view was that one material disruption to any major producer could cause signifcant moves to the upside. Te other areas that have shown surprising strength of late are the industrial metals and, most recently, steel. We see opportunities around copper and steel and are beginning to see some signs of bottoming in rare earth metals afer a very long bear market. In the precious metals space I wrote last quarter, that in my hear it three times rule, frst it was Jim Grant, then is was George Soros and then it was Russell Clark and we dabbled a bit, but it might be time to add some real weight to the gold miners as they have easy comps, a higher than expected gold price and there has been some meaningful consolidation and rationalization in the industry to help with the supply/demand balance that plagued these businesses. While it has been a roller coaster ride of volatility, as noted in the Q2 review, GDX and GDXJ were up big over the past three months and are now up a very impressive 24% and 36% CYTD. While it feels like a miss to not have had signifcant exposure to an asset that has moved so much, it is helpful to remember that these names are still down a stunning (57%) and (70%) from their peak, three short years ago, so there is still plenty of upside lef to capture over the long term (#AllTatGlitters).
Coming back to the U.S. equity markets, as we mentioned in the last two letters, we have heard from a number of our favorite managers that the opportunities on both the long and the short side are better than they have been in a long time (you can see evidence of that in the correlation numbers declining). While the average returns for long/short funds have been modest this year, the averages mask some really spectacular returns from some of the managers within the space. One common refrain we have heard is that the opportunities for shorting have not been this robust in many years as there are some truly amazing valuations within the technology, biotech, social and mobile segments of the market. We wrote about a couple of these last quarter and given the freworks during the quarter (and the potential we see for more drama in the coming quarters) I thought I would provide an update on them here. We wrote that the selling began in TWTR and the stock collapsed in the past few months, chopping $7 Billion of the market cap, but still has no profts and still sells at a stunning 29X Revenues (not earnings, because, again, they have none), and, this is the really ugly part, the true Insiders (venture backers and later stage investors) were just released from their post-IPO lock up, so the real Twitter-bombing may get underway here in May and it turned out that we were right, for about three weeks TWTR dropped nearly (25%) the week afer
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 5 Second Quarter 2014 the lock-up expired and stayed down until the last week of May, but then began a steady short-squeeze lif-of, recapturing all of the losses in June. Afer some consolidation for a few weeks, the real freworks hit last week when Twitter announced earnings (there still were none, but there were smaller losses than anticipated) and the stock surged 25% in one day, regaining a level it had not seen since the end of Q1. To put some numbers around that, TWTR gained $4B in market cap in a single day (back to an astonishing $26B), yet the company has less than $1B of revenues in the TTM and has lost close to $1B over the same twelve months. Fortunately, we werent short during the big squeeze, but we will likely be short in Q3. Another example of #TruthIsStrangerTanFiction (because, as Mark Twain tells us, fction is obliged to stick to possibilities, truth isnt), we also wrote how TSLA now has 23% of the market cap of F and GM combined (despite still only having 0.5% of the sales), still has no profts (although they are projected to make $1.67 this year so it is almost cheap at 130X forward EPS) and has not shown any capacity to ramp production at the levels implied by their stock price. Like TWTR, within a couple of weeks of the letter, TSLA shed (10%), but then proceeded to squeeze the shorts even harder (fortunately, we werent short here either), jumping an amazing 33% over the next eight weeks. To update the numbers above, the stock has moved to a 207 P/E as the 2014 EPS estimate has fall- en to $1.13 (must be trying to move toward the AMZN model, where you get a higher valuation if you spend all of your revenues, so there are no profts to compare to the analyst estimates). If these stories dont remind you of 2000, then you must not have been in the business. Tese are just two, of many, examples of the extreme valuations in the current environment where we expect to be able to write about excellent returns on the short side in future letters and show that it is defnitely #NotDiferentTisTime.
