May 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

A few weeks ago, Warren Buffett said in a television interview that equity prices still look cheap as long as interest rates remain low. In the same interview though, he mentioned that if he could short 20 and 30 year bonds (in effect betting that interest rates would rise) he would do that. What Buffett was effectively capturing with his statement is that stocks are cheap relative to bonds, but only because bond prices are so high that they verge on irrationality.

There is no greater example of this irrationality than in Europe where last month 10 year bonds were trading at negative interest rates. This should not be possible. A rational person would never loan someone $100 with a promise to receive $99 in return. Instead they would just keep the $100.

Negative interest rates can only exist because central banks around the world have pushed them there. Central banks have the power of government behind them, so they have the power to hold rates wherever they want.

For that reason, I wouldn’t bet on rates to rise until central banks allow them to. But just because central banks are keeping rates low doesn’t mean that stock prices should be measured against those low levels. Two wrongs don’t make a right, and just because bond prices are irrational doesn’t mean that equity prices should be too.

In the history of the United States, we’ve been at low government-mandated rates before, but didn’t fall into the trap of inflating equity prices along with them. The Federal Reserve’s discount rate was below 1.5% from 1934 through 1950. However during that whole period the S&P 500 averaged a multiple of just 12.8x. Even after the war, equity multiples remained low despite negative real interest rates. Between 1945-1950, equity multiples averaged just 11x earnings while the 10 year treasury yield remained below 3%.

Clearly history demonstrates that it’s possible to separate stock market valuations from bond markets. It’s a choice to peg equity prices to fixed income prices, and investors could just as easily choose to ignore markets that are clearly not dictated by natural market forces. But, practically speaking, in today’s world it seems unlikely that equity prices will decouple from bond prices. If bond prices remain irrationally high, it’s probable that equities will converge to those prices no matter how irrational that may be.

Luckily it’s not likely that bond prices will remain at these levels for the long term, because the Fed has no intention to keep rates here forever. In fact, the exact opposite is happening. Over the last 17 months, the Fed has systematically been removing the stimulus that has kept bond prices so high. At first it did this by tapering QE, then by hinting at a rate increase, and finally at some point in the next year, it is likely that the Fed will actually raise short term rates.

Benjamin Graham, Warren Buffett’s mentor, once said that in the short run the market is a voting machine, but in the long run it is a weighing machine. For the last six years, Fed policy has acted like a 50 lb. dumbbell on our market’s bathroom scale. It has increased the weight (prices) that scale displays at a given level of mass (profits). The Fed is now slowly lifting its weight off of that scale, and soon profits will be weighed on their own merits.

It’s difficult to say for sure what the “weight” of the market will be without the Fed’s dumbbell, but we do know that GAAP earnings peaked last year at $105. Since 1965 the average multiple of the S&P 500 on peak earnings is 15.5x. If the multiple returned to that level on today’s peak earnings, the S&P 500 would trade for 1,627, a 23% decline from current price levels. In bear markets, prices usually fall well below average though, which means that a decline could be much larger than just 23%.

Scott Krisiloff, CFA

April 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

With a quarter of the year now gone, the stock market is essentially still flat for 2015. Throughout the year, stocks have seesawed back and forth trying to find their bearings. Although a few months of sideways movement is common behavior for markets, history teaches us that prices don’t typically remain in a sideways range for much longer than that. After a few months of consolidation, prices will usually break out in one direction or the other. The question of course is which way will they break?

Fundamentals continue to suggest to me that the break should be lower, not higher. Valuations are still extremely high, earnings are likely to fall this year, and monetary policy is getting incrementally tighter. Still, as I talked about last month, there would certainly be precedent for higher prices, it would just mean that markets have reached into undeniable bubble territory.

While markets will resolve these issues over the next several months, I think the most important change that I noticed in the first quarter of 2015 isn’t something that markets are focused on at all, but has the potential to have a massive influence for many years to come. In 2015, it seems that the Baby Boomer retirement wave is finally hitting.

In my own wealth management practice, I am seeing signs that retirement is starting to “cross the chasm” to mass market adoption. Within the last quarter, several of my clients have let me know that they are retiring this year. These are quintessential Baby Boomers, born between 1945 and 1955. They have been working for 40 years plus and are simply ready to move on to other things. I couldn’t be happier for these individuals. Each one of them deserves the opportunity to kick back and relax after decades of contribution to our economy.

Yet, as an asset manager, the decision to retire is bitter-sweet for me, because I know that clients who are retiring go from being asset accumulators to asset distributors. Put simply, rather than growing the balance of their accounts, these clients will now likely be drawing them down, or at best holding them flat. These clients will now be unlocking their savings for the reason that it was accumulated in the first place: to finance their retirement.

