broyhill letter (q1-10)

8/9/2019 Broyhill Letter (Q1-10)

http://slidepdf.com/reader/full/broyhill-letter-q1-10 1/6

T H E B R O Y H I L L L E T T E R

The old saw reminds us never to confuse genius with a bull market. Anyone can become “expert” at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don’t always compliantly rally.Sometimes minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined,“buy the dips” can drift mindlessly into “buy anything”; a rising tide that is lifting all boats often proves irresistible.

- Seth Klarman’s 2006 Baupost Annual Letter

Executive Summary

Wikipedia denes Conrmation Bias as a tendency for people to prefer information that conrms their preconceptions

or hypotheses, independently of whether they are true. We are all guilty of this behavioral pitfall, but investors ignoreit at their peril. Research shows that we are twice as likely to look for information that agrees with us than we are to

seek out information that does not. Charles Darwin understood this and looked for disconrming evidence. While

researching his theory of evolution, he kept two notebooks: one that conrmed his hypothesis and another that

disproved it.

Self awareness is perhaps the most powerful defense against a long list of behavioral biases. Rather than looking for all

the evidence that everything is going well, investors would be well served by more closely examining the potential for er-

rors in judgment. By spending more time questioning the consensus and looking at ways things may go wrong, investors

are more likely to be positively surprised by the upside, rather than caught skinny dipping when the tide recedes.

Bull Fighting

The Investment Team at Broyhill recently spent several days with an outside consultant reviewing the potential for

behavioral biases to enter our investment discipline. While it is impossible to completely eliminate such biases, an

effective process should aim for ongoing improvement in awareness and draw upon various methods for minimizing

behavioral risks. The best way to counter Conrmation Bias is to spend more time with the people who disagree with us

most, so that we fully understand the opposite side of the argument. If we can’t nd logical aws in their reasoning, we

have no business holding onto our view so strongly. Other helpful tools include playing a game of Devil’s Advocate or con-

ducting a Pre-Mortem where the thesis is assumed to be wrong, and potential sources of failure are brainstormed.

After a 5.9% rst quarter return in the S&P 500, led by lower quality cyclical stocks, we’ve spent a considerable

amount of time speaking with equity market bulls and reviewing as many positive research reports as we could get our

hands on. We even turned BubbleVision (CNBC) back on in our ofces to hear what our favorite market cheerleaders

had to say! Our efforts to more fully appreciate the bull case for owning equities today conrms our concerns that the

potential returns from owning stocks at current prices do not compensate investors for the risks being taken. All of

the Wall Street research we came across suggesting that “stocks have further to run” can essentially be summarized

by the ve points outlined below.

F i rst Quarter 2010



A Sustainable Economic Recovery?

By far the most common argument we came across was the strength of the economic rebound currently

underway. Analysts point to a number of coincident indicators of economic growth - improving employment

trends, rebounding retail sales, surging manufacturing indices, and the notorious “inventory building” - as

reason for optimism. Importantly, we do not disagree that current economic data points are a substantial

improvement upon year-ago levels. Where most fail to connect the dots however is what impact this data has on future

stock prices. The sharp rise in Leading Economic Indicators last year foreshadowed stronger economic growth this

year. And while we are likely to see continued improvement in economic data near term, the same leading indicators

which painted a very bullish backdrop one year ago are now raising the caution ag. Note that equity markets have

historically traded lower six months after a peak in leading indicators, as shown in the charts below from Morgan

Stanley Research.

