QUOTE OF THE WEEK
"Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant."
– Warren Buffett
Read more of our favorite value-investing quotes.
MAY 10, 2015
On a regular basis, IntelligentValue systematically analyzes the overall economy and stock market and makes refinements to our stock-selection system. Changes in the characteristics of what is working in the stock market follow fluctuations in the business cycle. The business cycle simply is a description of economic changes over a period of time.
These changes are usually defined in terms of periods of expansion or contraction and are measured by indicators such as employment, industrial production, personal incomes, inflation, and interest rates, among others. Expansion is measured from the trough of the previous cycle to the peak of the current cycle while contraction is measured from the peak to the trough.
In the United States, the National Bureau of Economic Research (NBER) determines the official dates for business cycles. Since 1945, NBER has recorded 12 cycles, typically lasting a little less than six years. As most investors are aware, there have been two severe contractions (recessions) since the year 2000; from March 2000 to March 2003, and from December 2007 to March 2009.
At the bottom of these business-cycle contractions lie the most favorable investing opportunities. At these times, because of the typical recent severe selloff and losses experienced by buy-and-hold investors, the vast majority are wary of the market and are not interested in buying stocks. However, value investors are unemotional and allow that fear to play into their hands. In March 2009, our Intelligent Market Risk Analysis (IMRA) system told us the time was ripe to buy deeply undervalued stocks. The result was a return of 1600% for our DEEP VALUE Portfolio and 600% for the RELATIVE VALUE Portfolio for the remainder that year.
LIQUID ASSETS AT BUSINESS CYCLE TROUGHS
At the bottom of a recession/contraction, the most favorable stocks to purchase are those that are selling at a deep discount to plentiful liquid assets. The reason for this is that following a sharp selloff there remains a great fear of corporate failure, and investors seek out the companies that will be most valuable should a liquidation ensue.
In early 2009, a considerable number of investors thought that the second coming of the Great Depression was upon us. Corporate sales and net incomes were unknowns, and, in fact, S&P 500 profits had plummeted from $109 to just $8. However, opportunistic investors who saw that the market had bottomed targeted companies selling at deep discounts to liquidation-based ratios such as Price to Cash, Price to Current Assets or deep discounts to Book Value. IntelligentValue and other Benjamin Graham-influenced investors searched for companies selling at a discount to what's known as 'Net–Net' (Net Current Assets minus All Liabilities). In March 2009, you could buy corporate cash stockpiles in well-known companies for 40 cents on the dollar. It was a veritable value investor's paradise!
ADDING MORE BALANCE SHEET ASSETS AS PROGRESS IS MADE
From 2010 to 2012, as the economy sputtered in fits and starts, stock-selection ratios that focused on assets continued to produce the most profitable investment results. However, emphasis had moved away from cash to balance sheet items such as inventory, plant and equipment, land, investments, receivables, etc. Savvy investors still demanded assets backing their money.
By mid-2012, the US and world economies had gained a more solid footing and had entered a new phase. The 2011 threat of a European collapse and a potential US default on its debts had passed, and corporations across the world had cut costs to the bone. Profits were soaring. The world economy had entered a new phase; it was clearly out of the trough and into a time of growth.
MOVING TO INCOME AND CASH-FLOW STATEMENT/GROWTH FACTORS
At this time, stock-selection ratios that focused on sales, gross profits, operating income, operating cash flow, free cash flow, and growth began to produce more favorable investment results. IntelligentValue adjusted our stock-selection factors and formulas to take advantage of the growing economic environment and the stock market's adjustment to that dynamic. The result was a return of 112% in 2012 and 261% in 2013 for our DEEP VALUE Portfolio, and a return of 78% in 2012 and 108% in 2013 for our large-cap RELATIVE VALUE Portfolio.
2014 was a year of turbulence and consolidation following the excess returns of 2013. Like the broad market, our portfolios struggled in 2014, but still beat the market by a wide margin. However, as many subscribers may have noticed, so far in 2015 we have underperformed the market, and that's not acceptable to us for very long.