On the long side, there are actually a number of sectors in the U.S. equity markets where we see opportunities either to buy some attractively valued assets that have fallen out of favor, or participate in some outstanding growth businesses where valuations have not gotten out of line. Tere are some interesting plays within MLPs where the market has opened up to allow other types of businesses to participate in the structure (beyond pipelines and other mid-stream assets), many of which have an energy services (#Picks&Shovels) orientation, which we fnd very attractive. We have seen interesting opportunities in things like fracking sand, wastewater disposal, logistics and drilling. Similarly, there are some interesting REIT structures that could provide investors with continued solid returns, so long as you steer clear of the overvalued segments in core areas like malls and apartments (there could be some interesting shorts here). We discussed in one of our earlier letters how we liked the Airlines (and we still do), but we also see continued strength in other travel related businesses like Car Rentals and Hotels. One of our #ATWWY Webinars was about Consolidation = Upside, and all three of these industries have seen sig- nifcant consolidation which has helped boost proftability for the remaining players (#OligopoliesAreGood). Another space that has some momentum today is the HMOs (AET, WLP, UNH, CI) as the changes in the healthcare landscape have created signifcant opportunities for the leaders in this space (and Hospital operators like HUM, too). In another nod to Mr. Twain, the rumors of the death of the PC have been greatly exaggerated and the #OldTech sector has been, dare I say it, en Fuego (I have to use this phrase every time someone tells me I look like Dan Patrick, which happened last week when I was doing a remote shoot for Fox Business). Companies like MSFT, INTC, CSCO and HPQ, which had been relegated to the recycling bin as the Cloud was to render them all obsolete are staging a serious comeback and have dramatically outperformed the Cloud names over the past few months. Another sector that was pronounced dead last year when all the discussion of the #Sequester was going on was Defense yet companies like LMT and NOC continue to generate strong earnings and cash-fow and in a
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 6 Second Quarter 2014 world or rising geopolitical threats, perhaps a proftable strategy is #PlayDefenseWithDefense for these tumultuous times. One last long possibility is an interesting indirect play on the upcoming Alibaba IPO that we discussed multiple times above. Tere are two large companies, Yahoo and Sofbank (and perhaps other smaller ones) that own meaningful stakes of BABA who will reap large windfall profts if the IPO goes as well as some Analysts have forecast (the Bernstein Analyst has a $250 Billion end of day one valuation target). It appears that the valuations embedded in the YHOO and SFTBY stocks is materially under those levels of valuation, so it could be an interesting trade to pick up these names in advance of the IPO in September (#SumofhePartsArbitrage).
Back to the short side, there are four industry groups that look very poor today and the prospects for improvement in their businesses in the near-term seem dim. Consumer Discretionary, Homebuilders, Industrials and Ofshore Drillers have all rolled over hard this quarter. With more and more data showing that the consumer is tapped out (savings rates have collapsed, leverage has increased), housing is weakening (new home sales, permits and mortgage applications are all weak), global economic growth uncertain (global GDP is still not accelerating upwards) and oil & gas drilling continues to move back onshore in the U.S. (horizontal drilling and fracking are reopening basins that are much more economic than ofshore, particularly deep water), it appears that there are more likely to be better opportunities on the short side than the long side. Te one caveat to this view is that if the high yield credit markets were to somehow remain open afer the Taper ends (given how the short JNK/HYG story has quickly grown to a consensus, maybe that is possible), the huge volume of Private Equity and Strategic capital could turn its attention on these segments and cause some pain for short-sellers as we have seen happen in situations like the Coke investment in GMCR earlier this year. A handful of bailouts aside, the bigger picture remains negative and we believe that many consumer businesses are under attack by e-commerce and that the best opportunities will continue to be on the short side (#TinkOutsideTeBigBox).
