Whole Foods vs. Twinkies: 2011 Outlook

 

Clichés, as the late William Safire was fond of saying, should be avoided like the plague. And thus it follows that while there is no apparent reason why investment performance should in any way be related to the elliptical movement of the Earth around the Sun, it is nonetheless the case 2010 is near its conclusion and a new year beckons with the inevitability of “The Outlook for the Year Ahead.”

 

Looking back for a moment, our bottom-up, research-driven investment approach suggested that for most of the year, reasonable companies could be purchased for very reasonable valuations, and as has historically been the case, an investor is paid to act if these opportunities present themselves. We mostly did so, although in retrospect following every strong move by the stock market, we wish we had stepped on the gas a little harder. Generate competitive returns in up markets and outperform in down markets is the mantra of any long-term value investor and we solidly achieved this goal across all strategies in 2010, but it would be wrong for me not to mention we simply killed it in our International strategy, which completes three years of performance this month.

 

We will make the assumption that as of this writing and with much tree felling to come, the “Year in Review” has been fairly well-covered and thus it might be more helpful to review what we learned as investors about the world at-large, and our abilities to process the ever larger torrent of available information in order to make rational and profitable decisions for our clients. To sneak in a quote from one of Warren Buffett's original partnership letters, which remains an interesting and relevant reread and can easily be found on a Bing search (we still have a large position in Yahoo! for the record), “a majority of life's errors come about when one forgets what one is really trying to do.”

 

 

On that note, 2010 was a testament to the importance of flexibly keeping your own counsel. The investment world abounds with incredibly bright and articulate people who now have unlimited space on which to propound with great lucidity what they think is about to happen on nearly any topic, security, market or political arena. An investor today can spend days reading absolutely terrific commentary on the pressing issues of the world…and wind up no further along a profitable path than from whence he started. While it should be considered nearly a godsend when one is delivered the foresight to be presciently correct on a giant macro theme and then take the correct action in large enough size to matter, the reality is that a diligent investor has infinitely more opportunity to add value by focusing on the trees rather than the forest. A repetitive process of seeking out undervalued securities is not only doable, but it provides a sense of purpose and resolve when cognitive dissonance abounds. If the business is real and has staying power and your work suggests significant undervaluation, you have a mental anchor when the “price” or the overall market goes against you or ignores you in the short run. “You will not be right simply because a large number of people momentarily agree with you. You will not be right because important people agree with you. You will be right over the course of many transactions if your hypothesis is correct, your facts are correct and your reasoning is correct.” (Buffett paraphrasing Ben Graham.) I hereby resolve to read more annual reports and less Lunch with Dave (Rosenberg -Gluskin Sheff). Oh, and add this to the I can't prove it, but I know it’s true list: “It is incredibly rare for the guy who called the ‘top’ to be the same guy who calls the bottom. And vice versa.” The past year proved this can be applied to markets, economies and individual stocks.

 

 

Another thought that was reinforced in 2010 is the utter nonlinearity of life as we know it and how that plays out in financial markets. The whistle that blows for investor action at an important inflection point is unfortunately more akin to a dog whistle - the signal is simply out of our range. The consensus was that interest rates were in a near permanent state of lowness, which didn't stop the 10year Treasury from rocketing 80 basis points since Ben Bernanke first announced a sailing date for QE2. US large cap stocks were sold most of the year by investors as evidenced by mutual fund outflows and a distinct lack of our phone ringing for search participation. In both cases, when the turn came, you had to be mostly there (or not in the case of bonds) because most investors’ ability to turn on a dime is limited. As any number of real and imagined crises came and went this year, markets and securities often moved in convulsive and step function ways – it is their nature, get used to it.

 

Our last bit of self analysis is in regard to the healthy respect and proper perspective of the "math" of finance. There are innumerable ways to fall in love with the quantitative aspects of investing, from spreadsheet worship, to architecting CDO structures, to adoration with recent performance numbers, to the insidious nature of artificially low interest rates, which makes every deal “accretive” and any valuation supportable. Successful investing often requires a nuanced appreciation of the subtlety of the world around us in ways that are not exclusively grounded in mathematics. One of our bigger

winners this year was Pioneer Natural Resources, an energy company that is being cheered for valuable US acreage in the Permian Basin of West Texas and the ubiquitous Eagle Ford shale play in South Texas. Pioneer was always an asset rich, but perennial underperformer that languished in analyst community derision. At an energy conference, our intrepid analyst Geoff Stewart couldn't help but notice the paltry crowd at the Pioneer break-out session while 150 investors breathlessly packed into the main ballroom to hear a presentation by yet another $80 billion industry behemoth. That ‘tell’ set in motion detailed analysis that suggested that Pioneer was walking the walk as far as narrowing its focus to its “oily” Texas acreage, and its low-cost reserve base was clearly being overlooked by many investors. While its valuation appears to still be reasonable, Pioneer now fills a room and would make a truly ingenious acquisition candidate for an $80 billion behemoth looking for something to talk about in 2011.

 

While we are on energy and inching forward into 2011, we will bravely put forth Chesapeake Energy, as the negativism toward its strategic approach, its CEO and the price of natural gas in general are not at all subtly negative. While at the end of the day, the investor will be held hostage to the price of natural gas, we would suggest that there are subtle factors at work in the supply arena including the beginning of the end of “drill it or lose it” lease acquisition activity, a conceptual industrial demand pickup in a reasonable economic growth environment, and some legitimate questions on the real cost of drilling and willingness of investors to continue to fund uneconomic activity at $4Mcf natural gas. And while it cannot be mathematically calculated at the present time, the searing experience of having dropped $1 billion of personal net worth on a margin call in 2008, plus the media attention of being held up as a prime example of corporate egregiousness suggests change at the margin of Chesapeake’s capital allocation strategy. We will admit this presently defines the word subtle, but our work suggests a margin of safety in the low $20s.