This trend, which I am observing on a micro level in my business, is likely to have a profound effect on capital markets. These clients and millions of Baby Boomers like them are the owners of America’s productive assets. The owners of those assets are undergoing a major shift in investment objective. They are going from a growth mentality to an income mentality.

For the last several decades, Corporate America has been managing American companies to a mandate which is now changing. Companies have been asked to produce growth at any cost, because higher stock prices indicated to Boomers that their retirement portfolios were growing, which made for happy shareholders.

Early on, companies generated growth by retaining earnings and reinvesting capital, and as organic growth has slowed, lately they have engineered growth by buying back shares. Even though many times these decisions were made at sub-optimal levels, owners typically didn’t mind because they were looking for capital appreciation. But now owners will ask to realize returns, and owners can only do that in two ways: either by receiving dividends or selling shares.

In an ideal environment, Boomers would be able to generate returns without having to sell assets. Income received from dividends and bond coupons would be enough. However, this isn’t a normal environment. Today very few if any assets are producing enough income to cover necessary expenses. With the dividend yield of the S&P 500 ETF at just 1.9% and the 10 year treasury yield at a similar level, back of the envelope math suggests that a Boomer would need a portfolio of $2.6 million to generate $50,000 per year in current income before taxes.

It’s my sense that most boomers and their financial advisors have probably not underwritten their retirement with the assumption of a 1.9% return on their investment portfolios though. This means that in order to generate the requisite income, Boomers will have to become sellers of assets in order to produce yield.

The question is: at what price will they be able to make these sales? Current owners, who are aging, will be selling to a younger generation. This actually represents a natural transfer of assets from one generation to the next. However, for most of the younger generation, incomes cannot support purchasing those assets at current price levels.

Real estate is perhaps the most tangible example of this phenomenon. Talk to a group of Millennials about buying real estate in Los Angeles, and more often than not you’ll hear “I don’t know how I could ever afford to buy a house here.” Securities markets are just as expensive, but the problem is masked by the fact that the buyer is only purchasing shares not whole businesses. Incomes cannot justify today’s market prices, and the result is that younger generations are purchasing much smaller percentages of companies than they otherwise would be able to. The younger generation is trying to build its ownership of assets, but it can’t in the current environment.

As a result, when Baby Boomers become incremental sellers of their portfolios, they will have to do it at prices that younger generations can afford. In other words, this is one more reason why markets are probably headed lower.

So what does all this mean for our investment portfolios?

It’s important to remember that while forces like these are real, they evolve at such a glacial pace that it’s tough to apply them along any meaningful timeframe. To be clear, we’re not making any near term investment decisions based on the fact that Baby Boomers are retiring.

Still, this information does have an impact on our assumptions for trends in reasonable valuation. I would be much more prone to believe that the PE multiple of the S&P 500 could reach 30x again if Baby Boomers were at a different stage of their lives. However, since they are not, I do expect average multiples to decline, not rise, over the coming decades. In my opinion, that makes it even more important for us to continue to hold cash. Valuations will fluctuate widely around their long term averages and the averages are probably trending lower.

If you’re a Baby Boomer considering or approaching retirement, it’s important to keep in mind that today’s asset prices are inflated. The economic value of a portfolio at today’s levels can not necessarily be taken at face value. Stress your assumptions about the rate of return that your portfolio will generate. And if you have a strong stomach you may want to assume that the true value of your invested portfolio is about 30-35% lower than current levels. From those prices the standard 5-8% growth assumptions are more reasonable. The other alternative, which is the path that we are taking, is to utilize the tax advantages of retirement accounts to sell at these high levels.

One of my mentors in this business once told me that a great advantage in his life was being born in 1943. That made him an early Baby Boomer who was always just one step ahead of his peers. Anything he bought, he got there just before a wave of buying came along to force up the price.

Today we find ourselves in that situation reversed. As Baby Boomers age all the assets that they have accumulated throughout their lives are now being distributed. It will behoove Baby Boomers to be selling earlier than their peers so that they can realize peak prices and preserve capital to reinvest at more favorable ones.

Conversely, younger generations should continue to save, but remain patient holding cash. I promise that eventually we will get a chance to purchase the productive assets of society at prices which are reasonable relative to our incomes. The reins of the American productive machine are now being transferred from one generation to the next. The transition will not be totally seamless, but for those who plan ahead, it can be extremely profitable–for this generation and the next.

Scott Krisiloff, CFA

March 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

Last fall I wrote about how economic expansions can often take place in three phases.

The first phase is the recovery phase. In that phase, investors have just been burned by a bear market and therefore still don’t really believe that the markets and economy are recovering. Sentiment in that phase is characterized by cynicism and fear and valuations are usually low. In the current bull market, this phase lasted from 2009-2011.

