Sunday, July 1, 2018

Value Can Lead – Weekly Blog # 531

A Possible Turning Point

July of 2016 to June of 2018 may have been a turning point. Interest rates started rising to meet commercial demand for loans, even before the political conventions. Three weeks ago we began seeing that tech-led Growth funds were no longer the weekly mutual fund leaders, value is now leading. In a gross oversimplification some people divide equities between growth and value. According to a table in the weekend edition of The Wall Street Journal, looking only at the sectors within the S&P 500, note the following weekly performance:



Utilities               +2.25%
Telecom Serv      +1.18%
Real Estate          +1.06%
Energy                 +1.03%

vs.

Information Tech         -2.19%
Financials                     -1.93%
Consumer Discretion  -1.87%
Health Care                  -1.79%

One could choose to ignore very short-term performance results, which is normally wise. However, a glance at the charts of the three major stock indices might well suggest that there is a potential warning in the near-term data. Both the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 (S&P500) are showing reversal patterns and the NASDAQ Composite (NASDAQ) could be as well. Clearly something has changed and this could be labeled sentiment. The American Association of Individual Investors (AAII) conducts a sample survey of its members which can be quite volatile and the sample may not be representative enough. Nevertheless, it is worth noting that in a three week period, bullish responses dropped 37% to 28.4% of the sample and bearish responses rose 88% to a reading of 40.8% of the responses. (The causes for the sentiment shift will be discussed below.)

A Positive for Value

While some may disagree with me, I believe from a low level the increase in interest rates is a positive for those who are looking for value. The search for value is much more difficult than the search for growth in rising revenues and earnings. While many value advocates speak of intrinsic value, what they really mean is what price a knowledgeable buyer for the company would pay. Therefore, value is a derivative of the price of a transaction. Value-oriented investors attempt to arbitrage the difference between the current price and a future expected transaction price. If one believes in the commonality of assets, a similar transaction price for some could establish value or at least be indicative of it.

Rarely have I found complete commonality of individual assets and thus an adjusted price becomes the theoretical price, with the buyer really determining the value. Most buyers want to earn a premium over their cost of capital and therefore higher interest rates drive acquisition prices. Commercial interest rates imply that they have imbedded within them a credit cushion for bad debts particularly for commercial loans as distinct from borrowings by governments. Thus, in late June and early July of 2016, after the end of an undeclared recession started to raise commercial interest rates, buyers could foresee the profitable use of loans. Thus the beginnings of a new expansion started.

Cash Flows

One of the first tasks we learned from Professor David Dodd was to reconstruct financial statements so that they could be used by investors instead of creditors. To me the single most valuable statement for determining value was the Cash Flow statement, which is rarely commented upon by the pundits. Recently, when I looked at one of these documents it became clear to me that the proper reconstruction is dependent very much on the intended use by a potential acquirer of a company. Acquirers could be quick liquidators, passive investors, a buyer of talent, customers, patent seekers, or others desiring excess capacity and unique assets. In some cases the acquirer may want to remove capacity from the market. The following is a brief list of items found on the cash flow statement that should be handled differently depending on the user: depreciation/depletion policies, property, plant and equipment, acquisition or disposals, repurchase of company stock, repayment of debt, and dividends.

As a practical matter value is not only dependent on interest rates, but on the willingness of others to extend credit to businesses and individuals. Currently, we are seeing a surge in the willingness to offer credit, which is a counter-force to the central banks wanting to raise the price of money. I am concerned that the pressure to offer credit may lead to narrower profit margins, resulting in lower than appropriate reserves.

Stability Leads to Instability

At some point this over-extension of credit creates a vulnerability which could create a major distortion of risk and lead to a recession. Right now credit reserves look to be stable; however, please remember a quote from Hyman Minsky, “Stability leads to instability. The more stable things become and the longer they are stable, the more unstable they will be when the crisis hits.” Instability could mark the end of the current phase, making investing for value problematic.

Shifting Sentiments

I have already noted the somewhat dramatic shift in market sentiment. Many will attribute it to the troubled trade discussions. I personally believe the shift away from the tech-driven growth favorites was overdue. At least on a temporary basis, some retrenchment was to be expected in terms of excessively large positions.

In dealing with short–term trade movements it may be worthwhile to focus on July 3rd and July 6th.  The first date is another example of the media-political-academic complex wrapping history to their own needs and ignoring the real motivations of the principals. On July 3rd, 1863 the final day of the Battle of Gettysburg was fought. Robert E. Lee, probably the smartest American general, sacrificed some of his best troops in charges up a hill to breakthrough the Union lines. Most history books state that if he had won the day he would have pivoted and attacked Washington DC, likely resulting in the desired end of the war.

Looking at a map and understanding where the Union’s economic strength lay, as well as what was happening in Vicksburg on the very same date, shows me a different set of plans. If the Confederate forces had broken through in southern Pennsylvania they would not have pivoted, but instead headed north to disrupt the rail and other east-west train traffic. This would have isolated economic parts of the North and could have taken some pressure off the battle of Vicksburg, which was about to fall to Sherman, leading to the destruction of the South’s war making capability on Sherman’s march to the sea.

Bearing in mind another example of the general public being misinformed, we may be seeing a similar mistake in terms of perceptions of the trade/security issues we are now facing. On July 6 the scheduled implementation of the Trump tariffs is meant to happen. To my mind the trade issues are not the real focus of the current US Administration, security is.   

For whatever it is worth I do not expect anything of significance to happen on July 6.

What do you think on the switch to value and the trade and security issues?
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