In the wake of the collapse of 2008 investors are frequently choosing to make radical and rapid decisions since the urge to do something can be overwhelming at times. While our accounts have made meaningful progress in the return to the values of 2007 the remaining balance will require persistence, patience and discipline from our clients and me. In times of stress I think back to a book I purchased solely due to the title: “Tough time’s never last, tough people do” by Dr. Robert Schuller. Sometimes the boldest move an investor can make is simply be patient and allow the haze to eventually burn itself off where clarity in begin anew.
Investors who would not allow themselves to be intimidated by fear and confusion should value the fact they did not lock in their losses by cashing in and taking 3% or less in government bonds. Many investors took permanent losses in failed banks, mortgage companies and home builders, not to mention toxic mortgage backed securities, areas we largely avoided. In due time should our economy begin to pass the current soft phase those 3% bonds could turn insult into injury as the value of those bonds would be in peril should our economy surpass its current weakness but in fairness more attention needs to be devoted to government bonds later in this letter.
While I am far more optimistic about the intermediate term return potential for equities with the current high levels of investor pessimism versus the universal optimism in January, the future is far from clear. Despite the present uncertainties, the degree to which these issues are factored into the prices of the stock market is of larger importance. While I do continue to expect second half weakness for the remainder of 2010 as the inventory buildup, housing recovery begins to waver and federal stimulus wanes. We face an unusual amount and degree of non- traditional headwinds from sectors that normally provided stability like local municipalities. The decline in tax receipts from real estate have hurt many states which in turn have actually resorted to laying off employees for the first time in decades. Adding to the headwinds are the rise in government debt in relation to GDP and the corresponding rise in the clamor for Austerity. While there are a multitude of issues many of these issues are already factored into share prices and the repeated drumbeat of fear from Deflation and a Double Dip recession has begun to lose its effect for 2010.
Austerity can take many forms from the withholding of unemployment benefits, elimination of tax benefits along with tax increases to cover the cost of entitlement programs in 2011. Japan should serve as reminder to the effects of snuffing out fledgling economies as every time there economy has shown signs of life they’ve killed it. In 1997 with the Japanese economy showing promise the government raised the consumption tax by 2% which threw the economy back into recession. The Austerity-Hawks do represent a risk to the emerging economy that harken back to the Great Depression. Christina Romer Chair of the Council of Economic Advisors gave a speech in 2009 highlighting six lessons learned from the Great Depression:
1. Small Fiscal Expansion has only small effects. This would imply that Paul Krugman’s editorials in the NY Times stating the needs for Stimulus II might be spot on, as Stimulus I was not enough.
2. Monetary Policy can help heal and economy even when interest rates are at zero.
3. Beware of cutting back on stimulus too soon.
4. Financial recovery and real recovery go hand in hand.
5. The world will share the benefits or burdens of expansionary or austerity policies.
6. The Great Depression eventually ended.
Should our government fail to continue the expansionary policies as espoused by Democrats but bow to favor Austerians by talking of the reduction of debt then Deflation could continue to be a dominating trend and the value of our overvalued government bonds with feeble yields could be of great value to our portfolios.
There is in fact a study authored by Alesina and Ardagna* which analyzed the effects of 107 fiscal retrenchment/austerity plans within OECD countries (Organization of Economic Cooperation and Development) between 1970 and 2007. The authors found that only 26 of the 107 periods of fiscal restraint occurred with growth and the rest were deflationary. The 26 did share the commonality of being small open economies with weak currencies but accommodated by worldwide economic growth, not quite the situation we face today.
Investment returns relative to Deflation or Inflation
Source: Leuthold Group 6/30/10
The potential for a wide variety of outcomes from our economy might be the greatest in our lifetime. Hence equity allocations are being reduced into strength from our 70% weight of 2009 and early 2010. Chmn Bernanke appears to have a firm grasp on the risks of Deflation and has hinted that the Fed could further add stimulus to the economy with the purchase of long term government bonds with the hopes of reducing long term interest rates, which would help the housing industry. **This potential action by the Fed would drive long term government bond prices higher and thus be a counter balance to equity risks. Timing is key as it always is and as we have slowly reduced our equity exposure we have held the proceeds in cash rather than invest in bonds as by our measures there could be a better entry point for bonds down the road. If the ten-year Treasury were to move to 3.6% in yield we’d be a buyer.
