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I am a self-taught value investor that manages my net worth as an investment fund. Over the past 10 years, I have measured the returns rigorously and beat the S&P500 by ~5% per year. Follow me on Twitter - @Prasadcapitalmg Gmail: PrasadCapitalMgmt {at} gmail {.}{com}
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  • +24% In 2014 - Prasad Capital Management 2014 Review & 2015 Outlook

    January 1, 2015

    Prasad Capital Management 2014 Review & 2015 Outlook

    To Our Fellow Shareholders,

    2014 was another great year for our fund. We continued to find attractive investments last year, and stayed with a near-100% U.S. equity position throughout the year despite having an expectation of having a more balanced allocation in our previous letter.

    For us, that's another example of the limited value of projections - as Warren Buffett has said, "Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future." We try to live by that quote - we still attempt projections of various kinds, but we strive to minimize their influence on our investment decisions.

    U.S. equity markets continued to be strong, and our positions largely tracked the market, albeit with lower volatility and lower valuations. While most measurements of risk focus on the former, we believe the latter is what means our portfolio is less risky. It is fortunate that for now, both metrics show that our portfolio is generally achieving above-market returns with less risk.

    This letter will discuss our performance this year, and our outlook for 2015.

    2014 Performance

    Our near-100% U.S. equity position generated an annual return of 24% in the per-share value of your investments in Canadian Dollars.

    Combined with last year's 55% performance, the per-share value has almost doubled in two years (1.554 * 1.244 = 1.93). These results are primarily due to the U.S. market rally and the strengthening of the U.S. Dollar, and our decision to stick to a 100% U.S. equity strategy.

    For your reference, here's how we got to 24%: the S&P 500 went up 13.4% in the year (including dividends), the U.S. Dollar strengthening over the Canadian Dollar gave us another 9.3%, and we added 0.4% through active selection of investments. Multiplied together (i.e. 1.134 * 1.093 * 1.004), this gives a 24% total return.

    The graph below shows the annual performance of your fund in green (NYSEARCA:USD) as compared to the S&P 500 in blue.

    (click to enlarge)

    The graph below shows the historical value of our active management (the difference between the green and the blue above), which averages +3.9% over the almost 12-year period of May 2003 to January 2015.

    (click to enlarge)

    The value of our active management in 2014 was negligible (+0.4%), meaning that you could easily have replicated this year's return yourself with a single U.S. equity ETF, and we could have spent a lot of time doing other things! This does not bother us one bit - in a single year or even a few consecutive years, even the best active manager has a significant probability of under-performing the market. For value-driven investors, the chance of under-performing also goes up when the market is doing well.

    Analysis of Underlying Businesses

    The key to successful investing is to look at investments as a partial ownership in businesses, and to resist seeing them as tradable slips of paper whose prices move around every second.

    To encourage and demonstrate this mindset, we are presenting below a snapshot of your portfolio as a holding company, normalized for every $100,000 you have invested.

    This chart shows that your earnings yield (the inverse of the PE ratio) is about 7%, in contrast to 5% for the S&P 500. Your businesses are generating this extra yield mostly due to lower valuation - if you take the appropriate ratios, you can show that the return on equity, leverage, and other characteristics are similar to the S&P 500. The major difference is that price-to-book is 2.1 for you, while the S&P 500 is at 2.9.

    By the way, those of you wondering whether the lower valuation is explained by lower growth will be happy to hear that the 3-5 year growth rates are actually better for our revenue (near 7% vs the S&P's 4%) and similar for EPS (near 7% for both).

    A lower valuation, assuming we are correct that it is not explained by holding poorer quality businesses, should act as significant downside risk protection for you. There is simply much less to fall before these businesses reach ridiculously low valuations. For example, at the bargain-basement bottom in 2009, the S&P 500 was priced close to book value which would represent a 3x fall from today's valuations, but only 2x for our portfolio if book value is the floor for both.

    As a side note, looking at things from this business owner's perspective explains why we have been reluctant to shift any of our assets towards fixed income to balance our equity holdings. Our current portfolio yields 1.7% in dividends, with an expected earnings (and hence capital) growth rate of 7%. In contrast, ten-year U.S. treasuries offer a similar yield with a guaranteed growth of 0%. The gap is just too large for us to be willing to sell shares in productive businesses for the risk reduction that treasuries provide.