The second phase is the growth phase. As memories of the bear market fade away, investors begin to feel more comfortable committing capital to markets. By the end of the second phase, valuations usually rise to high but still somewhat rational levels and sentiment improves to become more optimistic. In the current bull market, this phase lasted from 2012-2014.

The third phase is the bubble phase; it is one that doesn’t always occur. The third phase is characterized by euphoria, greed and prices that disconnect from fundamentals. The marketplace takes on a casino mentality in which prices go up just for the sake of going up.

Today we sit at an investment crossroads. Since late September we have been in a transition between phases, but it’s not clear which direction we will go next. Down one path there is the possibility of the end of this cycle, which would bring a bear market. Down the other path is the prospect of a third phase, which would bring a level of excitement that we have not seen since the late 90s.

Up until now, I never thought that we would see a third phase in this cycle. The only three phase cycles that I’ve ever studied were the late 90s and late 20s. I did not think that we could have a repeat of the dot com era within two decades of the last bubble. But as I look around the marketplace, I’m no longer so convinced that we wont see a boom.

To be clear, on a fundamental level, I don’t see any reason that stock prices should continue to rise. Multiples have already expanded to extreme levels matching 1929, 1962 and 1987 (all three of which preceded 25%+ declines). Meanwhile, earnings growth has slowed meaningfully. In 2015 revenue for the S&P 500 is now projected to decline from 2014. Many people argue that stocks should rise to match low interest rates, but to accept that argument one would have to believe that interest rates are rationally priced. Thanks to central bank actions, fixed income markets may represent the greatest financial bubble in history.

Still, equity markets do seem to want to go higher, so without any fundamental underpinnings, a bubble is the only way for prices to continue the advance.

Let me say that I sincerely hope that we do not see a third phase of expansion. While a roaring bull market would certainly be exciting while it lasted, the aftermath of a three phase cycle has typically left the economy in tatters. If prices keep rising from here without a commensurate rise in earnings, there is nothing to be cheering about.

If we do enter a third phase, I am conflicted as to how we should react as investors. On the one hand the third phase of a cycle could pose an opportunity to make money. However, on the other hand, the third phase is the least predictable of any phase. There’s no telling where, when or how it could end, and once it does there is no fundamental safeguard to support purchases made at ethereal levels. It took 25 years for prices to recover after peaking in 1929. While that example may be extreme, it is still a possibility that capital committed today could be impaired for years into the future.

It’s also foolish to think that we are going to be able to get out before everyone else. There is nothing to say that a 1987-like crash couldn’t erase all paper gains within the course of a few days or a week. When there is no long term justification to hold our investments, we’re better off not holding them than trying to play a short term game.

As I’ve always written, valuation is our North Star. I will never purchase an asset that I believe to be uneconomically priced just because I think it’s “going higher.” I believe that this is the only responsible way to invest. We’ll keep navigating towards that North Star even if others drift off in another current, because we know that this is the only way for us to navigate our ship soundly so that we reach our long term objectives.

There may be some clients who feel differently though. If you are interested in taking on the risks associated with participating in a third phase of an advance, please contact me and we can work on a solution that’s right for you. My recommendation is unequivocal though. I think our greatest opportunity for profit is to continue sitting tight.

Scott Krisiloff, CFA

November 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

October was a wild month. In the first 15 days, the S&P 500 fell back down to negative territory for the year. In the last 16 days, it bounced back to finish up for the month and at new highs for 2014. As I write this, the S&P 500 is now up 10% for the year.

This year’s increase has been a statistically improbable advance. If the S&P 500 closes the year here or higher, it would be the third straight year that the index has risen by a double digit percentage. In the last 110 years (linking both the Dow and S&P 500), there have only been five times that the indexes have risen by double digits three years in a row in 22 attempts. Indexes have actually been much more likely to fall than rise in the third year following two years of double-digit gains. On average, indices have declined by 5% in those circumstances.

Armed with that statistic along with an aging economic cycle, high valuations and Fed tapering, I believed that 2014 was destined to be a weak year. There are still two months left until the books close, but as the year wanes, it’s looking less and less likely that the broad market decline that we’ve been waiting for will occur this year.

Looking at the current environment though, a large decline still seems more likely than a sustained advance. There has been a change in the market in the last couple of months. The dollar has been rising, interest rates have been falling and oil prices have fallen as well. These are not the type of signals that the market usually sends when the economy is booming. This is behavior that is more consistent with the early innings of a recession than the middle innings of an expansion.

