Cars, pots, rocks and sticks are some of the favorite playthings in our house. But to our kids, these toys really seem to come alive in the hands of someone else. So our youngsters drop whatever is in their hands and go grab the “alive” toy from the other child’s hands – even though they were already holding an identical toy. I understand why this behavior occurs thanks to parenting research. Who wants a lifeless static car when the one in the brother’s hands is speeding across the carpet with zooming sound effects provided by pursed lips and a nimble crawl?
Russia, Ukraine, Thailand, Nigeria and China have been the “shiny toys” that have attracted attention globally and in the media. They allow us to see a dark and unsafe world that trumps the fact that most people are happy to get along, be good neighbors and show tolerance of others’ beliefs and values. Simple, honest, quiet, good citizens going about their daily lives is not a headline-maker, whereas war, corruption, greed and power gone awry make for an intriguing read. Gandhi once said, “War will always be more compelling than peace.” And we find the truth in this when we look at the themes of popular television shows and movies.
I had the privilege of meeting Nigeria’s President, Mr. Goodluck Jonathan, a few years ago, and I can only imagine how hard it is to be in his shoes right now. But our leaders are only human. To blame and expect miracles from them is to think that the red truck that my son Henry is zooming with really is alive – while the identical red truck in Patrick’s hands that is not zooming along the floor like Henry’s is somehow less alive. Powerlessness is hard for anyone to swallow, especially high-functioning people who are used to getting things done and having power and control over their circumstances. The parents, friends, grandparents, teachers and others with empathy for the 273 kidnapped Nigerian girls can only say the “Serenity Prayer” so many times before they want to shift into action, any action – even if it is self-defeating, reactive or short-sighted. Irrational people who do not seem to value human life, except their own kin perhaps, are not going to act in a rational manner. A friend of mine who did the disaster planning for the U.S. government during the Cold War (his job was, for example, figuring out the “what do we do” scenario if a nuclear bomb went off in Manhattan) once said to me, “Paul, crazy people are crazy. The biggest mistake you can make is to think they are rational and will behave like you and I would.” But we want certainty – and will pay high prices for it. Some love the comfort of a President like Vladimir Putin at the helm of their country, while others will join a “party” and support it even when they watch its policies and leaders’ behaviors violate their basic good values in their everyday lives and the way they vote.
Shiny Toys and Investments
Like the movement of shiny toys, we seem to be wired as humans to think that the right time to buy is when an investment is in movement: up a lot (and buy) or down a lot (and sell). Just this morning, I read a statistic on the (higher) prices paid by private equity firms in Europe. The article highlighted how the markets have found reassurance (and thus buyers of private equity) since Europe did not implode despite Greece, Italy and a few tens of billions of unpaid Euro debt. In 2007, before the crises, they paid an optimistic (at that time) 9.7 times EBITDA (earnings before interest, taxes, depreciation and amortization). Last year, they paid 8.7 times, and this year the average is 10.4 times.
Investors are paying a much higher price for earnings now than the high of the last optimistic cycle. When a child grabs a toy from a friend, even when an identical toy is available, they have a “consequence” … a time out from a parent, or a shove or punch from the child reluctant to have his toy pulled from his hand. Similarly, chasing “shiny toys” as an investor has a consequence. Most investors do not realize that the “investing” community is driven more by the “buyers’” interest than the merits of the investment. In other words, Wall Street sees that it can raise funds to sell the latest shiny toys – today it is the likes of Twitter, Airbnb, JD.com (Chinese Internet company), LinkedIn and some indexes. They are selling at prices that remind me of the silliness that was experienced back during the “Internet bubble” period a mere 15 years ago – of course this time, people say, “It is different.”
Wall Street will sell you what it thinks you want. For example, UVXY is the symbol for a security that was “invented” to “sell” to the bearish world-coming-to-an-end types. It was designed to provide twice the daily performance of the VIX index (an index used to benefit from downside market volatility). The security came out in 2011 and hit a high of $97,919.97 on October 4, 2011. As of May 23, 2014, UVXY is selling at $40.59 a share, for a loss of around 99% for the poor souls who saw this shiny toy and bought it because they thought the world was too complacent about the economics of the globe. The manager of the UVXY fund is happy to sell you shares today, and millions of dollars’ worth have been sold and bought daily for quite a while. But life goes on. The person chasing things at the extremes may be lucky once in awhile, but universally the world does not tend to reward the person who jumps to grab the current shiny toy investment.