    Prasad Long-term Performance

    Coming back to your fund's performance, here is the long-term graph of your returns vs the S&P 500 in U.S. Dollars. Over almost 12 years, the S&P 500 in U.S. Dollars has returned 9.0% per year, turning $1 into $2.75 (this includes dividends, but no taxes). With our active management, the annual return has been 13.4%, which has turned $1 into $4.35 (U.S.D). The latter number includes the effect of taxes, and so our value-add is conservative, although we have not done the math to figure out how much higher it would be before taxes. The graph below shows the impact of compounding our 4% above-market return over time.

    (click to enlarge)

    In addition to the excess performance documented above, this year we studied the relative volatility of our portfolio. While we do not believe volatility is the best measure of risk, it is still useful to keep an eye on whether conventional finance can explain away our excess returns above by pointing to higher "beta" volatility.

    It turns out that our 2014 volatility has been significantly lower than the S&P 500 despite slightly exceeding the market return. Each point in the blue line below shows our excess daily return averaged over the past hundred trading days. The orange line shows the same thing but takes the absolute value of daily returns as a volatility metric.

    (click to enlarge)

    This graph shows that our volatility was significantly lower than the S&P 500. It will be interesting to monitor how these lines behave in coming years. Incidentally, for those wondering about the conventional "beta" metric, our 2014 beta was 0.755, which aligns well with the lower volatility shown in the orange line above.

    Tangent - How Longer Time Horizons Fix Valuation Errors

    We'd like to pause here to demonstrate an interesting mathematical property that we haven't seen discussed anywhere else before. This calculation mathematically shows why a long time horizon helps investors achieve a return matching the earnings growth rate of the businesses they invest in. Historically, that growth rate has been about 7%, and hence the stock market return has also been 7% over long time periods. For those more interested in the details, this is driven by an earnings retention rate of about 50% and a return on equity that has stayed in the 12-14% range.

    If earnings grow at 7%, your return will be 7% plus an adjustment for the starting and ending PE ratios between when you buy and sell your investment. The key point is that the "valuation error", which we define as the ending PE ratio divided by the starting PE ratio, is less of a factor as the time horizon increases because compounding of the growth rate begins to dominate the valuation error.

    For example, in the graph below, if you were to buy at a PE ratio of 50 and sell at a PE ratio of 25, the valuation error would be 0.5 (25 divided by 50). If this happened over one year (the dark blue line below), you would lose 47% because the 7% earnings growth rate gets swamped by the 2x drop in PE ratios. That same error, if made over 50 years, allows the 7% compounding to dominate and leads to an annual return of 5.5% which is not so bad in the context of a halving of the final PE ratio!

    (click to enlarge)

    Prasad Capital Management - Investment Philosophy

    Our investment philosophy has not changed this year, so we encourage you to reference our 2013 letter where we spelled out this philosophy in detail.

    Prasad Capital Management - Investment Approach

    Our investment approach, first outlined in our 2013 letter, has continued to change somewhat in 2014. As we anticipated in the previous letter, in 2014 we shifted our 50-50 divide between index funds and individual stocks to a 20-80 divide, meaning 80% of our assets are now in individual stocks. This change has enabled us to maintain the higher earnings yield we discussed above, despite the S&P 500's valuation climbing to reasonable but full levels.

    2015 Market Outlook

    Overall, we remain bullish about U.S. business in general, and on expectations for business returns over the next decade. The only thing that gives us pause about market returns (as opposed to business returns) are the relatively high valuations that those businesses fetch today.

    However, until rising bond yields and rising inflation become more likely, we are comfortable with a near 100% U.S. equity allocation, especially for the 80% of our assets held in individual stocks which are at significantly cheaper valuations.

    In this section we will describe some themes and data that we believe are relevant to this decision making.

    Strong U.S. GDP

    The growth in U.S. GDP continues to provide positive surprises. The graph below shows the annual growth in real GDP per capita. It is computed without any seasonal adjustments or revisions, by taking the average of the latest available value for each of the past twelve months (month N-11 to month N), and dividing it by the twelve months prior to those (month N-23 to month N-12).