Currencies, commodities and bonds are all acting in unison and telling the same story of economic weakness. The only asset class that is bucking the trend is US stocks. However, even within equities, there are pockets of indication that the economy isn’t as healthy as the major indices appear to reflect. Defensive sectors like healthcare and utilities are leading the advance, while consumer discretionary is lagging, which it usually starts to do before a recession. Additionally, small cap stocks have had a particularly weak year. They are flat now, but were down 10% for 2014 in mid October. Taken all together, large cap equities, specifically the S&P 500, look like the odd man out.

Importantly, outside of equities, prices are acting in a way that suggests that the absence of QE is having an impact on the market. The Federal Reserve stopped buying bonds at the end of October. In the past, whenever the Fed has done this, deflationary concerns have started to pop up. The weakness in oil and strength in bonds and the dollar are hallmarks of deflation.

Since 2009, the Federal Reserve has stopped purchasing bonds twice, once in 2010 and again in 2011. In both instances, equity markets fell hard. In fact, since 2009 the market has never been able to maintain a rally without the Fed expanding its balance sheet through bond purchases.

2010 and 2011 aren’t the only times in history that the Fed acted to rein in the growth of its balance sheet with negative consequences either. In 1937, the Fed raised reserve requirements over the course of 11 months following a bull market that rose in nearly a straight line for two years. The analogy to this time period is eerie, not only because we’ve also had a two year bull market driven by easy monetary conditions, but also because in 1937 when the Fed raised reserve requirements, it emphasized that the move was not an end to easy money policy, merely a normalizing measure. Still, despite low interest rates, the Dow lost nearly 60% of its value in 1937 and 1938 and retraced the entire 1935-1937 advance.

While I continue to believe that the probabilities point to a large decline, there are of course always other scenarios. In particular, I’m watching closely for signs that we are in a “three phase” rather than “two phase” market cycle. In a three phase cycle (the 1990s and 1920s are two examples) there are three periods of a bull market rally which each last a couple of years with periods of weakness in between. In the first phase there is total disbelief that the rally is happening. In the second, there is acceptance and belief that the economy is improving, and the third phase is characterized by euphoria, especially among retail investors. We have already seen the first two of these phases in our current bull market, but it still remains to be seen whether we will get the third.

The reason that I don’t believe we will see a third phase is that the third phase is usually propelled by renewed stimulus from the Fed. For now it does not look like the Fed will apply more stimulus to markets. However, there is a caveat: the recent actions of foreign central banks may be providing the stimulus that the Fed is not. Within the last quarter, the BOJ and ECB have each committed to further easing of monetary conditions. Japan has done so aggressively. If foreign central banks can provide the same stimulus as the Fed, then we could have a three phase cycle which leads to a true equity bubble, where the S&P 500 tops out in the 2500-3000 range in 2016.

I’m not a believer that foreign bank easing is the same as the Fed easing though. Looking at history, one contributor to the 1937 cycle was that the Banque de France devalued the Franc. France was the last major holdout on the gold standard at the time. Many thought that France’s devaluation would finally lead to stability. But, to the contrary, the capital outflows helped cause recession.

Since the beginning of the year, it has always been the plan to ride out 2014 and then reassess the environment to determine whether this looks like a two or three phase cycle. My working assumption remains that this is only a two phase cycle. Our eyes and ears are open though and we’re certainly not too proud to change course if the facts are conflicting with our outlook. The next couple of months will be telling.

Scott Krisiloff, CFA

October 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

It may not look like we’ve done a lot in 2014 because our portfolios haven’t changed much this year. But beneath the surface we have definitely made progress, adapting and evolving, continuing to become better investors. The market hasn’t given us many opportunities this year, but that doesn’t mean we haven’t stopped looking. I have a growing list of companies that I would love for us to own. I’d just like to own them at better prices.

I’m confident that eventually we’ll get the bargains that we are looking for, and so I’m not in any rush to force our cash into the market. Prices have started to slide in the last few weeks and are certainly more favorable than they were a few weeks ago, but they are still far above what I consider to be fair value. Especially now that the Fed has withdrawn QE from the market, it’s possible that prices could fall much further.

Still, last quarter I did make purchases in a few accounts where investors deposited new funds. I’d like to review the new purchases here not only because they may make their way into more portfolios, but also because I think they are good examples of how we have continued to refine our investment style. Remember that all of our portfolios are tailored to individual clients, so you may not have these holdings in your portfolio quite yet. If we don’t buy more of these specific companies we’re certainly looking for more like them:

–For Avondale Clients only. If you would like to read this section of the investor letter, please contact us.–

If you compare the reasoning behind these new holdings to the ones that we’ve purchased in the past, I think you might notice some subtle improvements. The biggest change is that we’re putting more emphasis than we ever have before on finding exceptional management teams, whom we view as partners.