While any stock-selection approach is going to have periods of outperformance and underperformance, IntelligentValue has never had a losing year (including 2008) and has always significantly outperformed the market. What's the reason for the underperformance of our proven stock-selection criteria in 2015? We believe that the US equity market has entered a new phase.
This past Friday's report of 223,000 jobs created in April (and a drop in the unemployment rate to 5.4%) helped spark a stock rally to close out the week. The report offsets the unusually weak report in March while not being overly high. It signaled the economy wasn't slowing as much as had been feared, but wasn't growing so fast as to warrant a Fed rate hike.
We believe that the economy is in mid-cycle. How can the US economy be mid-cycle when we are already six years into the recovery? Didn't we previously say that most business cycles lasted about six years? With stock market valuations being criticized daily as "too high" already, this would typically be a time to think about being defensive. However, leading economic indicators show that there is likely to be no recession for more than a year, inflation is nowhere to be found, and the economy is not yet overheating. As a result, the Federal Reserve has not started to tighten rates.
ADDING MOMENTUM FACTORS
Stock valuations are high, enormous amounts of excess liquidity are sloshing around in the world economy, unemployment is reaching levels considered to be 'full employment.' However, there is no sign of inflation or Federal Reserve tightening. Based on history, the Federal Reserve is going to keep rates low and, as a result, the market has moved into a phase of momentum and bubble formation. We've all been here before, and it's not likely to end pretty. However, for the next year-plus, we expect stocks with prices that are moving higher to continue moving higher.
IntelligentValue regularly samples essential criteria in the market to measure 'what's working now.' Since the mid-October 2014 correction, what's been working is Value + Momentum factors and formulas. We made adjustments to our stock-selection ranking systems and buy/sell rules to take this change into consideration and expect our returns to reflect those changes in coming months.
By being flexible and regularly making carefully measured, systematic changes in our stock-selection regimes, we hope to continue to provide significant outperformance of the market that meets yours and our objectives. This week's changes to the stocks in our DEEP VALUE and RELATIVE VALUE Portfolios begin to reflect the refinements we have made to our stock-selection systems.
A PERFECTLY-TIMED TRANSACTION
ATLAS AIR WORLDWIDE HOLDINGS
On March 22, we recommended the purchase of Atlas Air Worldwide Holdings (AAWW) and bought it at the market open the next day at a price of $47.25/share. Then on April 12, we did an analysis of AAWW and reiterated our buy recommendation. Along with the fundamental analysis, we presented the following price chart which included our Intelligent Price Oscillator™ in the lower window:
Atlas Air Worldwide's chart shows a high-probability technical setup. Combined with the company's undervalued fundamentals presents an optimum opportunity.
In our April 12 profile of AAWW, we said, "Based on the fundamental technical analysis tenet of buying when a stock is oversold and bouncing from a support level, AAWW's price chart is now presenting an optimum entry point. When combined with well-established value fundamentals, this stock presents a high probability investment opportunity. Atlas Air Worldwide is a STRONG BUY."
TODAY'S UPDATE: In its April 30 earnings announcement, AAWW shocked investors with exceptional results. First-quarter profit rose to $29.2 million from $4 million a year earlier, with per-share earnings rising to $1.18 from $0.32, well above analyst's expectations. Sales rose 10% to $445 million. The stock price gapped sharply higher following the announcement, and robust gains continued last week.
The chart below shows AAWW's current price picture in the top window, along with our Intelligent Price Oscillator™ in the lower window. As you can see, AAWW did a double bounce off of the support line we identified in our April 12 analysis. The take-off we anticipated was delayed by a couple of weeks, but it certainly did take off!
From a fundamental standpoint, we consider the shares close to being fairly valued and from a technical view the stock is now overbought. We are selling Atlas Air Worldwide at the open tomorrow for a profit of 19.6% from our original recommendation and a profit of about 29% from our April 12 reiteration of the buy signal.