In short, last year’s monster rally in stock

markets was a leading indicator of current

economic strength - not the other way

around. What concerns us is the recent

deterioration in the index, which is likely a

precursor to weaker stock market returns

and a slowing economy in 2011. Conse-

quently, this would also be consistent with

economic history which warns that historic

deleveraging episodes have been painful,and on average have lasted six to seven

years. Research from McKinsey Global

Institute suggests that if today’s econo-

mies were to follow this path, deleveraging

would only just begin two years after the

start of the crisis, and GDP would contract

for the rst two to three years of delever-

aging before growing again. But the global

nature of today’s crisis, coupled with large

projected increases in government debt,

could easily delay the start of the delever-

aging process and result in a much longerperiod of debt reduction.


soc: OeCD, isM, iFO, eCri, NBer, Mogn snly rch

soc: Mogn snly rch

2



New & Improved Corporate Profit Growth

Wall Street’s love affair with corporate prot growth and rising earnings estimates is almost as strong as analysts’ belief

in a “sustainable economic recovery.” Without exception, every portfolio manager we spoke with cited the strength in

corporate prots as reason for optimism. Once again, we nd it difcult to argue that last year’s aggressive reductions in

capital spending won’t result in dramatic year-over-year earnings growth. But given how fast expectations have risen, it’s

important to understand exactly what analysts are pricing into projected results. The graph below, by Hussman Fund’s

Bill Hester, plots long term S&P operating

margins in blue. Operating margins currently

being forecasted by Wall Street, in red, show

that analysts are pricing in a speedy return to

the record prot margins seen only at the lofty peak of 2007.

Let’s ignore for a moment Wall Street’s miser-

able track record of actually predicting earnings.

Even giving “the street” the benet of the

doubt, investors should tread very carefully

when expectations are this high under any cir-

cumstances. If the consensus already expects

earnings to soar over the next year, then the

consensus should already be invested ahead of

this news, leaving little room for upside. Research

from Ned Davis supports this thesis, indicating that the average gain on the market when earnings expectations have beenas high as they are now has been (3.4)% annually. This is quite a turn when compared to the 17.2% average gains in

the S&P 500, when expected earnings growth has been below 4.2%. For the record, analyst estimates for forward

earnings were less than (20)% at last year’s bear market lows . . . and not a bad time to buy stocks.

The sentiment of equity mutual fund man-

agers (shown left) clearly illustrates that the

consensus is fully invested today. After our

own “lost decade” and two merciless bear

markets, portfolio managers are even more

fully invested than they were in 2000 and

2007. Retail participation in stocks is much

higher than generally perceived. KennethGailbrath, the astute Canadian-American

Keynesian, had it right when he surmised,

“There can be few elds of human endeavor

in which history counts for so little as in the

world of nance.”


soc: Hmn Fnd

3



Don’t Ask a Barber If You Need a Haircut

The majority of research we came across classies stocks in one of two buckets: cheap or “fairly” valued. While

optimism may be entrenched in the human (and portfolio manager) psyche, assumed prosperity is not synonymous

with safety. Coincidently, psychologists have often documented a self-serving bias whereas people are prone to act in a

manner that is supportive of their interests. Unfortunately for us, simply by virtue of an expert’s apparent condence

(we’ll resist the urge to mention Cramer), investors are likely to blindly follow poor advice from supposed “authorities.”

Since our brain actually turns off our natural defenses when we are told a person is an expert, allow us to separate

valuation fact from ction.

First and foremost, valuations based upon forward earnings estimates are heavily dependent upon the level of operating

margins implied in those estimates. Even assuming today’s forecasts for a quick return to record prot margins areaccurate, valuations based on forward operating earnings are not attractive. And from a risk management standpoint,

there is little margin of safety in current estimates, given that even a minor reduction in prot margins would cause

the scale of overvaluation to widen materially. Second, we strongly suggest that anytime you hear an alleged “expert”

use the phrase “stocks are cheap relative to the alternatives” that you ignore anything that follows this statement (and

probably most of what you might have heard leading up to it). Valuation is an absolute concept, not a relative one.

Arguing that stocks are attractive because they are cheaper than bonds (or any other asset class) is equivalent to arguing

that a $75 case of Budweiser is attractively priced since a single bottle of Bud costs $5. We’d note that both are out-

rageously expensive, and suggest beer drinkers look for a $.50 bottle of Miller Light.