Each week I read dozens of conference calls looking for managers who are committed to building real business value for the long term. When I find them, those are companies that go to the top of our watch list because good leadership is the single largest determinant of the success of a company. Good leaders will find a way to make their companies better tomorrow than they are today and position the organization to succeed in the long term.

Not only do I think that screening for management teams maximizes our probability of monetary success, but more importantly, I think this is the best way to align our personal values with our investment portfolios. To the extent that you have entrusted me to be an extension of yourself and your savings, I try to find management teams that we can feel are an extension of us as well, who would act as we would if we were the boots on the ground and were fortunate enough to have their immense talents and knowledge.

Listening to great management teams has had effects beyond just the investments that we make. It’s also influenced the way that we make them. Early in my career, one of my mentors advised me: don’t wake up in the morning thinking about what stocks you’re going to pick today. Wake up in the morning thinking about how you’re going to make money today. I don’t think I fully understood it at the time, but in watching America’s best CEOs, the distinction has become clearer. Picking stocks is about playing Wall Street’s game, making money is about building sustained value. My job is to wake up in the morning thinking about how to make you money today. As time goes on I’m working on solutions to continue to do that more effectively. In the next few weeks I’ll have an announcement of a venture that will hopefully lay the groundwork to act more like a CEO and less like a hedge fund manager, so that we can use our resources to truly build value.  Stay tuned.

Scott Krisiloff, CFA

August 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

Stocks finished July lower than where they started thanks entirely to a large decline on the last day of the month. Up until July 31, markets had been enjoying a relatively calm month, but seemingly out of nowhere, the S&P 500 declined by 2% and has traded with some weakness ever since. The S&P 500 is now up a little over 3% for 2014 and the Dow is back to negative territory for the year. The Russell 2000, an index that measures small cap stocks, is down 3.8% year to date. Thus the bull/bear stalemate of 2014 continues.

Although the market has shown some weakness of late, the economy has looked stronger than it has at any point in the last six years. Last month we saw the heart of earnings season, when most large companies report their quarterly results to shareholders. Although I had been skeptical that companies would be able to show strong earnings growth, corporate America came through with a very impressive 2nd quarter. With 89% of S&P 500 companies reporting, second quarter earnings are on pace to grow by 8.4% versus the same quarter last year.

It’s clear from second quarter results that the economy has fully recovered from the financial crisis. For the past six years businesses have operated with caution. Today, management teams are finally ready to take risk again, to expand capacity and invest in growth. Businesses are borrowing, hiring and may be beginning to build new facilities.

Still, while economic activity has strengthened, it’s important to separate the market and the economy. The two are correlated, but don’t necessarily move hand in hand. By now, second quarter results are old news. Stock prices have already moved to reflect the strength of the economy and markets have turned their attention to what happens next. In fact, this might be the root cause of why stocks have been weak since the end of July. Once all of the good economic and earnings data was digested, investors looked forward and asked: will it get better than this?

From a pure market perspective, the market has some strong headwinds to contend with from here. Most importantly, valuations are still high. Even with the economic strength, earnings need to grow a lot more in order to match current price levels. As I’ve warned in the past, valuation will eventually dictate prices. Either prices will fall to meet earnings or earnings will rise to meet prices. Because of the strong second quarter, earnings have a shot of rising to meet prices, but prices have to slow their advance to let earnings catch up. This will take some patience on the part of investors, but that’s not a character trait that investors always display.

Another potential speed bump is that Quantitative Easing will end between now and the end of the year. As of the beginning of August, QE is only $25 billion per month, which means that the pace of monetary growth is relatively close to what it has been in more normal environments. This is important because it means that QE might not be large enough to provide an extraordinary boost to the market anymore. This is another possible explanation for recent share price weakness.

If it turns out that markets are falling simply because they need QE to support them, then we should be on extreme alert. We know for sure that markets have risen like a rocket ever since QE was started. We suspect that QE has been our rocket fuel. If we start to lose velocity because we have run out of propellant, we could start to decline very rapidly. The hope with QE was that it would be enough to get us into orbit, safely away from the pull of gravity. If it turns out we haven’t gotten there, things could get messy.

As for our portfolios, we’re not making any major changes to the large cash position that we’ve built for now. The economy is flashing green lights, while the market is flashing yellow. That’s not uncommon in a transition period. The economy will always look strongest before it turns. You may recall that in 2009 it looked weakest when the market bottomed. This recovery was unfathomable then—almost as unfathomable as a recession would be today.