We could probably dedicate an entire letter to #China as the economy, the market, the political transition and the sheer size of the country/population command an inordinate amount of press coverage, investor interest and rumor activity, all of which provide meaty content to weave into a quarterly letter. Te incredible diversity across the country also ensures that there are always winners and losers in various markets and makes China a #TargetRichEnvironment for investors. Te biggest overarching story (that with the greatest potential impact over the long term) is the New Leadership and their commitment to the Reform agenda. We have an emerging theme that we have been developing from a study of history of government leaders that used the word Reform, or who were labeled Reformers and the results are quite dramatic (think Ronald Reagan in the U.S. or Margaret Tatcher in the UK). Tere are a number of places around the world today where the Reformer label is being thrown around like India, Indonesia, Mexico, and, most notably for this section, China. Just one example is that the new President, Xi Jinping, has initiated a serious crackdown on corruption in the Party (so serious that companies that were dependent on the corruption trade, like white liquor maker Kweichow Moutai, fell more than (50%) in 2013) and has put over 25,000 government ofcials under investigation (or arrest). Mr. Xi clearly believes in taking short-term pain for long-term gain and he has shown a signifcant commitment to policies that focus on shifing the economy from Fixed Asset Investment toward Consumption and stripping out the pilferage that was so common in the previous leadership regimes. Clearly it is likely to still be a good thing to be a Party member, but perhaps the slippage per member will be measured in millions instead of billions going forward and those savings can be directed to productive activity instead of condos in Toronto, Maseratis and luxury watches.
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 7 Second Quarter 2014 With #Reform as the primary backdrop, we believe that China could be a very interesting place for investors in the coming quarters and years (and perhaps the dramatic turn in the past month is the leading edge). We discussed the opportunities that we have seen in the SOEs and how a commitment to reform within the largest State dominated industries could provide big upside for investors who get out ahead of that transition. China Coal Energy is an example of a company that has been shunned by investors since 2009, falling over (80%) from $16 to just under $4, but has recently rebounded 10% on optimism for the future based on the Reform Agenda. Time will tell if this is simply another bounce on the stairs leading down (precisely what the long-term chart looks like) or whether this is the beginning of a multi-bagger opportunity for long-term investors. Another opportunity that could potentially generate very signifcant returns is the Chinese banks. Te banks have also been in terminal decline for years, having fallen between (10%) and (40%) since 2009, but most recently began to turn up smartly on the rumors of the beginning of a new PBOC stimulus program. Tere is a huge amount of Western fear and trepidation about the level of bad loans on the books of these institutions, but in talking to one of our favorite managers in Hong Kong (who has seen the previous two banking cycles and restructurings), he is confdent that these companies are in the #TooBigTooFail camp and that the government will do their best Super Mario impersonation and #DoWhateverItTakes to make sure they remain viable (the government has huge reserves with which to absorb the bulk of any losses). Another compelling point he made is that given the global shareholder base are the ones who have lost money over the past few years (where they have no vested interest), he believes that the government will become even more supportive of the stock prices if they see local investors beginning to buy the banks at these depressed prices.
Te shif to Consumption in China is multi-decade opportunity and we have talked at length in previous letters about the opportunities we see in #ChinaInternet, Consumer Retail, Consumer Services, Healthcare and Alternative Energy. A couple of areas look quite interesting in the near term as some signifcant dislocations in prices of auto manufacturers and businesses related to Real Estate have been beaten down dramatically during the recent growth scare and crackdown on property speculation. Car manufacturer Great Wall Motor Co. had been a darling of the China equity market, rising an astonishing 14X (1,400%) since 2009, completely bucking the Bear Market that had dragged the Shanghai Composite down (35%) and limited the Hang Seng Index to a meager 20% return. However, the fears of an economic slowdown put a dent in Great Walls stock price over the last three quarters, chopping the market cap in half. Te company trades in Hong Kong as 2333:HK and had dropped (35%) through the beginning of May (while the index was fat) and has zigzagged higher over the past few months and looks poised for a breakout. On the RE front, the loudest China Bears continue to growl loudly about an impending property implosion in China and investors fed the scene as companies like China Vanke, China Overseas Land, China Resources Land and Poly Property Group (002:CH, 688:HK, 1109:HK, 119:HK, respectively) had been in constant decline during 2013 and Q1 2014, before fnding a foor in May and June and bouncing nicely in the past month (up 18%, 16%, 18% and 9%, respectively). Tis sector is clearly out of favor and has lots of enemies who continue to make claims of fraud and other spurious assertions (ofen with very little hard evidence other than some old pictures of #GhostCities #OldNews), so much so, that one might think they were #TalkingTeirBook and were short (and are perhaps feeling a little squeezed of late). Te property developer pain has been more constant over the past year, but the pain in the e-commerce related real estate names (SouFun and e-House) has been more acute. Afer surging 300% from early 2013 through the beginning of March, fears of slowing RE transaction volumes sent SFUN & EJ into a tailspin as they lost half their value in twelve short weeks.