    (click to enlarge)

    For all the noise from experts about the "new normal" of slower GDP growth, this graph shows that the recent 4% real growth is about as good as it has been in any other expansion. We view the negativity as further evidence that pessimism from the previous decade is holding people back from equity investment, and as an opportunity for those who focus on the data.

    Inflation vs Deflation

    Another negativity in the markets today focuses on the prospect for deflation spreading from Europe and Japan to other countries. We freely admit to not knowing much about the European or Japanese situations, but from a U.S. perspective, the data we have looked at doesn't support anxiety about deflation.

    The graph below shows several inflation metrics for the U.S. since 1990, all using moving averages that take the average of month N-11 to N and divide by the average of month N-23 to month N-12 as we did for GDP above.

    (click to enlarge)

    The blue line is based on the normal CPI, the red line on the services CPI which tends to be a little bit smoother, and the green line on non-supervisory hourly wages. Our underlying assumption is that increases in wages are unlikely to co-exist with deflation. Perhaps more precisely, we assume that increasing wages along with deflating prices (i.e. increasing real wages) are unlikely to lead to an adverse outcome for investors!

    Looking at the data, wage related inflation (red and green lines) has been above 2% for some time now, and CPI inflation (blue line) turned upward towards 2% in 2014. We don't see any sign of a deflationary spiral in the U.S.

    U.S. Strength Relative to Other Countries

    Shifting gears from U.S. growth to the market action internationally, we see more evidence for U.S. strength.

    During the banking crisis six years ago, we recall many articles and conversations announcing the end of U.S. dominance in the world, questioning whether the U.S. Dollar would continue as the world reserve currency, and declaring the 21st century to be one where emerging Asian nations like China, India, etc would rise up to challenge U.S. supremacy.

    In those days, we often argued against this expectation, arguing that the U.S. was more rapidly dealing with its excesses and that the rest of the world seemed to be more exposed. Since we never like to use predictions to drive our investment decisions, our 100% allocation to U.S. markets was driven by other factors like availability of data and the breadth of the market, but this belief certainly helped boost our confidence in our approach.

    To see the details behind our predictions here, see the 2011 article here, and in 2013 here (from days when we didn't even have all the data below). The graph below shows that our expectations are being realized in market prices, helped along by the U.S. energy revolution that we must admit to having no early anticipation of.

    (click to enlarge)

    After peaking in 2010, the ratio of markets that are correlated with the commodity cycle (Canada in blue and emerging markets in red) to the S&P 500 has been steadily dropping, much as it did in the 1980s for Canada and the 1990s for emerging markets.

    What is interesting, and scary for Canadians, is the strong correlation between the Canadian and emerging markets, a phenomenon that only began in the late 1990s but has held strongly through the recent commodity cycle.

    The steepness of the downward trend since 2010 makes us fear that the previous low of 0.5 is not an overly pessimistic scenario, which would imply a drop of 38% from today's levels (some or all of that drop could be in the form of the S&P 500 going up of course, although a 60% rise in the S&P 500 seems unlikely from today's levels).

    In our view, investors in Canada or emerging markets would be wise to consider this trend when deciding on their asset allocation to the U.S., which in our portfolio continues to be at 100%.

    Commodity Cycle Unwinds

    This year was noteworthy for us in that it dramatically accelerated a trend that we have been expecting for a few years now. As the commodity cycle reverses, the U.S. Dollar has strengthened dramatically, and oil (along with the energy sector) has weakened.

    One of the first graphs we published showed the relative values of each of the 9 sector SPDR ETFs which break the S&P 500 into 9 different sectors (link to the old article).

    Below, you can find the updated version of this graph - the new one below also includes re-invested dividends to avoid unfairly penalizing high yield sectors like utilities.

    (click to enlarge)

    In 2011, we were commenting on how the technology SPDR (NYSEARCA:XLK) peaked near 25%. It is interesting that the energy SPDR (NYSEARCA:XLE) peaked near 25% as well in 2008. The recent plunge has brought it within shooting distance of 15%, which is still far enough above the usual 8-12% range that it warrants caution when valuing energy sector companies. It is quite possible that energy company margins and other return metrics will not quickly revert to the experience of the past decade.