Ultimately though, valuation is our north star, and until value gives the signal that we should make purchases, we’ll sit tight. There are a few companies that I’m watching very closely and have started to accumulate shares where appropriate. I don’t anticipate that these purchases will have a large impact on the overall positioning of the portfolios though. We like to make purchases at bargain prices where possible and there just aren’t many bargains to be found. I’m confident that will change sooner or later.

Scott Krisiloff, CFA

July 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

The first half of 2014 is in the books and the S&P 500 has surprisingly been able to post a 6% gain. Against that mark, our portfolios are flat. The results have been less than stellar, but I’m not ready to declare that I’m disappointed by our performance quite yet. It’s still way too early to close the book on 2014. So far earnings growth has not kept up with the market’s price increase, which makes year to date gains unstable.

Candidly though, it’s clear that I became too conservative too quickly with our portfolios. The market has run farther than I thought possible. Still, I’m not sure I would have made much different decisions if I could do it over. We sold holdings at prices that I think were favorable to us and included the outlook that stocks would be priced with unreasonably bullish assumptions towards the end of the cycle. My biggest mistake was underestimating how long this environment could persist for. I always intended for us to leave some returns on the table in order to ensure safety. I did not count on the bullishness lasting this long though.

Our strategy has been in keeping with a letter that Warren Buffett wrote to Katharine Graham, the CEO of the Washington Post, in 1975 about how the Post should manage its pension funds. In the letter Buffett wrote the following:

“There is an offsetting advantage [to investing in stocks] which can be of very substantial value…that relates to the periodic tendency of stock markets to experience excesses which cause businesses…to sell at prices significantly above privately-determined negotiated values. At such times, holdings may be liquidated at better prices than if the whole business were owned—and due to the impersonal nature of the securities markets, no moral stigma need be attached to dealing with such unwitting buyers.”

Effectively, Buffett advised Graham that sometimes stock prices rise beyond a level where a private seller (an insider) would be willing to sell a whole company. In those circumstances, Buffett advised taking advantage of the environment and selling shares.

We have stuck to that advice and have sold whenever the prices of our individual holdings have met Buffett’s criteria as best as I am able to estimate it. I believe that our actions are supported by the evidence. This year has been the most active year for acquisitions since 2006 and largest for IPOs since 2000. In other words, prices have reached levels that insider owners, who are guaranteed to know more about their businesses than the buyers, believe that they are receiving a favorable selling price. We should feel encouraged that we are selling along-side these individuals.

While many rational business people are taking the opportunity to sell, markets are in a manic phase, where the most important determinant of value is the price paid by the most recent buyer. Discussions of fair value have mostly faded away. The most popular justification for buying stocks here is “they’re going up and could keep going up.”

That’s not an unreasonable justification per-se. There are people who can and have made money in such an environment. However, the environment is not favorable to the prudent long term buyer. We’re searching diligently for new places that we can invest our capital, but the pickings are slim.

As we enter the second half of 2014, interest rates are the key to this market.  Inexplicably, interest rates fell in the first half of the year as stock prices rose.  Either dynamic is perfectly fine by itself, but falling rates in tandem with rising stock prices seems to offer a conflicting view of the world.

If interest rates are falling because growth is slowing, then stocks are going to have a very difficult time meeting increasingly sanguine earnings growth expectations. On the other hand, if stocks are rising because of higher growth expectations, then inflation expectations should be rising too, putting upward pressure on interest rates.

In the second half I expect that this contradiction will have to be resolved either through rising interest rates or falling stock prices. We don’t really care which happens—we stand to benefit from either possibility.

Scott Krisiloff, CFA

June 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

After heading sideways for most of the year, the S&P 500 now looks like it is showing signs of life. In April, the index rose above 1900 for the first time and for the time being, it appears that the path of least resistance is higher.

This isn’t what I expected to happen, but the economic data has been solid, and as a result, many people are chasing a rising market. Even with the good data, prices are once again rising faster than earnings though, which means that this advance is driven more by psychology than fundamentals.

When prices rise faster than earnings, the two will eventually re-converge. Either earnings will grow to meet prices or prices will fall to meet earnings. We are positioned for prices to fall to meet earnings, but I am watching intently for any indication that earnings can grow to meet prices. Currently it does not appear that long-term growth will be strong enough to support these levels, which is why I think we are still on the right path by staying conservative.

Without strong earnings growth, there is no reason to chase a rising market. Any price increase will ultimately prove to be unsustainable without earnings to support it. In the near term, prices can rise from extreme to more extreme levels, but it doesn’t make sense to try to game these short-term moves. If we gamble that prices will rise and are wrong, there is nothing to support our investment at these levels. So unfortunately, I must continue to preach patience, even though it’s possible that we may have to endure some more uncomfortable months ahead. I hope that our patience is not wearing thin.