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 8 Second Quarter 2014 Suddenly, in early June, rumors of a reversal of the ban on property purchases emerged and these stocks were #HotProperties again and have surged 28% and 38% respectively in six weeks. We think there is huge upside in these companies as they are the dominant players in the China RE markets. For some perspective, lets compare SFUN to one of the two leaders (in quotes since they have a fraction of the market share that SFUN and EJ have) in the U.S., Zillow and Trulia (who just announced a merger last week) and let the reader decide which one you would rather own (be short). SFUN expects revenues in 2014 to be close to $800 million and profts to be $300 million and sells at a market cap of $4.6 billion, or 6.7X Sales and a P/E of 15. Z expects to have revenue of $300 million in 2014, but has no profts, and sells at a market cap of $5.8 billion, or 24X Sales and an expected P/E for this year of 483 (#WePreferProfts).
We talked extensively about the Bradley Turn Dates in the Q1 letter and discussed how these dates tend to usher in a change in trend of markets - what has been hot cools of and what has been cold heats up. Te #YearofheAlligator theme was premised on the changes that we anticipated would occur around the January 1 st turn date and there has been a very strong correlation over the frst half of 2014 with what we discussed might occur. Tere was another major turn date on July 16 th and it appears that there could be some predictive power again if the frst few weeks develop into a more major trend. Interestingly, the DJIA made a peak precisely on the 16 th (while the S&P 500 made a peak a few days later), which, coincidently, was the day that the Malaysian Airlines jet was shot down over Ukraine, and U.S. stocks have been struggling (down nearly (4%) in a couple weeks). Te Shanghai equity markets made a breakout from their downward channel at the same time and have been surging ever since (up a little over 10% over the two weeks) and the CSI 300 A-Share index made a sharp turn upwards right on the 17 th (16 th in the U.S., if we get technical on the International Date Line). Some of the European markets appear to have turned down hard in recent weeks with Germany changing direction closest to the Turn Date. Gold and Gold Equities also look to have made a peak around the 17 th
(Bradley Dates have a three day window), which conficts with our positive view on the potential upside, but, our view is a long-term view and there could be a short-term period of weakness over the coming months for precious metals (particularly if the Dollar continues to strengthen) so we will respect the Bradley information and tighten our stops here. Another area to watch is interest rates, and the long- bond in particular, as this asset has followed the Bradley pattern precisely over the past year and the incredible strength seen over the past seven months could easily take a breather, and TLT is sitting just under its level on the 16 th today. Again, we will tighten up our stops and pay close attention to any additional signs of economic strength (like the recent 4% GDP print) that could prompt investors to sell bonds, or could prompt the Fed to jawbone about raising rates sometime sooner in 2015. In commodities it looks like Oil made a peak around June/July (this one is not so clearly related to the Bradley date), but NatGas looks like it may have made an interesting bottom around the 21 st (probably close enough), while the Ags just continued plunging right through the Turn, although they may have begun a turn this week (this one is a tough call, but these markets are really oversold). While the Bradley Turn Date is just one of many momentum and sentiment indicators, we have talked to many of the most prominent traders and investors over the years who had a very high degree of respect for the logic of the natural cycles theory and integrated these dates directly into their investment process (#RespectTeCycles).