 

Now that we are all older and wiser, what sayeth we now? Our “Outlook” usually falls back on a “normalized” sense of equity returns in the mid- to high-single digits for the long run, from which we add to or subtract from factoring in current valuations in the portfolio and the market as a whole. While it can be argued that the fervor of the recent rally has sapped some of this intermediate upside, we think between reasonable economic activity, operational competence and generally solid capital allocation strategies, we can expect the value of our holdings to appreciate at least in line with a normalized “forecast,” and then we get our boost from purchasing this value and/or growth at 20% to 50% of our estimate of intrinsic value. We see plenty within the portfolio that fits this model, and a reasonable amount outside of it.

 

We remain highly cognizant of the other side of the story, which is that we are in the middle of what noted investor Seth Klarman calls a “Twinkie Market” where you have a feeling of satisfaction for the moment, but it is all based on artificial ingredients being served up by Washington. (We are getting rid of all our stored up quotes from 2010 per our resolution.) Thus our portfolio continues to cling to a “balanced” approach to economic leverage, as valuations suggest neutrality as to whether the economy is truly on the verge of picking up legitimate steam or is simply locked into further muddle. We remain utterly convinced, however, that our bigger problems are fiscal in nature rather than monetary and while progress has been made, they remain a long way from growth-oriented. Political statements aside, we will always vote for more stasis out of Washington.

 

To illustrate a mini-theme, we will co-opt some thoughts from one of the very few outside research services we use – Murray Stahl and ContrarianResearch - and apply it to some of our own holdings. The “theme” is that much of what is moving in the stock market over the past four months involves economically sensitive names, the obvious idea being that if we aren’t falling into a deflationary abyss dimly lit with fluorescent bulbs, then an investor wants to be in the equities most leveraged to the economy. The correctness of that statement aside, the applicability here is that this investment requires an economic forecast, which can then be somewhat easily applied to corporate earnings, an analysis of historical multiples can be proffered and attached to that earnings forecast and voilà, a targeted stock price. We do this all the time ourselves as part of a process to establish a reasonable normalized earnings range in a world that clearly likes its cyclicality.

 

But what is clear about this exercise is that it requires economic and earnings forecasts, which as countless studies have shown and Wall Street analysts have demonstrated, are inherently unpredictable. Yet in classic behavioral finance style, we believe we can forecast so we try to do it, much attention and precision is attached to them and the stocks dutifully move. Getting to the point in this exercise is that there are another group of stocks which might be better referred to as NAV (Net Asset Value) stocks, which have not moved nearly as much and represent superb stores of value that we would be very appreciative of seeing recognized in 2011. Our focus group runs across all strategies and includes Loews, Brookfield Asset Management, White Mountains Insurance, Allegheny Corp and a pair of Liberty companies. The contradiction here is that each of these companies sells at or below stated book value and/or a very reasonable estimate of their pieces, but is not considered an “earnings” story that can easily be reduced to economy/earnings forecast/attach multiple/spit out value methodology. And yet they have long demonstrated histories of generating above average returns to shareholders. So conversely, the most logical predictor of success − people − is also the least forecastable and thus value can be underappreciated, as it clearly is today.

 

Many of the same issues we have explored in 2010 will be with us in 2011 and within the context of limited space, we will offer a spectrum of random thoughts for the investor to consider in 2011 and our best wishes for a healthy and prosperous New Year.

 

Jeffrey Bronchick, CFA

Principal & Chief Investment Officer

jbronchick@rcbinvest.com

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While we utterly understand the “disgust trade” when one reviews the world's poli-economic institutions, is it not possible that the prevalence of GLD, the gold ETF, as a top ten holding in many of the world’s largest hedge funds is indicative of “I own it because it is going up” and thus the opposite is possible?

 

Historically speaking, it is often the case that coming out of recession, corporations have both low levels of sales and low operating margins. As the economy turns, both sales and margins improvement and the stock reflects both stronger growth and improving profitability. In today’s world, much of corporate America did a superb job of reacting to the downturn and actually entered the upturn with near or record margins. So under the heading of “what next” is it possible some of the upside in some stocks has already been spoken for even in the event of good economic growth in 2011 and beyond?

 

The fact that Americans are not piling into planes and buying rounds of Guinness in Ireland or ouzo in Greece is indicative of the truly intellectually bankrupt state of affairs in Europe, as the “normal” adjustment of currencies to reflect differing states of economy is held hostage by intermediate idealism. We have no idea when, but registered voters will eventually have their say.

 

Before you listen to any sentence that begins with “the market looks cheap on forward earnings,” recall that the market almost ALWAYS looks cheap on forward earnings (see above). The MSCI World Index sells at what appears to be a very undemanding 12.5x forward earnings, which happens to be the exact multiple as the market top in March 2008.

 

It is incredibly difficult to make the blanket statement that “the muni market is a destined for a disaster.” There are thousands of individual issues with their own credit situations and it is highly possible to pick, choose and find value. That said, welcome to California.

 

There has been an overwhelming bearish consensus among investors and economists for almost ten years on interest rate (count us for 8 of the 10), that predictably have been proven wrong as rates have dropped and bonds have outperformed the S&P 500. Reported inflation, which is a topic in and of itself, remains plugged at 1%, the “real” yield on long-term bonds has averaged 2% for almost 140 years, and the nominal yield on 30-year Treasury is over 4%. One of those numbers is going to change in 2011.

 

© Reed, Conner & Birdwell

www.rcbinvest.com