Last month a Norwegian journalist who has been reading along with these letters contacted me asking for a bearish quote. He mentioned to me that I have been waiting for “quite a long time” for a decline. My response to him was that it really depends on how you define a long time. Within the context of economic cycles, the six months that we’ve been bearishly positioned is not exceptionally long.

We experience time in hours and days, but economic cycles are measured in months and years. The average economic expansion has lasted 58 months since World War II, and we are in the 60th month of this expansion. On that time scale an extra three or six months is not meaningful. But when you are in the thick of things, that time can feel like an eternity.

It is probably this very disconnect that ends up creating economic cycles. The cycles last just long enough for emotional memory to fade so that we can make the same mistakes a second time. Market cycles trend towards extremes because we project the short term onto eternity and convince ourselves that the present environment will continue indefinitely.

Prices do not trend linearly in one direction though. Economic cycles rise and fall, and even though it may feel like things will stay this way forever, I can promise that they will not, and it’s highly likely that the top will be the precise moment that we’re most convinced that they will. The longer that prices rise without a commensurate increase in earnings, the more likely that the correction will be severe when it eventually arrives.

Scott Krisiloff, CFA

May 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

The S&P 500 continues to tread water in 2014. The index was up 1.92% at the end of April, but so far 2014 has been a stalemate between bulls and bears. The index crossed back and forth between positive and negative territory throughout last month, and the S&P 500 has actually spent slightly more time below breakeven than above it this year.

Although the S&P 500 is mostly flat, there are some important segments of the market have been deteriorating. Since mid-March, many popular momentum stocks are down more than 20%+ from their peaks. The Nasdaq and Russell 2000, which are indexes that contain a higher proportion of aggressive momentum names, are both down for the year. At the same time, defensive asset classes are faring best. Interest rates have fallen as bond prices have rallied and utilities stocks are among this year’s top performers. When defensive assets are leading and aggressive assets are lagging, it is typically not a positive signal.

Markets are sending weak signals, but investors seem ready to write-off the warnings signs. In April, we found out that first quarter earnings growth was uninspiring and that GDP only grew by 0.1%. The numbers were weak, but most investors readily accepted that the economic weakness was wholly due to weather. Counterintuitively, weak data has led to higher expectations because investors are expecting a big bounce back. Many analysts are now speculating that we will get 4% GDP growth in the second quarter. The higher bar will be harder to clear.

Meanwhile, we’re seeing textbook late cycle behavior in the economy. Leading economic indicators like securities prices and the housing sector are showing weakness, while lagging economic indicators like unemployment, energy, and commercial real estate are showing strength. Additionally, inflation is starting to percolate and the Fed is tightening monetary policy by tapering asset purchases. To top it off, retail investors are more heavily invested in their brokerage accounts than at any time since September 2007.

Furthermore, the conditions are ripe for a decline. This economic expansion is now the 6th longest in history, this bull market is the 4th longest in history, and equity valuations remain higher than at any point outside of the dotcom bubble. We all know that markets periodically become volatile, but today hardly anyone truly believes that the economy or markets could see a material fall.

This willingness to overlook negative data is typical when the economic cycle is cresting. Bull markets are often compared to parties, and we appear to have entered the “beer goggles” phase of this one. There are plenty of reasons to be concerned, but investors are too intoxicated by the effects of a prolonged bull market to maintain clear vision.

Bull market beliefs have become deeply ingrained by relentless reinforcement over time. Investors have been well trained to accept that: 1) interest rates will stay low forever 2) PE ratios will stay high forever 3) it’s not unreasonable to value a growth company based on 2019 revenues and 4) the Federal Reserve has absolute authority to control the economy. Sadly, these beliefs are probably held most deeply by the people who have argued most passionately against them. The former bears have been painfully disproven for years. As a result, long time bears’ confidence is shattered and most have likely already found new investment strategies. After 17 months without a meaningful decline, bears are all but extinct.

All of this evidence is pointing to the fact that we are through the inflection point where we go from climbing the wall of worry to descending the cliff of confidence. Our orientation has likely flipped. On the way up, bears turn into bulls; on the way down bulls turn into bears. The weakness in momentum stocks is especially telling, because it shows that selloffs are not being driven by bears who are having brief moments of influence, but instead by bulls jumping off the top of the pile.

As the cycle inflects, many stocks will fall enough that they will start to look attractive, but we have to be careful to make sure that we are not judging them with our new-found beer goggles. The realities that we have come to accept during our bull market party are not necessarily ones that will remain when we wake up sober.

Scott Krisiloff, CFA

March 2014 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

The S&P 500 was up 4% last month and even though the index is still effectively flat for the year, February’s rise was particularly heartbreaking for bears. Bears endured a horrific rise in 2013 and just as it looked like there was finally going to be a little relief in January, the market turned right back around to reach new heights.