    On the lower end, we have been finding good values in the financial and technology sectors, which makes sense with the XLK and XLF values so far down relative to the others. In our view, those sectors are likely to provide good low-risk returns going forward.

    State of Profit Margins

    Most bearish arguments tend to focus on elevated profit margins, usually measured in terms of corporate profit as a % of GDP. The graph below is a good illustration of this argument.

    (click to enlarge)

    The line shows that the percentage is close to 11%, a level that was never approached in all the decades before 2004. This graph is indeed a scary one, although for us the fact that it rebounded so quickly after the big drop in 2009 made us question whether there was something else going on.

    The above data looks at profits as an aggregate while the underlying companies are changing over the decades, including a change to increasing service-based businesses in the U.S. economy.

    Below we slice similar "profit divided by revenue" data so that we look at today's S&P 500 companies and only vary the time. The graph below shows the past 20 years of net margins for these companies combined.

    (click to enlarge)

    The blue line shows net margins are near 6% in 1994, which is similar to what the previous graph shows. However, they reach 9% and largely stay there from 2000 onward with blips down during the two big contractions in 2001 and 2009. The red line shows another effect that we discussed last year - taking out the effect of lower interest expenses, margins today at about 15% are not very different from the mid-1990s. They have failed to reach levels of 16-18% at previous peaks in 2000 and 2007.

    While we are not economists and do not have a great explanation for the differences we are showing, we suspect that the profit margin story is largely a story of changing business types far more than it is of easy monetary policy or corporate pricing power.

    At the end of this analysis, it is clear that business returns have been reasonably stable for 20 years, despite large changes in the economy (both good and bad!). We therefore think it wise to invest with the assumption that U.S. business returns in terms of margins or return on equity will not shift significantly going forward.

    Big Picture - 15 years of Poor Returns

    Another way we like to think about market expectations is to consider the recent experience of the average investor. The graph below is an interesting way to see the cycle of strong returns followed by poor returns that 20th century history demonstrates.

    There are two good ways to measure market returns - the first is to take the index value, assume dividends are re-invested, and subtract inflation. This represents an investor in saving mode, where their investments are accumulating including dividends. The second way is to not include dividend re-investment (i.e. assume that dividends are spent). This represents an investor in a more retirement-like mode.

    (click to enlarge)

    The lines in the graph above show how long it has been, in months, before the last high when measuring the market as described above. The blue line is for the first (saving) mode while the red is for the second (retirement) mode. In both cases, only in recent months has the market cleared the previous high set in late 2000. This means that a saver or a retiree who started in 2000 has only kept up with inflation after 15 years. The saver would have hit a new high a bit faster from re-invested dividends, but regardless, the record has been poor over the past 15 years.

    The past times where there have been long lags in new inflation-adjusted highs (1929 to 1958, and 1969 to 1991) have been some of the best times to invest. Of course this is not a fool-proof argument in that the lags are mostly explained by wild valuations at the points where the lags begin (1929, 1969, and 2000).

    Our only point is an intuitive one in this argument - it is unlikely for investors who have in aggregate experienced such poor returns for 15 years to be fuelling a bubble in equities in 2015.

    Balance Sheet Strength

    One change in corporate America that is not discussed much, but is undeniably strong today is the corporate balance sheet. The graph below shows the ratio of liabilities to assets for the companies in all the S&P 500 companies, organized by which of the 9 sector SPDRs they belong to. The same values for those same companies (when available) from 5, 10, and 20 years ago is also shown.

    (click to enlarge)

    It is clear that the amount of leverage is significantly lower across most sectors. It's important to note that these numbers do not factor in the lower cost of debt (i.e. low interest rates). This can be included by computing what is known as a "coverage ratio" which is the earnings before interest divided by the interest expenses. Conceptually you can think of this as the number of years of interest expenses that a company can pay with its last year of earnings. The graph of coverage ratios is shown below.

    (click to enlarge)

    With the exception of the financial (NYSEARCA:XLF) and utilities (NYSEARCA:XLU) sectors, the coverage ratios are very healthy.