In thinking about the core message of this letter, we are focusing on the idea that this cycle will be similar to previous historical cycles and that the Central Banks have not eradicated the business cycle with QE. To that end, we appreciate the challenge of the timing of these cycles and we wrote last quarter that we all know from experience that its very difcult to say
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 3 9 Second Quarter 2014 precisely when something like a major trend reversal will occur, but we also know from experience that we can prepare ourselves for that eventuality by paying attention to the Kindleberger cycle (when are the Insiders selling?), and being willing to move our portfolios to a more protective position. Te key point here is understanding the cyclical behavior of the Insiders (those with above average insights about specifc companies) and the Masses (those with below average insights about specifc companies) and how the behavior of each group creates investment opportunities to be both long and short depending on where we are in the cycle. We also wrote about how Stan Druckenmiller said that too many investors believe they must stay exposed to all markets all the time regardless of valuation and potential future returns, which he said is a tragically fawed assumption. Stan made truly outstanding returns over the years by ignoring the conventional wisdom (an oxymoron if ever there was one) that #BuyAndHold was the superior investment strategy. He also laid waste to the concept of being bullish or bearish all the time, saying rather that to be a great investor, you have to be a Pig, which means that you are only going to have a couple really great ideas in any year, so when you have them, you have to invest BIG. We fnd ourselves in violent agreement with Stan on these points and we believe in our construct that it is #NotDiferentTisTime, it is time to #BeTactical and when we have real conviction in an idea to #BeAPig.
Update on Morgan Creek
We are pleased to announce that we took over the management of the AdvisorShares Morgan Creek Global Tactical ETF at the end of July. We are very excited about providing an ETF vehicle that refects our best thinking on global tactical asset allocation. We believe that this investment solution can play an important role as a core holding in investors and Financial Advisors client portfolios providing strong returns as well as insights on strategic and tactical asset allocation ideas and regional/sector ideas. For more information of this exciting new addition to the MCCM suite of investment solutions, please visit www.advisorshares.com or contact any of us if you have questions.
We hope you have been able to join us for our new Global Market Outlook Webinar Series titled Around the World with Yusko. We have been hosting this series of topical discussions on a monthly basis and most recently have presented our thoughts on why we believe 2014 will be the inverse of 2013 in #TeYearofheAlligator, followed by focused sessions on the fantastic opportunities in Japan and the Peripheral European markets (GIIPS). Accompany- ing the presentation of one of our Best Ideas Temes each month, we also provide a short update on the Tactical Fund following each #ATWWY call. If you would like more information, please email investorrealtions@morgancreekcap.com. For more specifc information on our Registered Investment Products, please visit us at www.morgancreekfunds.com.
Following on the success of our inaugural iCIO Investment Summit held in New York City last December, we brought the iCIO show back home to North Carolina in May and it was a sold-out, smash hit. Congratulations to Andrea and her amazing team for taking our Conferences to the next level. Te Investment Summit format was envisioned to provide an opportunity to generate high-level Conversations, Ideas and Opportunities (hence CIO) amongst senior investment professionals regarding the ever-changing investment environment and the results have exceeded our lofy expectations. Te speaker faculty for the May Summit was our best yet (and that is saying something since our historical faculty lineup has been top notch) as we were very fortunate to have a number of the brightest minds in the investment business join us, including Kiril Sokolof, Burton Malkiel, John Burbank, Van Hoisington, David Zervos, David Hornick and Dan Clifon. Tanks to all who attended and it was exciting to see such a wide
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK 4 0 Second Quarter 2014 spectrum of participants including Foundations, Endowments, Pension Funds, Family Ofces and other investment management organizations be with us in NC. It was also very special to have everyone join us for the Morgan Creek Capital Management Ten Year Anniversary Celebration! It was such a special evening on fun and fellowship and it was humbling for all of us to have so many of our friends and extended family take time to help us celebrate this milestone. We are just getting warmed up at MCCM and we are excited about what the next decade will bring.
