Monthly Archives: December 2015

a footnote to yesterday’s post

December 17, 2015 By in junk bonds, Uncategorized Tags: 1 Comment

Yesterday I wrote about the Third Avenue Focused Credit fund, which shut itself down amid a tsunami of redemptions.  (The SEC has since blessed its liquidation plan, by the way.)

Several thoughts:

–Typically, institutional clients abhor their managers keeping cash reserves.  Their idea is that they do the asset allocation, which they consider the brainy part of the business, and leave the details to the managers they hire.  They don’t want managers upsetting their asset allocation plans by holding more than a tiny amount of cash.  On the other hand, they want the ability to withdraw their funds instantly that the mutual fund/ETF form gives them.  Given that the majority of the shares of the Focused Credit fund were “institutional,” this may have been part of the fund’s problem.  In hindsight, the institutions should have had separate accounts to hold their money in.  On the other hand, it’s hard to turn down the cash that clients are pleading with you to take.

–One secret to investing is to ride your winners and cut your losers.  There’s a tendency for investors of all stripes to do the opposite.  Sometimes they even sell some of their good securities to buy more of their losers.  Don’t ask me why.  My only answer is that no one likes to admit he’s made a mistake.

In particular, when a fund sees redemptions coming, I think it must sell assets across the board, with particular attention to offloading the least liquid, most losery holdings it has.  Otherwise the fund ends up making itself less and less liquid.  If brokers figure out what’s going on, which they will surely do pretty quickly, or if another fund begins to sell, these less liquid holdings may become unsalable, except at crazy low prices.  (All a broker has to do is look at your latest SEC filings or your own marketing materials to learn in detail what you own.)

–Another secret to investing, especially applicable to value investing, is to buy low. Its corollary is to sell high. Both are much harder to do than most suspect.  In fact, stock market participants typically do the opposite.  Some fund managers will even use the flow of money into their funds (or lack of it) as a contrary indicator.  They adopt a bearish stance when they’re flooded with cash and become more bullish as the buy high/sell low crowd starts to leave.  Maybe you can’t hold cash, but you can hold some highly liquid, if boring, positions.

my takeaway

I don’t know the people at Third Avenue and have no idea how they handle management of their portfolios in general or how they dealt with redemptions at the Focused Credit fund.  Even if the managers did everything by the book, my guess is that the withdrawals were so overwhelmingly large that closing the fund was the only option.

The Focused Credit demise came during a period of economic expansion.  Yes, natural resources junk bonds have been in trouble, but the general economy isn’t.  I wonder what would happen to junk bond funds in an economic downturn?

 

 

 

 

Third Avenue Focused Credit Fund

December 16, 2015 By in junk bonds, Uncategorized Tags: , , , 1 Comment

a decision to liquidate

Last week the Third Avenue Focused Credit Fund (TFC), a junk bond fund managed by well-known value investor Third Avenue Management, decided to cease normal operations and liquidate itself.

The fund had lost about two-thirds of the assets it had at its high point to a combination of market losses and investor redemptions.  TFC apparently had reached the point where it determined it could only sell further holdings at big price concessions.

Rather than do so, the directors of the fund opted to stop honoring redemption requests, distribute all its cash on hand to shareholders and put the remaining fund assets into a liquidation trust.  Third Avenue is in the process of issuing shares in this trust to TFC shareholders, who will receive the proceeds of liquidation sales as and when they happen.

How did this happen?

According to the New York Times, the lead portfolio manager of TFC was telling investors that everything was fine two months ago.

I’ve looked at the SEC filings for TFC since mid-2014.  Three things jump out at me (remember, though, I’m a stock guy, not a junk bond person):

–there’s no undue concentration in any industry or sector area (I’d suspected there might be)

–the percentage of assets classified as “level 3,” meaning basically that they’re being valued by a theoretical model rather than a daily market price, went from negligible in mid-2014 to about 20% of assets in September 2015.  I don’t know whether this came about through a change in portfolio strategy (which would strike me as odd) or whether it’s the result of liquidity drying up in the bonds TFC held.

–net assets were about $2 billion on September 30th.  According to the NYT, they had shrunk to $790 million ten weeks later.  That implies an avalanche of redemptions.

What caused the massive outflow?

Who knows.  My only observation is that the majority of shares were “institutional,” which typically means each holder had at least $500,000 worth of shares.  Maybe a small number of them represented a large chunk of the fund’s assets and they all decided to allocate away from TFC during their year-end planning.