    The healthy balance sheets of American corporations makes it easier to get strong returns with minimal bankruptcy risk going forward.

    Summary

    The data above, combined with our more cheaply valued portfolio, gives us reasonable confidence that our returns should be good over the next five years and beyond. Investing is a long-term game, and with the majority of our net worth invested alongside yours, we are committed to continue compounding market-beating long-term results on behalf of all of Prasad Capital Management's investors.

    Jan 26 11:57 AM | Link | Comment!
  • +55% In 2013 - Prasad Capital Management 2013 Review & 2014 Outlook

    Prasad Capital Management 2013 Review & 2014 Outlook

    To Our Shareholders,

    2013 was a very good year for our fund, the first in which we have been writing publicly about the fund's activities, positioning, and outlook. US equity markets climbed over a myriad of worries, both domestic and global, driven by a strengthening US economy and relatively low starting valuations. As we look forward in 2014, our stance will be more balanced than the 100% US equity position throughout 2013, as valuations have become somewhat less attractive.

    This letter will discuss our performance this year, and our outlook for 2014. This being our first shareholder letter, we will also spend some time describing our philosophy behind, and approach to, investing in general.

    2013 Performance

    Our near-100% equity position was well-rewarded in 2013, giving you an annual return of 55% in the per-share value of your investments in Canadian Dollars.

    Such home-run years are as rare as they are rewarding, and you should not expect this performance to be a recurring feature. For your reference, here's how we got to 55%: the S&P 500 (NYSEARCA:SPY) went up 32% in the year (including dividends), the US Dollar strengthening over the Canadian Dollar gave us another 6.7%, and we added 10.3% through active selection of investments. Multiplied together (i.e. 1.32 * 1.067 * 1.103), this gives a 55% total return.

    Our relative outperformance from active management in 2013 (+10.3%) came largely from investments in health care, defense, and technology companies, all of which were at depressed valuations last year and were a source of the under-performance in 2012. This year, these investments made up for their lacklustre 2012 as fears about the Affordable Care Act and reduced government spending receded. That said, some of our technology investments are still lagging the market and we expect them to provide outperformance in future years.

    The graph below shows the historical value of our active management, which averages +4.2% over the almost 11-year period of May 2003 to January 2014.

    (click to enlarge)

    What is this extra performance worth in absolute terms? Over this period, the S&P 500 in US Dollars has returned 8.7% per year, turning $1 into $2.42 (this includes dividends, but no taxes). With our additional +4.2%, the annual return has been 13.4%, which has turned $1 into $3.82 (NYSEARCA:USD). The latter number includes the effect of taxes, and so the +4.2% value-add is conservative, although we have not done the math to figure out how much higher it would be before taxes. The graph below shows the impact of compounding the extra 4.2% over time.

    (click to enlarge)

    Prasad Capital Management - Investment Philosophy

    Our investment philosophy is value-based, which is to say we try to buy investments that are cheap with the expectation that if we do this, good things will happen to us on average and over long periods of time. Our core principles are:

    1) Anybody making investment decisions for the fund should have a majority of their net worth invested in the fund

    This principle is an extremely important one, and the only one that we would argue must be shared by any investment manager. The reason is fairly simple - unless it is true, you can never be sure that investment decisions are being made with preservation of capital as the primary consideration (vs. other things like maximizing fees, maximizing bonuses, getting a promotion, etc). Our investment manager has almost all of his net worth invested in the fund.

    2) Our investment decisions should be based on value judgments that are primarily quantitative

    This means we will buy something if it is priced much lower than our calculation of value, no matter how scary it feels to do so. On the flip side, we will sell something priced much higher no matter how bad it feels to leave the happy times behind and to pay capital gains taxes. The last, and equally important, implication of this principle is that if we don't feel reasonably confident in calculating value quantitatively, we will never make an investment.

    3) 3) We should be diversified - no more than 5% of our assets should be invested in any individual stock

    Many value investors, most famously Warren Buffett, avoid diversification and instead focus their dollars on their best ideas. While we understand and agree with that approach in theory, we also know our limitations - we don't have the knowledge or judgment required to be confident in putting 10% of our assets into a single stock investment. So we will target having 20 to 40 stocks that we invest in. If we can't find that many good values, it will inevitably be time to hold cash or bonds instead.