Our December iCIO Investment Summit will be here before we know it, on December 9, 2014 and will be held at Club 101(40 th & Park) in NYC. We will be hosting a welcome reception on December 8 th
at Celsius at Bryant Park (5 th Ave. & 42 nd St.) from 6pm-8pm. Tis is one of our favorite places to visit during the holiday season. Come join us as we take in the views of the ice rink surrounded by many shops and vendors who are only there during December. Please go to www.iciosummit.com for more details. We are pleased to announce that we have already confrmed KPMGs Chief Economist Constance Hunter as one of our guest speakers. As always, Morgan Creek current investors (in any one of our products) receive complimentary access to the iCIO event. For more details, please contact Andrea Szigethy at aszigethy@morgancreekcap.com or Donna Holly at dholly@morgancreekcap.com.
If you fnd yourself in the Southeast in early October, we are hosting our annual NC Investment Institute Forum & Roundtable on October 7 th at Te Umstead Hotel in Cary, NC. Te speaker faculty listing and agenda is available and posted online at www.ncinvestmentinstitute.org. Tis is a great place to meet investors, managers and consultants in the South. Tis main forum is open to anyone interested; however, our NC Investment Roundtable is open only to Chief Investment Ofcers, Portfolio Managers or senior investment team members. We expect this to close out soon so please register online if you would like to attend our Fall Program.
As we transition into our second decade, we want you all to know how grateful we are to have had the opportunity to provide investment management solutions to our clients for the past decade and how excited we are about continuing to work with all of you going forward. We could have never achieved such a milestone without the continued support, loyalty and friendship of such a tremendous group of friends and partners. It is a great privilege to manage capital on your behalf and we are appreciative of your long-term partnership and confdence.
With warmest regards,
Mark W. Yusko Chief Executive Ofcer & Chief Investment Ofcer
Tis document is for informational purposes only, and is neither an ofer to sell nor a solicitation of an ofer to buy interests in any security. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such oferings, nor is it intended that they will. Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources.
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK
Upcoming Educational Programs Save the Date for Future Morgan Creek Events
NC Investment Institute October 7, 2014 (welcome reception Oct. 6 th ) Te Umstead Hotel, North Carolina To Register: www.ncinvestmentinstitute.org
Te iCIO Investment Summit December 9, 2014 (welcome reception Dec. 8 th ) Club 101, New York City To Register: www.iciosummit.com
Around the World with Yusko Webinar Series Next webinar: August 26, 2014, 1:00pm EDT To Register: Please contact IR@morgancreekcap.com
For more information on any of our upcoming programs please contact Andrea Szigethy at aszigethy@morgancreekcap.com
Q2 2 0 1 4 MARKET REVI EW & OUTL OOK - DI S CL OS URES General Tis is neither an ofer to sell nor a solicitation of an ofer to buy interests in any investment fund managed by Morgan Creek Capital Management, LLC or its afliates, nor shall there be any sale of securities in any state or jurisdiction in which such ofer or solicitation or sale would be unlawful prior to registration or qualifcation under the laws of such state or jurisdiction. Any such ofering can be made only at the time a qualifed oferee receives a Confdential Private Ofering Memorandum and other operative documents which contain signifcant details with respect to risks and should be carefully read. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such oferings of these securities, nor is it intended that they will. Tis document is for informational purposes only and should not be distributed. Securities distributed through Town Hall, Member FINRA/SIPC or through Northern Lights, Member FINRA/SIPC.
Performance Disclosures Tere can be no assurance that the investment objectives of any fund managed by Morgan Creek Capital Management, LLC will be achieved or that its historical performance is indicative of the perfor- mance it will achieve in the future. 2005-2013 results are audited. 2014 performance data is not yet audited and is subject to change upon audit. Monthly performance numbers are not individually audited and only a funds annual fnancial statements are audited. Performance may difer based upon New Issue eligibility, individual dates of admission and actual fees paid. All performance refects reinvestment of dividends (if any) and all other investment income (which should be evaluated when reviewing performance against other indices). Te performance data set forth in this presentation is based on information provided by underlying managers and is believed to be reliable but has not been independently verifed by Morgan Creek Capital Management, LLC.