February’s rise puts the bears under an extreme amount of pressure. The market has risen virtually in a straight line for fifteen and a half months. If the market continues to rise and bears don’t participate, they are risking their careers and credibility. Bears simply cannot afford to miss out on another rally.

To add to the bear’s anxiety, March and April are historically two of the best months of the year for equities. No doubt bears are looking at this potential advance and panicking. Perversely, this panic is likely what caused February’s rise. Bears are so sensitive that even the slightest possibility of a stable economic environment was enough to force them to come rushing back into the market.

Although it did come as a surprise, February’s advance is still consistent with the very late innings of a bull market. Equity prices were pushed higher solely because of heightened emotions and the absence of bad news. This kind of reaction suggests that the final bears are capitulating.

These capitulating bears can continue to push prices higher in the short term, and I would not be surprised if stocks continue to rise in the coming weeks. Eventually, however, the capitulation is what sets a more lasting peak because once the bears are through there isn’t anyone left to buy.

I wish that I could say we were positioned to take advantage of a potential near term rise, but unfortunately we aren’t and don’t have any plans to be. The only thing that keeps us from getting caught up in emotions like other bears is avoiding the temptation to reposition for a quick gain. Our portfolios are deliberately maneuvered like an aircraft carrier rather than a speedboat in order to mitigate the risk of making capricious decisions. We take a long-term view when investing and a positive outlook for the next couple of weeks does not change the outlook for less calm seas on the horizon. We should be prepared to be frustrated in the near term, but I’d rather be frustrated than abandon our discipline.

Importantly, I believe that heightened emotions are clouding investors’ ability to see a deteriorating environment. The greatest concern is that stocks have not gotten any cheaper this year. They have only become more expensive. At current levels, the S&P 500 is trading at the exact same PE multiple that it did at the peak of 2007’s bull market. The only time in history that the S&P 500 has traded at a higher multiple on peak earnings is the 1997-2000 period.

In addition to high prices, earnings growth is slowing while growth expectations are rising. This is best illustrated by analyst expectations for what the S&P 500 will earn in 2014. In 2013, the revenue per share of the S&P 500 grew by just 0.63% while earnings (thanks to margin expansion) managed to grow by a mediocre 5.6%. In 2014 analysts are projecting revenue growth to accelerate to 3.6% and earnings to grow by 8.9% (thanks to even greater margin expansion than 2013).

In 2014 there is even less slack in the economy than there was last year so it’s difficult to see how revenue will grow significantly faster than it did in 2013. Likewise, it is difficult to make the case for further margin expansion. Corporate profit margins are at or near all-time highs, and have benefitted from weak labor markets and low inflation. If economic activity is really going to continue to pick up in 2014, the outlook will likely have to include higher inflation and tighter labor markets. Both of these would pressure profit margins.

Another headwind to growth and margins is that productivity growth has slowed and is likely to slow further in 2014. Productivity is the most important driver of real economic growth, and the fundamental source of productivity is innovation, which allows people to do more with less. In the recent cycle, mobile computing has been the single biggest productivity driver for the economy. Today that wave has slowed and is now effectively over. Everyone who needs a smartphone or a tablet in the US already has one. Some investors are currently chasing hot new growth avenues, but there is no category of products on par with the smart phone that is on the precipice of mass adoption. There will be revolutionary products down the line of course, but we are currently in a lull in the innovation cycle.

Besides productivity, debt accumulation is one other factor that could boost short-term economic growth, but is unlikely to materialize. While corporate borrowing may step up in 2014, consumer borrowing is really what moves the needle on aggregate debt. Specifically, mortgage borrowing is the most important category. The next time there will be real mortgage growth is when Gen Y levers up to buy homes. Gen Y has a tremendous amount of borrowing capacity and will eventually fuel a borrowing boom, but demographically the wave is still a couple years away. The median age of Gen Y is 28 years old, which means that the individuals who will become Gen Y’s mass affluent are just finishing up professional schools and re-entering the workforce. In a couple of years they’ll have the savings to make a big splash in housing, but probably not in 2014.

Finally, investors are fully aware of one more economic cloud, but seem to be willfully ignoring it. The higher the market climbs, the more likely the Fed is to withdraw monetary stimulus. QE3 is a large part of the reason that stocks have not had a significant pullback in 15 months. And as long as stocks maintain their current position or rise from here, QE will be finished before the end of the year. The Fed is the bull market’s ticking clock. In the past, Fed policy provided a floor for equity markets, but now it provides a ceiling. It is a ceiling that we are rapidly approaching.

Scott Krisiloff, CFA