    O4) Our value judgments should be grounded in historical record, not speculations about the future

    Investment predictions can be categorized into two groups - predictions in which the future resembles the past, versus predictions in which the future will be different than the past. The former often take the form of expecting "mean reversion", while the latter often involve paradigm shifts.

    Occasionally, the future does shift dramatically from past behaviour, but we are skeptical of our ability to predict when this will happen. More importantly, when the market consensus is making such predictions, we believe they are wrong more often than they are right. So we will be more successful trying to profit from the cases where history repeats, even if it means missing profits or even occasionally taking losses when history does change.

    This principle means you will not see us investing in successful growth stories (like Google as a past example, and perhaps Twitter or Facebook as future examples). We just don't know enough to pick the winners with high confidence, and will leave those elusive profits, and more likely losses, to others.

    Prasad Capital Management - Investment Approach

    Our fund is just over 10 years old, which in the investment world makes it fairly young. So it's appropriate that our investment approach is not fixed in stone, instead changing gradually from ongoing research and learning. The description below gives you a broad view of our current approach, although you should be sure that it will change gradually over time.

    Our investments are almost completely in the US, and fully exposed to the US dollar. The economic and corporate data available in the US is broad and deep enough for our needs, and more importantly, reasonably trustworthy compared to other countries. Also, as our shareholders are Canadian, it is valuable to diversify by having most of our exposure outside the narrow, commodity-focused Canadian economy.

    We currently drive our investments with a asset allocation model that tells us what % of our assets should be allocated to equities, long/medium/short government bonds, and corporate bonds. Of the % allocated to equities, we invest approximately half in broad-market index funds. The other half is allocated to 20 to 40 individual stocks that we pick using a bottom-up analysis of stocks.

    The reason for a 50-50 divide between index funds and individual stocks is a form of diversification. Our top-down analysis and bottom-up stock choices are both value-driven, and since both have been giving positive results we're not yet ready to choose one exclusively. Having both provides a small amount of insurance against mistakes in either.

    From our earlier statements that we had 100% equity exposure in 2013, and that we outperformed the S&P 500 by 10%, you can correctly infer that the choice of individual stocks has a large impact on our results despite the 50-50 split. If we continue to generate positive returns from stock-picking, as we hope to, we are likely to move towards greater weighting of individual stocks within the bounds of our asset allocation model.

    2014 Market Outlook

    The debate for investors in 2013 centered around three major questions that continue to be important in 2014:

    i. What is the correct earnings multiple to use when the government has mandated low long-term interest rates through Quantitative Easing programs?

    ii. What is the normalized level of earnings to use for valuation given historically high profit margins?

    iii. What growth rates should be priced into US equity valuations? Have growth rates for GDP and earnings shifted into a permanently slower gear?

    Let's look at each of these in turn.

    Multiples & Interest Rates

    Common wisdom is that interest rates affect the correct earnings multiple you should use when valuing stocks. Since the value for any stock (or any other investment) is the discounted present-value of the cash flow from that stock, and the discount rate is a function of the risk-free rate of return, interest rates dramatically affect this calculation.

    However, analysts correctly point out that a significant amount of a stock's price is derived from cash flows far into the future (50 or 100 years even), and so current artificially low rates should not be used as the discount rate. Using a higher discount rate immediately drops the present value, and so these analysts said equities were expensive all through 2013 and even earlier. These analysts argue the correct multiple should be reasonably constant regardless of interest rates - often the "Shiller PE" based on professor Robert Shiller's work that uses 10-year average earnings for the S&P 500 is averaged over time to give a guide to fair valuation. Over time, the average Shiller PE has been 18, while the S&P 500 started 2013 at 21 (and ended 2013 at 24.5).

    If you look at the Shiller PE over time, though, it is clear that the Shiller PE ratio has moved in tandem with prevailing long-term interest rates. The graph below shows this against the 30-year treasury yield.