THESE FOUR ISSUES can CAUSE YOU TO FAIL AS AN INVESTOR. DO ANY APPLY TO you?
Having launched IntelligentValue in 2004, we have had the great fortune of being able to share investment success with a family of thousands of satisfied subscribers. We've also been disappointed to see a significant number of subscribers cancel their subscription and leave in frustration. The reason? For 99.9% of them, they are not satisfied quickly enough.
Based on email correspondence with them, the vast majority of this group are young and inexperienced with investing. Brainwashed by the media, many believe quarterly earnings reports are the be-all and end-all of investing. Forecasts of the future are the stock-in-trade of the Wall Street money machine. When the two are combined; short-term results and forecasts of that result, people are sucked in by the same traits of humanity that lure people to Las Vegas. The majority of people are flat-out gambling when they put their money down on a stock that an expert has predicted (guessed?) will beat earnings estimates at the next quarterly report.
On Tuesday, they hear a talking head on CNBC predict that a hot stock will beat earnings estimates on Thursday. They log on and click the buy button at their electronic broker’s website. It's as easy as pulling the lever on a slot machine. The stock either beats or disappoints, and they win or lose. It's about the same as adrenaline rush as roulette; put your money on black or red and spin the wheel. Half the investing public is buying and holding stocks they know nothing about in a mutual fund, and the other half is treating investing as their personal, in-home, Las Vegas casino. Unfortunately, big Wall Street brokers and the media are trained facilitators of that self-destructive behavior. It's in their interest because there is big money to be made in pandering to human frailty.
Value investing is anything BUT a casino-type rush. We are buying stocks that are most assuredly NOT HOT. For most of the companies we buy, you probably have never heard of them. They are the unloved, forgotten, neglected, downtrodden, and beat up. Many of them would be called 'losers' and evoke laughs from your friends if you told them about the boot lace manufacturer in which you had bought shares. However, in the long run it's those 'loser' stocks that decline the least, outperform the most, and provide you with steady, outstanding annual returns while making the go-go, popular stocks look pathetic when they crash-and-burn.
However, a certain portion of the people who join IntelligentValue have already been indoctrinated to chase the hype that surrounds companies like Tesla, Sarepta Therapeutics, Google, Gilead, etc. It's difficult to convert a person from an adrenaline-junkie trader to a true value investor. Not many stick with it and have the patience to wait for a company that is priced lower than its intrinsic value grow to full value.
We also find that for many people who cancel, they believe they can get a better return somewhere else. They become part of the 'chase-for-performance’ crowd. These individuals apparently feel that they have to get returns here, now, today. If they don't, it's on to the next 'hot hand' advisor, mutual fund or newsletter they have heard about.
Mark Hulbert of the Hulbert Financial Digest regularly does reviews of the performance of investment newsletters with year-to-year comparisons. Since 1980, his data shows that people that subscribe to the newsletter that had the best performance the previous year have only a 16% chance of beating the market the following year and instead, a 28% chance of losing money. In other words, the investment newsletter with skyrocketing performance last year is likely to experience reversion-to-the-mean this year, will probably underperform the broad market this year, and may even lose money.
Investors would be well advised to find an approach that they clearly understand and which has steady returns, and then stick with it through thick and thin. Just like jumping from one stock to another, jumping from one hot approach to the next is a sure-fire recipe for losses.
MISUNDERSTANDING VALUE INVESTING
A small portion of investors who give investing more thoughtful consideration may be attracted to the value approach. However, for all the press it gets from academic studies and success stories of famous practitioners such as Warren Buffett, Carl Icahn, Seth Klarman, Whitney Tilson and others, value investing is still a minuscule niche in the spectrum of investing approaches. The vast majority of individual investors pursue the popular approach of attempting to predict growth and quarterly earnings beats by 'hot-story' companies.