I’ve seen stuff like this happen before

In most of the instances I’ve observed, however, the fund is part of a large asset management group–a brokerage firm or a bank–that steps in and buys the illiquid assets at the fund’s carrying value, thus providing money to meet redemptions.  Third Avenue is apparently not big enough to do so.

lessons?

Not many.

Past junk bond crises have shown that this asset class is much less liquid than one might think.  Also, if things turn ugly it’s probably better to own shares in a fund with a deep-pocketed parent.

 

 

 

 

 

oil: confusing correlation and causation

December 15, 2015 By in oil and natural gas, shale oil, shale oil and gas, Uncategorized Tags: , Leave a comment

This is about the current state of the oil market.

The fact that two things occur together (correlation) does not always mean that one causes the other.

For example, every morning the rooster crows and the sun comes up.  But killing the rooster won’t plunge the world into eternal darkness.

Birds fly south and winter begins: birds fly north and winter ends.  Same story.

 

Some commentators are arguing that the sharp decline in the price of oil is a harbinger of recession, using the argument that low prices and recession are very often linked.  I don’t think this is correct.

The causal connection between lower demand and price works something like this:

When aggregate global demand begins to contract, sellers of end products see their businesses begin to slow down.  They may cut their prices to sell stuff they have on hand and they certainly begin to shrink their inventories to a level that matches the lower demand they are experiencing.  They do so by cutting back new orders sharply.  Middlemen do the same.  This process typically hits producers with a very sharp decrease in new orders.  Producers respond in the only way they can, by cutting prices.

In the case of oil today, none of this is true.  Yes, prices are only a third of what they were eighteen months ago.  But aggregate demand is steadily rising.  So too world inventories.  The majority of oil producers are increasing their output, as well.

What’s happening with oil is that years of very high prices established a pricing umbrella that encouraged new entrants (shale oil), previously uneconomical, to invest tons of money and enter the business.

Established producers, meaning OPEC, have started a massive price war to force the new guys into bankruptcy.  The producers are learning the basic, but bitter, lesson that it’s much easier to keep new entrants out (by keeping prices low) than it is to deal with them once they have invested in plant and equipment and have begun production.

Shaping a Portfolio for 2016: dealing with oil

December 14, 2015 By in oil and natural gas, Shaping a Portfolio for 2016, Uncategorized Tags: , , , Leave a comment

Energy stocks now make up about 7% of the market capitalization of the S&P 500.  That’s not much.  They make up about 14% of the junk bond universe, however.  And they’re a huge chunk of emerging markets.  To my mind, it’s the spillover effect from these latter two areas where the price of energy may have an effect on the stock market.

forecasting earnings

I think it’s impossible to know what the earnings of oil and gas stocks will be for 2016.

If an exploration company spends $10 million to find 1 million barrels of oil, oil and gas accounting rules call for it to expense $10 of finding costs every time it produces a barrel.  On top of that, it expenses the out of pocket costs of extraction.

A complication:  suppose the extraction costs exceed the selling price of the oil.  If so, the oil company won’t produce any.  It won’t have revenue, but it won’t have a loss on its income statement, either.

If, however, the oil company decides the field is permanently impaired, it could write part of all of the cost of the field off at the end of this year.  That would allow it to show an accounting profit on output from that field in 2016.

This kind of housecleaning has already begun with Royal Dutch Shell, which has written off a number of high cost projects.

To the extent that the industry as a whole has large, non-recurring writeoffs this December, 2016 earnings will look better than we now think.  We won’t know this for a while, however.

reported earnings probably don’t matter that much

It seems to me that the stocks are no longer trading on reported earnings, but on the spot price of oil and gas instead.

It strikes me, too, that we’re now entering some sort of capitulation phase with oil and gas stocks, where panicky investors tend to throw the baby out with the bathwater.  This phase could last a considerable amount of time, especially if energy prices continue to slide during what is supposed to be the strongest season for demand.  So there’s plenty of scope for near-term bad news.

We’ll know that the capitulation is over only when the stocks stop reacting negatively to oil/gas price declines.

the energy sector is now a small part of the S&P 500

At today’s size, it would take a 15% fall in the Energy sector to clip one percentage point off the return on the S&P 500.  One could argue that in this sense, oil and gas no longer have a large bearing on the fate of the index.

one worry

It seems very clear to me that the current decline in energy prices is similar to what happened during 1982-86.  That is, a period of very high prices leads to the creation of supply overcapacity that causes the price to subsequently plunge.