    (click to enlarge)

    To us, this data makes it fairly clear that the level of inflation and interest rates is very relevant to stock valuation. What remains is to decide how much to trust the current low level of interest rates given the government-driven "financial repression" through Quantitative Easing. As we mentioned in our investment philosophy above, we can't accurately predict what rates will be in the future - there are many arguments for higher rates, and many for similar or lower rates in the future. So our approach to valuation uses current long-term interest rates with a historically appropriate risk premium added to them.

    Normalized Earnings and Profit Margins

    Most bearish arguments you can read today will focus on the historically record-high profit margins that companies are enjoying today. The graph below is one of the common ways this is shown, where the profit share of GDP is at 11%. Analysts often point out that Warren Buffett once said this value always stays in the range of 6%, but it has lifted way past this in the past 8 or so years.

    (click to enlarge)

    However, there are a few aspects to this data that are worth analyzing more deeply before assuming that these profit levels must soon revert to the historical mean. The graph below shows 20-year margin history from an aggregation of 50 S&P 500 companies representing approximately 40% of the S&P's total market cap. While we would have preferred to cover the entire S&P, the data is manually assembled and we don't have historical data for the entire index. Still, 40% of the market cap should be representative. The blue line matches reasonably well with the corporate profit blue line above - margins were at 5% in 2001, up to above 10% in recent years with a brief dip in 2008.

    (click to enlarge)

    The red line is the margin for these companies before they make interest payments - EBI is earnings before interest. This is interesting because it factors out the capitalization structure of the companies and instead focuses more closely on what their profit margins are. What is clearly visible here is that the red line is more stable, and these EBI margins are not at ridiculously high levels. This demonstrates that most, if not all, of the high profit margins today are from low levels of interest expense for corporations. If rates go up, these expenses will certainly rise and affect margins. But this means the profit margin argument is just an interest rate prediction masquerading as a mean-regression prediction!

    Consider one more graph below, this time showing return on equity (ROE) for these same companies over the past 20 years. Different businesses can have very different margins while being very successful. For example Coca Cola has high margins, while Wal-Mart has very low margins, and yet both are very good businesses. While no measure is perfect, the quality of a business is better measured by return on equity, which shows how well they produce profit on invested capital. The graph below demonstrates profitability viewed by this better lens is not historically abnormal at all.

    (click to enlarge)

    All of this analysis leaves us believing that normalized earnings don't need any adjustment for profit margins, and can be used as they would be in any other years and with the same limitations.

    US Growth Rates

    The last factor we'd like to analyze is the idea of growth rates, which many analysts have predicted will be significantly lower in the future for the US. There is a widespread belief that the US has "peaked" in terms of economic power, and that the emerging markets of the world (China in particular) will dominate the coming century. We believe that this is a paradigm shift prediction that, as with all such predictions, has many more chances of being wrong than it does right.

    Historically, emerging markets are very cyclical in nature, and at the peaks of those cycles the investing world is enamored with the fast-growing, "Wild West" nature of these markets. It is only as risk mounts and some catalyst sends the cycle in reverse that people realize why these markets require additional risk premium.

    Consider the graph below, which shows a simple ratio of the MSCI Emerging Market index to the S&P 500.

    (click to enlarge)

    This graph shows the cyclicality nicely, although we realize there are only two cycles shown. The peak of the first cycle in 1994 was when the Pacific Rim was predicted to take over the world, instead leading to the Asian Flu issues and a low in 1998. The second cycle peaked in 2011, and in the past few years strong US returns have brought the ratio down to near 1.0, which can continue to fall further if the cyclical argument is true.

    Incidentally, since we are a Canadian fund with Canadian investors, it is interesting to look at the MSCI Canada index in the same light, shown in the graph below.

    (click to enlarge)

    It is interesting to see that the Canadian index doesn't show any correlation with the emerging market boom in the mid 1990s, but after 2001 the correlation is incredibly high between Canadian and emerging market indices. The recent cycle has been driven by the Chinese growth story (and the insatiable commodity demand it entails), which looks to have fed the Canadian rally directly.

    We view this data as a good reason to expect future tailwinds for our US-focused investments as historical trends repeat.

    Looking at US growth specifically, one of the concerns that analysts have is shown nicely with the graph below.