However, for those who do understand the concept of buying tangible corporate assets at a deep discount to their intrinsic value, perhaps they don't appreciate the fact that it takes some time for a value-investing thesis to come to fruition. For example, the companies chosen for our RELATIVE VALUE Portfolio are profitable, quality businesses, but for some reason they are temporarily being mispriced by the market. Perhaps it is simply because the company has been ticking along, producing substantial performance like clockwork, but without fanfare and publicity. In other cases, there are 'hotter' stories about other sectors in the media. Disregard is a key reason that companies become undervalued.
It can take a few months for the investing public to catch on to the undervalued stocks in our portfolios. The range of days that we hold positions in the RELATIVE VALUE Portfolio is from 6 to 239, with an average of 70 days (3.5 months) and 81% of the stocks we select for the RV portfolio are eventually winners. However, for some of the people who subscribe then cancel shortly thereafter, even 3.5 months is apparently too long.
For the DEEP VALUE Portfolio, it is a little more complicated. Many of the businesses appear ugly on paper, their stock price has been declining for months, they may have been losing money quarter after quarter, and their prospects appear bleak. When the average person sees some of the stats on these companies, it's difficult to make them understand why they should buy ownership in such a 'dog.'
However, our results show that for these companies, their temporary troubles result in a stock price that is significantly overdone to the downside. Inevitably, the 'invisible hand' of capitalism begins to work; assets are redeployed, inept management is replaced, laggard divisions are spun off, and the company’s prospects are renewed. It can take a bit longer, but 78% of the stocks in the DV portfolio are eventual winners and the result has been a triple-digit average return since the portfolio's inception.
OUR INSTANT-GRATIFICATION WORLD
Unfortunately, the problem is larger than just a tendency to treat investing like roulette, changing from one advisory service after another in a chase-for-performance, or a misunderstanding the mechanism of value investing's success. The problem likely spans much more territory in human behavior than just the world of investing. The problem is probably a result of the fast-paced, instant-access world in which we live today.
Everything from on-demand movies to scratch-off lottery tickets to instant messaging has heightened people's expectation for instant delivery of results. Instead of reading 'Gone With the Wind,' millennial read the Cliff Notes. The result is a culture of instant gratification that many feel is making the concepts of substance and in-depth understanding a thing of the past.
When I was beginning my career as an investment analyst, research for companies that met a basic value thesis of low price-to-earnings or low price-to-book meant a one-hour drive to the firm's central office to access the 'resource library.' Then the process began with hours of digging for the correct reference binders to find the appropriate company data, and more hours digging through the printed 10-Ks, 10-Qs, S&P or ValueLine pages before I might – might – find a company that met my primordial value criteria. That resulted in more hours digging through the paper annual and quarterly reports to find the information I needed, and then manually inputting the numbers into a primitive Lotus 1-2-3 spreadsheet.
It was a week-long process to generate a five-stock list of candidates. Today that can all be done in 20 seconds from a smartphone. However, I'm glad I have that experience of digging through stacks of annual reports, 10-Qs, 8-Ks, and Form-4s. As a result, today I intimately understand the inner workings of publicly traded corporations.
Perhaps I'm just dating myself by raising the issue of instant-gratification as part of a troubling source of individual-investor failure. Perhaps I'm being a hypocrite because I also enjoy 100-meg/second Internet speeds and movies on demand. But I think something is being lost when investors don't understand the reasons why one approach to investing works and why another one is failing.
Perhaps it has something to do with today's hyper-speed expectation that we can place a tick mark in a box, hit 'enter,' and instantly get a result that pleases us. Just push a button on the computer to get rich! If we're not richer this week, then push a different button next week. If only it were that easy, then everyone would be doing it! Unfortunately for many, it takes more to increase your wealth through investing. For those who have the other issues under control, perhaps the only thing it requires is patience.
To re-quote Warren Buffett from the 'Quote-of-the-Week' at the top of this page, "Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant."
We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.