I don’t think there are wider macroeconomic implications.   It’s all about the microeconomics of benefit to oil consumers and hurt to oil producers.  For the S&P 500, that ends up being a net plus.  For emerging markets, especially for OPEC, it’s a net minus.

I find it hard to follow the logic of the argument that if very high oil prices are bad for the world economy, then low ones are also bad.  Yet that’s what I’m beginning to read and hear in the financial media.  It’s taking the form of a claim that the price decline is not being caused by oversupply–which it clearly is–but by a recessionary falloff in demand.  The low oil price, these commentators say, is the first evidence that the world is entering a business cycle decline.

If investors in general begin to believe this, we could talk ourselves into a period of stock market weakness.

For long-term investors, this shouldn’t have any effect on investment strategy.  For more trading oriented, a stock market selloff based on false premises could provide a buying opportunity.  When?  My guess is as we enter the seasonal energy lull early next year.

 

 

 

 

 

 

 

Shaping a Portfolio for 2016: summing things up

December 11, 2015 By in Shaping a Portfolio for 2016, Uncategorized Tags: , , , , 1 Comment

Today I’ll try to put numbers to my guesses about growth around the world next year.  I think the best way to do this is in two steps, first without trying to factor in what I think will be a negative influence from natural resources industries, and then making both economic and stock market adjustments for them in a second round of analysis.

the US

We’re likely to have trend growth in the US next year, meaning a total of +4% expansion, consisting of +2% real and + 2% inflation.  Because publicly traded companies are typically the best and the brightest, this will probably translate into +8% growth in earnings.

Let’s say that Fed interest rate rises have little net effect on growth and that the dollar has peaked (meaning that headwind is gone).  This may be a bit too optimistic.

I’m guessing that, unlike the past couple of years of aggressive share buybacks, we won’t companies retire more shares than to offset the issuance of new ones to employees through stock option plans. Therefore, 8% earnings growth will translate into +8% growth in earnings per share.

Given that half the earnings of the S&P 500 come from the US, this means the domestic contribution to S&P 500 earnings growth will be +4%.

the EU

The EU is maybe two years behind the US in recovery from recession.  But it has clearly turned the corner and will grow in 2016.  It also has the tailwind of substantial currency depreciation behind it, and the strength of Greater China and the US, major export customers.

Europe is also a substantial beneficiary of the fall in energy prices, although that plus is tempered a bit by the weakness of the euro against the dollar.

For all these reasons, the EU will likely enjoy above-trend growth next year.

Let’s say that the EU will expand by +2.5% real, with +1.5% inflation, for a total of +4%.  That probably also translates into +8% growth in profits for S&P subsidiaries located there, and a +8% advance in eps.

Given that 25% of the profits of the S&P 500 come from the EU, this means that region’s contribution to index earnings will be +2%.

emerging markets

Let’s separate emerging markets into Greater China and everyone else.  In broad strokes, the everyone else are natural resources producers, who are in recession and who will make a negative contribution to S&P 500 growth.  The question is how negative the situation will be.  -3%?

On the other hand, I think that mainland China and its direct sphere of economic influence will have a better 2016 than the consensus now expects.  Let’s say +6%.

If we figure that China and the rest are both roughly equal in size, this implies that emerging markets, which account for 25% of the profits of the S&P, will make a positive contribution to growth in earnings, but a negligible one.  Let’s say +0.5%.

the total

My back of the envelope analysis suggests that the growth in S&P 500 profits will come in at +6% – +7%.  next year.  Not a banner result, but still enough to nudge the index ahead.

the price earnings multiple

In what will be a period of rising interest rates, it seems that there can be no cogent argument for PE multiple expansion in 2016.  If anything, multiple contraction should be the order of the day.

On the other hand, the Fed’s intentions have been widely telegraphed for an extremely long time, so it’s equally hard to argue that the market hasn’t already factored into today’s prices a large portion of any negative effect.  In fact, it seems to me that the market PE already incorporates in it all the tightening the Fed is likely to do.  Nevertheless, there’s always someone who hasn’t gotten the memo, so there will be some negative effect, at least initially.

The most prudent assumption, I think, is that Fed tightening will make little difference to the PE.  The contrarian in me says the money-making stance to take is that the PE will rise once the market sees that Fed tightening will only occur very slowly.  But I’m not willing to take that risk.

a market of stocks

If I’m correct, 2016 will be a mildly positive year, where outperformance will come from astute stock selection rather than playing macro trends.

On Monday:  adjusting for natural resources, especially oil.