    (click to enlarge)

    This graph shows that the recent strong GDP growth numbers are still quite poor in the context of past decades of history. The graph below adds an element that is important to consider, which is population. This is important because GDP has a drag from lower population growth over time, while we see per capita GDP as a more relevant metric of economic well-being.

    (click to enlarge)

    To us, these graphs (especially the red per-capita line) don't conclusively show a much worse economic growth picture going forward - we will have to wait for more data to see where the recent upturn in growth peaks. To get another view on this that is focused more on the S&P 500, the graph below looks at earnings growth over 10 or 20 year periods using 10-year-average earnings.

    (click to enlarge)

    The earnings growth picture is quite smooth. Using long averages of earnings avoids any debate on profit margins that we have already addressed earlier, and demonstrates that growth rates of near 6% have been fairly reliable over long periods of time and should continue to be reliable going forward.

    Overall Outlook

    Synthesizing the analysis above together, we see S&P 500 valuations entering 2014 as balanced, which implies an approximately 50% equity allocation. It is likely that very strong momentum will carry markets to higher levels, but the current environment requires some caution, especially if rates continue to rise.

    The same concern about rates rising also implies focusing on short duration bonds, although if low levels of inflation hold, the premiums that long bonds provide may get high enough in the near future.

    Disclosure: I am long SPY, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Jan 08 4:42 PM | Link | 2 Comments
  • Apple - Value Investment Or Speculation?

    There are times where a stock becomes the focus of attention for both value and growth investors (as much as I hate to use those hackneyed terms).

    Apple (NASDAQ:AAPL) is a perfect example - it's a company whose products so many people love, and one whose stock has been under-performing, making most of the conventional metrics look value-like.

    Apple's TTM PE ratio is 10.1%, and its forward dividend yield is 2.8%. TTM free cash flow is very close to the earnings (2% higher). If you stopped digging here, this would be a slam dunk investment.

    But if we look at Apple's history beyond the past year, it becomes more clear that while it may very well be a great investment, it is a speculative investment and not a traditional value investment.

    The graph below shows a history of the net margin for Apple:

    (click to enlarge)

    As you can see, the margins have been on a tear, rising to close to 30% most recently. Is Apple a proven 30%-margin company? The graph hardly demonstrates a proven ability to earn this level of margins. In contrast, I recently wrote an article about Coca Cola (NYSE:KO) as a great value investment (see bit.ly/11bxOIZ). Below is a graph of Coke's margins:

    (click to enlarge)

    You can see 2 interesting things here: 1) Coke earns lower margins than Apple, and 2) Coke has earned high margins for a long time. While I realize that Coke and Apple are in totally different businesses, you could do this analysis with any other stable value stock and get the same conclusions. The first point is perhaps the most worrying for an Apple investor - does Apple's business model really allow maintaining these higher-than-Coke margins for a long period of time? Regardless of how you answer that question, you are entering speculative territory by needing to predict the future much more than a value investor would be comfortable doing.

    What if we look at Return on Equity (ROE)? The graph below shows that again, Apple's ROE has zoomed up in the last decade - great for investors in the *last* decade, but what about the *next* decade? It is hard to claim that Apple has proven its ability to reliably earn extraordinary returns for long periods of time.

    (click to enlarge)

    My final argument will be the graph below, which shows the PE yield calculated two different ways - one (in blue) as the traditional TTM earnings divided by the price, and the other (in red) as the 5-year-average-EPS divided by the price.

    (click to enlarge)

    You can see that the red yield is only 4.5% based on today's prices. This again highlights that Apple's high earnings yields are only valid if you assume Apple's ability to extend, or at least maintain, its very recent track record of sky-high margins and returns on capital.

    I want to re-iterate - the purpose of my article is not to argue that Apple is a bad investment. It is just to say that if you buy Apple stock, you should do it knowing that you are trying to predict the future of its business model. That prediction will determine whether you are successful or not in your investment. If you, like me, are a value investor that wants to minimize predictions (i.e. speculations!) of the future, then you should pass on Apple - by my calculations, only if it was trading near $300 per share would I get interested.

    Disclosure: I am long KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: KO, AAPL
    Jun 14 4:32 PM | Link | Comment!
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