The fear of Deflation remains very real with our current jobless recovery which may take much longer than in past cycles and extend into 2012. However, a Double Dip recession does not appear in the cards at present as was noted in our blog at www.greeninvestment.com/blog. But the risks are rising that 2011 could be trouble when higher taxes begin to have an effect.
Ultimately this economic cycle will end and just as Warren Buffet is fond of saying: “You can’t tell who’s been swimming naked until the tide goes out”, the inverse is just as true with gold dealers harp on FOX about fear and the decline of our economy while gouging customers with exorbitant fees to purchase gold. Who can say they won’t be swimming naked as well when the tide turns back in?
The methods of investment selection we employ within the RMHI Equity Model date as far back as the days of the 1930’s and The Great Depression, but with a few modern quantitative changes. Benjamin Graham and “The Intelligent Investor” created the concept of Margin of Safety which is arguably the best quantitative method of investment selection ever devised. Our focus is on balance sheets and the traditional relationships of Price to Book Value and Net Current Assets in relation to the stock price. In such uncertain times the pursuit of high growth equities could represent a serious danger without the underlying protection of the “Margin of Safety” which is defined as the value of the equity in sharp discount to Net Current Assets (NCAV). The RMHI model is based on several very Old School techniques of valuation. The Margin of Safety concept may be easier to grasp to the non-financial geek, where ownership of a share is considered a stake in the company rather than a short term trading widget as espoused by the folks of Fast Money and James Cramer.
We need our clients to understand that risk reduction does not necessarily mean returns must suffer, that is if we’re able to buy a stock cheaply….the profit is essentially made on the purchase if we can buy the shares below the Net Current Asset Valuation and remain patient for the value to be discovered. At present there are no publically available Socially Responsible Investment (SRI) funds or management companies that actively employ the Margin of Safety concept.
Margin of Safety
An example of the Margin of Safety concept authored by Benjamin Graham is the shares of Gravity Co. Ltd where the cash per share on the books minus current liabilities is actually greater than the share price.
Gravity Co. Ltd. Symbol “GRVY”: Based in South Korea, develops and publishes online games. Owns flagship Internet game Ragnarok Online.
Data as of 12/31/09 Audited by Korean member firm of Pricewaterhouse Cooper
Total Current Assets $ 71 million minus Total Current Liabilities $ 7 million = Net Current Assets $64m
Debt $ 0
Shares outstanding 27.8 million
Net Current Asset Valuation per share $2.30
Stock price as of 07/27/10 $1.50 a share
Margin of Safety 34%
Despite this absurdly cheap along with an impeccable balance sheet, is the fact that revenue for GRVY grew approximately 20% in 2009 along with positive cash flow with earnings before taxes and interest of $11 million.
Our thesis: An investor has a form of downside protection offered by the cash on the books. The stock would have to rise by 34% to simply comply with the Net Current Assets, the underlying online game and software business along with future growth are thrown in for free.
I believe at some point in the future the shares of GRVY will trade for at least the NCAV or $2.30 a share which would be just over a 50% profit. However should the company continue to execute their business plan as they have recently the shares could travel farther than $2.30 per share. In addition, potential takeover by majority owner? Softbank-controlled Japanese game publisher GungHo (Gravity’s largest licensee, increased its stake to 59% in 2008). Gravity’s below-cash valuation may entice GungHo to make an offer.
As with any company Gravity is not without its risks. The company has long delayed the sequel to its Ragnarok Online franchise which is its largest source of revenue. Hopefully, the company will release the sequel within 6 to 12 months which would sharply boost revenues and earnings.
The Ragnarok franchise will satisfy many social profiles since the game does not include any violence, adult themes or explicit graphics.
Many of our present holdings have similar balance sheet / share price relationships and a few were outstanding performers thus far in 2010: within the past two months we have had two holdings be either the target of a good old 1980’s hostile takeover: RCM Technologies or have hired investment bankers to determine how to maximize the assets of the company: Hawk Corporation.