Goal: Find the Middle Ground and Make Money
When one of my kids grabs the “shiny toy,” Amy and I show him the other toys and explain that the one he has, like his brother’s, can zoom too. Often that does not matter, as all parents know THAT is one of the first full sentences children seem to learn. So logic and explaining the utility value of a substitute toy (both Amy and I have been schooled in economic terms, which seem to show up often in our discussions with our toddlers) seem to do little good to help with the tears and getting back on the path of joy-filled, engaged, perhaps even slightly quiet play.
Investors who have made up their mind that: 1) the world sucks, 2) investors can’t win, and 3) that investing is really a speculative game of luck, will usually get little enjoyment out of their boring investments just like the child that sees his toys as toys that aren’t alive like those in the hands of other kids.
Investments (and there are lots of them to choose from) create wealth or income from various factors – income, dividends, growth in assets, growth from reinvesting profits and investors bidding up the price. Like the child who soon loses interest in the “must-have toy” bought for him in his tantrum at Toys “R” Us, investors often get disenchanted with an investment that does not meet their expectations and sell it – even if it is doing well and it is reasonable to be patient and know it will perform as expected. Deciding to sell a fundamentally-sound investment simply because of price weakness is usually a bad decision (as is buying simply because of price strength). The chart above illustrates this by looking at one of the most predictable dividend growers in the world: tissue and diaper giant Kimberly Clark. While the growth of the dividend has been pretty steady-eddy (orange line), growth in the stock price (blue line) has been much more erratic, providing plenty of opportunities for price momentum-focused investors to get whipsawed. At FIM Group, we believe that markets are going to stay volatile and the volatility will be sector- and security-specific. We think investors are, as always, a bit irrational in their approach, which means they will sell off good, solid assets to buy the shiny new one that Wall Street is so happy to champion. As we have done for 30 years, we will pick through those investments that have great merits and buy them when we believe risk-adjusted investment value is there, and the price we pay for that value favors good long-term performance.
Today we are finding compelling investments. We are at this time, as usual, favoring companies that have ethical, good management, solid future prospects, good current income, growing cash flows, and solid, financially flexible balance sheets. We are also concentrating client investments in industries that many consider boring – real estate, mining, food, agriculture, energy, health care, healthy living and such. What I do know is that when the current shiny investments lose their luster, the solid investments in our clients’ portfolios will again look very promising, be bid up and we will sell them if their price seems to be on the higher band of valuation as illustrated in the chart to the left. Everything is cyclical – investments, our children’s favorite toys and the stuff the press helps us obsess about.
I do pray that the kidnapped Nigerian girls return home safely, and rather than high fences, more police, more soldiers and surgical strike capabilities as a solution, that the world starts to think in terms of how we can create compassionate hearts and tolerant, virtuous societies as a cause of peace.
When I was a kid growing up in Southwest Michigan, my buddies and I would often imitate the over-the-top, rapid-fire radio and TV promos for the monster truck and tractor pull shows that seemed to hit our area each summer. In an era predating all the web-connected digital toys of today, we actually had to entertain ourselves on our bus commutes to school. So we’d sit in the back and one of us would start the ritual with SUNDAY! SUNDAY! SUNDAY! Then we’d spontaneously try to one-up each other, round-robin-style, throughout the bus with our best monster truck call imitations.
In our craziest monster truck announcer voices, we’d go through legitimate monster truck names like BIGFOOT, ORANGE CRUSH and GRAVE DIGGER! Someone would inevitably throw in a sideshow act to mix it up a bit like COME SEE DYNAMITE LADY BLOW HERSELF APART! And then we’d just start making stuff up. One of my favorite calls was THE MEAN SCREEEEAMIN’ WHEELIE MACHINE! inspired by images like the one below of a car-crushing monster truck temporarily defying gravity. We never got kicked off the bus with these theatrics, and I have a theory that at least one of the older bus drivers was a closet monster truck mega-fan given her smirks as we filed out of the bus each morning.