4



Since forward earnings are not reliable and relative valuations have little predictive ability, investors would be well

served to use a method which 1) normalizes prots and 2) covers a long enough time period in order to assess the

model’s predictive ability. The Cyclically Adjusted PE (CAPE) is one method which accomplishes both by averaging

earnings over ten year periods. The validity of this approach has been tested and is robust (projected returns are dis-

played above). Despite this, the CAPE is habitually ignored as it naturally shows that the market has been cheap about

half the time, which shouldn’t be a surprise to anyone (except Wall Street) since an “average” consists of both below

average and above average readings! Alas, to limit claims that “stocks are cheap” to only half of the total occurrences

would reduce commissions on Wall Street by . . . about half. With the market trading at a CAPE of 22 today, equity

investors nd themselves back in a familiar position – in “Group Five,” the most expensive quintile of historic valuations

where expected ten year returns are lackluster at best, and quite often negative.

Awash in Liquidity

Hands down our favorite justication for optimism, this one is actually a “sell side” catch-all which covers: low

ination, disination, cash on the sidelines, expansionary scal and/or monetary policy, low interest rates, etc. All

are rumored drivers of higher stock prices, except for one minor problem – the phrase “awash with liquidity” was

also in vogue in the ‘70s, in ‘87, in ’99 and repeatedly from ’05 through ’07. Investors may wish to respond to this

phrase in the same manner as other “expert

testimony” discussed above. Put simply,

while low ination may help explain why

stocks are currently overpriced, it does

not alter the long term consequences

associated with that overpricing. High valu-

ations produce low long-term returns, whilelow valuations generally produce attractive

long-term returns. Please take a second look

at the chart above if you are still questioning

this. It really is that simple.

To be sure, we rmly believe that monetary

policy exerts a strong inuence on leading

indicators. One of the earliest signs of stim-

ulus in 2008 was a pickup in money supply

growth. That being said, roughly a year has

passed without additional rate cuts from the world’s major central banks and money supply growth has been slowing

dramatically. The period of broad money growth is over. In fact, several central banks have begun to raise rates inrecent months, providing a further drag on money supply growth and a likely headwind for leading indicators. So

much for all that liquidity!


5



Simple Is As Simple Does

The more mathematically challenged investors we spoke with prefer to hang their hats on the truism that every prior

decade of poor stock market performance has been followed by a decade of strong performance. While this may hold

true, investors who blindly follow such shallow recommendations may nd themselves thoroughly disappointed in ten

years. Past performance is not indicative of future results . . . but starting valuations are as good an indication as any. Bad

decades have historically been followed by good decades because ten years of poor performance had always resulted

in cheap stock markets, in the past. This is emphatically not the case, when the starting point is 44x cyclically adjusted

earnings as it was in 2000! As shown below, the past ten years of poor performance has simply brought us from those

nose-bleed levels back to valuations consistent with prior bubble peaks.

Bottom Line

Investors have a clear tendency to extrapolate recent trends into the future. Our strategy for the past year has been

built largely on the belief that investors would shift from Discounting a Depression to Relying on The Rebound at

precisely the wrong time. Sometimes, even we are surprised by how Predictably Irrational consensus behavior really is.

Nonetheless, we’ll go out on a limb here and say, “Now is the wrong time.” We’ll refrain from using “precisely” since

we would have said the same three months ago. Can markets continue to ignore elevated valuations and forge higher

in the short term? Sure. But in buying stocks today, investors are purely speculating that they will be able to sell them

to a greater fool at some time in the future. There is simply no investment merit in buying stocks when they are trading at prices as high as today, only speculative merit - not unlike buying a home worth $250 for $500K, expecting to sell

it for $1MM in six months.

Volatility has recently reached levels last seen in July of 2007. Sentiment Trader reports that “speculation in the options

market has spiked to its highest levels since the spring of 2000.” And the last time the put-call ratio was this low was

in early 2004. Needless to say, there are some inconsistencies between today’s total disregard for risk and the near

unlimited uncertainties that cloud the global economic outlook. While the opportunity cost of earning next to nothing

on cash appears painful, the real pain has always been felt by those who extrapolate current trends too far and overpay

for low-quality securities. An old saw reminds us never to confuse genius with a bull market.


6

broyhill letter (q1-10)

Documents