A third company telecom services company IDT Corp. was our best performer of the quarter. Shares were purchased on average between $10 and $12 a share. What brought it to our attention was the fact that IDT had $9.63 per share in cash with emerging profitability. The cash on the books was our Margin of Safety and at present shares trade for over $18.
In addition, we’re looking at several small holdings which pass the RMHI model but also have a very unique valuation where the Net Current Assets exceed the price per share. These are equities (in addition to Gravity)that have a cushion of safety inherent due to their current assets and become very attractive for sharp price appreciation due to mergers, takeovers or return of capital to shareholders (dissolution of the corporation).
Future considerations: What I’m about to write is considered financial blasphemy and the irony cannot be lost on even the most dense of investors. But I have a belief that as an investor I should look under every rock and every neglected corner of the world and not be bound solely to the U.S. market. With all the references being made to the US resembling Japan I did not just a double take but a quadruple take and shook my laptop in disbelief when in the process of running investment screens with the RMHI model I noticed a new crop of equities showing up in clusters. I won’t keep you waiting but here it is…………..what they had in common were they were Japanese stocks: Hitachi, Nippon Telegraph and Telephone, Interactive Initiative ads, Canon, Fujifilm, NTT Docomo.
Japan: The Land of the Rising Stocks
- Cheapest market valuation in the world on a Price/Book value basis at 1.2x book value which compares to over 3x book value for India and China while the US is just over 2x book value.
- The Nikkei topped out at nearly 40,000 in 1989 while today it rests just under 10000.
- The contrarian trade to Emerging Markets: In a recent Merrill Lynch survey over 60% of investment managers were overweight in their asset allocation to Emerging Markets while approximately 50% of managers surveyed revealed they were underweight Japan. Manager sentiment is frequently an inverse barometer of future performance.
- June 2010 the Wall Street Journal reported that for the first time in three years foreign investors are increasing their exposure to the Japanese stock market.
- Very little correlation to GDP growth and 7 year stock performance. For Japanese equities to perform relatively well very little growth in Japanese GDP will be required, it may just take growth regardless of the rate.
- Most major Japanese companies which took losses in 2010 are expected to produce profits in 2011 which coincides with new Japanese business reforms. 2011 earnings do not appear to be reflected in share prices as very high quality companies are selling cheaply. Hitachi sells for just 13x 2011 estimates and 1.3x book value.
- Byron Wien of Blackstone Group added Japan to his 2010 list of surprises with a prediction that the Nikkei would surpass 12,000 for a gain of over 20% based on its current value. Personally speaking a move to 11,000 seems more likely, which is still a very nice gain.
Summary: We face an unusual set of economic headwinds with a myriad of possibilities for the end result. But investors are still faced with the normal quest for retirement funds and a better life where investing in CD’s or bonds yielding 1% are not a realistic option for the investor with a long term horizon. In addition, while investor sentiment has deteriorated sharply (a very good thing going forward) we do not have the values present that existed in late 2008 and early 2009 which allowed us maximum equity exposure. Hence, I believe going forward equity positions should be reduced into market strength with our average equity allocation will be approximately 55%, ideally 30% for bonds and 15% in cash. “Ideally” is relative since the bonds class offering the best counter balance to equities would be US Treasuries in the 10-20 year range and are quite overvalued at present. Until the over-valuation is worked off we’d be better off holding cash in lieu of bonds.
As for equities, the RMHI model which identifies the best prospects for finding Value along with price appreciation potential. Top of the list in the RMHI equity model in recent weeks have been shares of major Japanese companies which have endured over 20 years of malaise and may be near a pivot point in performance going forward. As a statement of fact, the Nikkei is the most undervalued market based on price to book value in the world and investment managers worldwide are severely under allocated to Japanese shares.
Brad Pappas
August 1, 2010
RMHI is long shares of RCMT, HIT, HWK, NTT, IDT, GRVY
*Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spending,”2009; forthcoming in Tax Policy and the Economy,available at http://www.economics.harvard.edu/faculty/alesina/recently_published_alesina
**Bullard, James of the St. Louis Federal Reserve. “Seven faces of The Peril” July 2010
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