The reason for this mini stroll down monster truck memory lane is that, like the mean screamin’ wheelie machine noted left, a mean screamin’ reversion machine lurks in financial markets today. Mean reversion is just a fancy way of saying that certain financial and economic data tends to return back toward average levels (or the “mean,” for those who made it through their college stats course) over time. In other words, these data points go through cycles rather than continue on a perpetually higher or lower path. Two “metrics” in particular that can be very monster truck-like in their behavior as they rise up in temporary defiance of market gravity only to come crashing down on unsuspecting investors are profit margins and valuation ratios.
Mean Screamin’ Reversion Machine #1: Corporate Profitability
Let’s take a look at corporate profitability first. The figure on page 4 is from the St. Louis Federal Reserve Bank. It shows that aggregate U.S. corporate profit margins (the ratio of profits to sales) have historically ranged between 5% and 14%. Business cycles, external competitive forces, and even the internal struggle between management and shareholders have historically combined to keep profit margins in a peak-trough pattern within this range. As legendary investor Jeremy Grantham puts it:
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.”
Investors, though, tend to forget this cyclical nature of profitability and often fall into the trap of projecting the profit margins of the moment far into the future. Today’s Wall Street bulls (those who think the U.S. stock market looks attractive at current prices), for example, have been arguing that the current record-high levels of profitability will persist or even grow further in the years ahead. They cite factors like lower effective tax rates, lower interest expense, weaker union bargaining power, higher adoptions of productivity-boosting technology and stronger lobbying power (coupled with a corrupt government) as reasons high margins are here to stay. These bulls may prove correct and a new, higher average level of profitability may emerge that reflects these factors. But if the mean screamin’ reversion machine pulls profit margins back through their historical peak-trough pattern, investors thinking otherwise may find themselves facing a whole lot of pain.
As a very rough example, take the actual earnings per share (EPS) for the S&P 500 stock index in 2013. EPS was 100 on sales per share of 1,113 for a profit margin of 9% (note that this is calculated differently than the above figure from the St. Louis Reserve, but it has historically trended the same). With the recent S&P 500 price level of 1,883, that makes a price-to-earnings (P/E) ratio of 18.8x. Assuming that this P/E ratio stays the same but that corporate profit margins simply revert back to their longer-term average profit margin of around 7%, the S&P EPS would be 78 and the market level (on the same 18.8x price-earnings multiple) would be around 1,465,
or 22% lower than current levels.
Mean Screamin’ Reversion Machine #2: Valuation Ratios
Now that we’ve warmed up our math brains a bit, let’s look at a second mean screamin’ reversion machine: market valuation ratios. A valuation ratio like the previously -mentioned price-to-earnings ratio simply expresses how much investors are willing to pay for a given level of some fundamental variable, in this case earnings. When investors get more optimistic about the future outlook for earnings, they tend to pay more per unit of earnings, resulting in a higher valuation ratio. When they get more pessimistic, they tend to pay less per unit of earnings, resulting in a lower valuation ratio.
In other words, these ratios are really a measure of sentiment, swinging along a pendulum of greed on one end and fear on the other.
The figure below looks at the historical price-to-earnings ratio of the S&P 500. As is illustrated, the P/E ratio is now around 18.8x versus a long-term mean of 15.5x and a range of 5x-25x (excluding the spikes circa 2000 and 2009 when sentiment was either crazy in the tech bubble, or when index earnings were crushed during the financial crisis). Like those who argue for a “new normal” of sustained higher profit margins, valuation bulls will declare that P/E ratios can stay high because investment alternatives to stocks are lacking (lousy CD and bond yields) or policy-makers will stay highly supportive for a long time to come. In other words, they expect the mean screamin’ reversion machine to stall out for awhile until a new mean is set at higher levels.
Just as the case may be for corporate profitability, valuation bulls may prove right and the risk of mean reversion may be nothing to worry about. But to illustrate the simple math, let’s run a few more quick numbers. If we woke up tomorrow and U.S. stock market investors were only willing to pay the historical mean P/E ratio of 15.5x for the same trailing 12-month earnings per share of 100, the market today would trade at 1,550, 17% lower than today’s levels.
And what if we woke up to a world where profit margins had mean-reverted as well as P/E ratios? In that scenario, we would take the mean valuation ratio of 15.5x and multiply against earnings of only
78 to equal an S&P 500 market level of around 1,200, 35% lower than today’s levels. That’s enough math for this newsletter, so I won’t quantify the ugliest scenario, which would see both profit margins and valuation multiples plunge through their mean levels down to their historical troughs (remember the mean is just the middle point of these cycles). Let’s just say that such a scenario would be a REALLY MEAN SCREAMIN’ REVERSION MACHINE!