Forward-Looking Statements Tis presentation contains certain statements that may include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical fact, included herein are "forward-looking statements." Included among "forward-looking statements" are, among other things, state- ments about our future outlook on opportunities based upon current market conditions. Although the company believes that the expectations refected in these forward-looking statements are reasona- ble, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual results could difer materially from those anticipated in these forward-looking state- ments as a result of a variety of factors. One should not place undue reliance on these forward-looking statements, which speak only as of the date of this discussion. Other than as required by law, the company does not assume a duty to update these forward-looking statements.
Indices Te index information is included merely to show the general trends in certain markets in the periods indicated and is not intended to imply that the portfolio of any fund managed by Morgan Creek Capital Management, LLC was similar to the indices in composition or element of risk. Te indices are unmanaged, not investable, have no expenses and refect reinvestment of dividends and distribu- tions. Index data is provided for comparative purposes only. A variety of factors may cause an index to be an inaccurate benchmark for a particular portfolio and the index does not necessarily refect the actual investment strategy of the portfolio.
No Warranty Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources.
Risk Summary Investment objectives are not projections of expected performance or guarantees of anticipated investment results. Actual performance and results may vary substantially from the stated objectives with respect to risks. Investments are speculative and are meant for sophisticated investors only. An investor may lose all or a substantial part of its investment in funds managed by Morgan Creek Capital Management, LLC. Tere are also substantial restrictions on transfers. Certain of the underlying investment managers in which the funds managed by Morgan Creek Capital Management, LLC invest may employ leverage (certain Morgan Creek funds also employ leverage) or short selling, may purchase or sell options or derivatives and may invest in speculative or illiquid securities. Funds of funds have a number of layers of fees and expenses which may ofset profts. Tis is a brief summary of investment risks. Prospective investors should carefully review the risk disclosures contained in the funds Confdential Private Ofering Memoranda.
Russell 3000 Index (DRI) this index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. Defnition is from the Russell Investment Group.
MSCI EAFE Index this is a free foat-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. Morgan Stanley Capital International defnition is from Morgan Stanley.
MSCI World Index this is a free foat-adjusted market capitalization index that is designed to measure global developed market equity performance. Morgan Stanley Capital International defnition is from Morgan Stanley.
91-Day US T-Bill short-term U.S. Treasury securities with minimum denominations of $10,000 and a maturity of three months. Tey are issued at a discount to face value. Defnition is from the Depart- ment of Treasury.
HFRX Absolute Return Index provides investors with exposure to hedge funds that seek stable performance regardless of market conditions. Absolute return funds tend to be considerably less vola- tile and correlate less to major market benchmarks than directional funds. Defnition is from Hedge Fund Research, Inc.
JP Morgan Global Bond Index this is a capitalization-weighted index of the total return of the global government bond markets (including the U.S.) including the efect of currency. Countries and issues are included in the index based on size and liquidity. Defnition is from JP Morgan.
Barclays High Yield Bond Index this index consists of all non-investment grade U.S. and Yankee bonds with a minimum outstanding amount of $100 million and maturing over one year. Defnition is from Barclays.
Barclays Aggregate Bond Index this is a composite index made up of the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index, which includes securities that are of investment-grade quality or better, have at least one year to maturity and have an outstanding par value of at least $100 million. Defnition is from Barclays.
S&P 500 Index this is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. Te index is a market-value weighted index each stocks weight in the index is proportionate to its market value. Defnition is from Standard and Poors.
Barclays Government Credit Bond Index includes securities in the Government and Corporate Indices. Specifcally, the Government Index includes treasuries and agencies. Te Corporate Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specifc maturity, liquidity and quality requirements.
HFRI Emerging Markets Index this is an Emerging Markets index with a regional investment focus in the following geographic areas: Asia ex-Japan, Russia/Eastern Europe, Latin America, Africa or the Middle East.
MSCI Emerging Markets Index this is a free foat-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of No- vember 2012 the MSCI Emerging Markets Index consisted of the following 23 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Tailand, Turkey, and United Arab Emirates.