Now if I haven’t lost your interest yet, let me make an important note. When we build and manage portfolios here at FIM Group, we do so one position at a time “from the bottom up.” This is quite different from those who might attempt to mimic the performance of the broad stock or bond market and simply buy market index funds. Instead, we focus on the three critical factors that we believe drive positive investment outcomes: the fundamental quality of each position we own, the price at which we own portfolio positions, and the parameters set in collaboration with each unique client (think portfolio cash needs, volatility tolerance, etc.).
Because we invest in individual holdings and have absolutely no mandate to “own the market,” we do not spend too much time obsessing over the broad market level mean reversion risks noted above. We do, however, look quite critically at mean-reverting factors (profitability and valuation of which are two of the biggies) when we analyze risk at the portfolio holding level. For example, we might ask of a given holding: how do current profit margins look against a firm’s historical record and against industry peers? Is the current market price sufficiently discounting the risk of profit margin reversion back to average levels? Are profit margins temporarily elevated due to unsustainable factors like postponed business investment? If margins were to mean-revert, would we still consider the holding a bargain?
Through the process of constantly asking questions like these and making investment decisions that depend on the answers we come up with rather than on pre-set asset allocation targets, our portfolios evolve to reflect our best assessments of risk and return. At present, as might be expected given the degree to which broad U.S. stock market profitability and valuations appear to be stretched, our process has led to portfolios containing very little exposure to the most popular U.S. stocks. While we own relatively off-the-radar U.S. names like Gaiam (health and wellness media and accessories) and Medical Properties Trust (hospitals), the majority of our equity exposure consists of foreign-listed companies where we are finding much better value. We remain believers in the cyclical nature of markets and the risks presented by MEAN SCREAMIN’ REVERSION MACHINES. We’re happy to let others put trust in those touting “new eras” for factors like corporate profitability and investor sentiment, and we stand ready to pounce on opportunities that arise should these reversion machines come crashing down.
As our lives have become more intertwined in the digital world, there is a new key facet of 21st century estate planning that many people overlook – a digital estate plan. Take a moment and think about how many digital assets you actually have – everything from social media (Facebook, Google+, Twitter, Flickr), financial accounts (online bank and brokerage accounts and e-commerce, such as eBay, PayPal, Amazon and “digital wallets”) and loyalty program benefits (frequent flyer programs, credit card reward points, etc.). They also include information from home security system passwords to home computer and software usernames and passwords. There can also be substantial monetary or legacy value built into some of these assets, such as value associated with owned domain names or the nonmonetary legacy value of pictures and videos stored digitally.
So what happens to all of our accounts and files when we become incapacitated or pass away? The digital estate plan lays out your digital assets and provides directions on how to access and handle them upon your disability or death. Having a plan in place should make it easier for your family or personal representative to act on your behalf when you can’t. As an example, they could continue your online bill, loan and credit card payments, preventing potential losses to your estate. For those of you who are very cloud-oriented and tech-savvy, ask yourself, “How difficult is it going to be for someone to act on my behalf if they cannot even access my computer, let alone the software and online access for my cloud-based programs and apps?”
The first step in creating your digital estate plan would be to create a comprehensive inventory of your digital assets. We have posted a detailed digital asset inventory form on our website for your use: Download Now. Or, if you prefer, you can obtain a copy on a thumb drive by calling one of our offices. Once you have taken the time to complete the inventory, the next step is to store the form with a “trusted person” – place the document in a safety deposit box, or encrypt the document and file it with a trusted adviser such as your CPA or attorney. The key is to keep the inventory accessible but definitely protected. In addition to keeping the inventory safe from theft or unauthorized access, you should make a point of updating the digital asset information on a regular basis.
Depending on the complexity and value of your digital world, you might want to consider nominating a digital executor in your Last Will to handle these assets with more detailed dispositive provisions for assets with significant value.
The current federal laws regarding unauthorized access to digital assets and your stored communications, as well as some user policies and service agreements in place surrounding others accessing your digital accounts, does make planning around digital assets complex. If you have any questions or would like to pursue this topic further, please give one of our FIM Group advisers a call.
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