What follows is the “Looking Ahead” portion of my monthly letter to investors at T11. I have created an email list that sends this report out at the beginning of each month to those interested. The full report contains commentary about the general markets and individual positions held in managed portfolios, as well as overall performance. To be added to the list email me at mail@T11Capital.com
In my zeal for a long-term bull market that I believe has been and continues to be severely underestimated by participants of all pedigrees and notwithstanding a short-term bearish opinion on the same, I would like to amplify on what I perceive to be opportunities for above average, risk-adjusted gains by the simple act of following the path of least resistance.
The path of least resistance in the case of the current bull market and perhaps, all bull markets that have come before it and will come afterward is in the pursuit of growth. Not growth as a sector, such as social media companies, but rather growth through acquisition. In other words, M&A.
In a highly competitive corporate environment, that is marked by access to cheap capital, there will come a natural tendency towards staving off human propensity towards fear by becoming larger in the eyes of the predatory competition that seeks to monopolize on growth. This can be done most easily by acquiring synergistic targets that will prove immediately accretive, thus providing a rousing standing ovation from a shareholder base that is equally vested in the protection and further, cultivation of the corporations revenue base.
It can then be assumed that the M&A boom that has continued to be a key driver of equity gains will not just continue but accelerate going forward. Those pundits who typically twist such information into a bearish potpourri of misinformation will insist that an acceleration in M&A activity to record levels indicates the same type of corporate irresponsibility that led to peaks in M&A booms of the past. Most notably and recently, 2000 & 2007.
Correlation does not equal causation. Mergers and acquisitions were indeed a driving force behind the bull markets leading into the peaks. However, in the case of each bull market, there were maturing forces caused by inefficiencies in the economy that ended up toppling the economy, taking with it all forces for economic good, M&A included.
In 2000, the emergence of technology, led by the internet, created a non-discriminatory environment of overvaluation. In 2007, the emergence of real estate as a key asset class for individuals, along with unbridled access to capital led to economic growth that depended on real estate valuations increasing at X% per annum in order for the economy to remain viable.
In both cases, the economic vitality of the nation rested on the shoulders of “mom and pop,” aided by a creative Wall Street infrastructure that fed their appetite for leveraged risk.
Jeremy Grantham had an outstanding article published in Barron's during July arguing for a “veritable explosion” in M&A activity the likes of which we have never seen. Here is an excerpt:
A further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don't tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy.
There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word "uniquely" in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making.
He goes on to say:
If I were a potential deal maker I would be licking my lips at an economy that seems to have enough slack to keep going for a few years. Also, individuals and institutions did feel chastenedby the crash of 2009 and many are just now picking up their courage. And as they look around they see dismayingly little in the way of attractive investments or yields. So, the returns promised from deal making are likely to appear, relatively at least, exceptional. I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed.
Undoubtedly, such a trend presents opportunities to investors for outsized gains going forward. A strategy for taking advantage should not simply rely on choosing companies that would make attractive acquisition targets, as this can potentially lead to lumpy gains, if gains are to be present at all.
One strategy that has a much more defined payout, with very limited risk that takes full advantage of the boom in M&A is to invest in an SPAC (Special Purpose Acquisition Company).
The SPAC is not a new idea by any stretch. The idea of SPACs took off in the mid-2000s, with a bulk of SPACs coming into the public market in 2007 (see chart below).
The failure of many of these SPACs either pre or post acquisition led to overall performance numbers that were less than desirable. The popularity of SPACs into the peak of the financial bubble in 2007 undoubtedly contributed to the net negative results that has caused investors to turn their back on these investments presently.
An SPAC is a very simple shell company that is typically brought public by an experienced management team that has expertise in a particular industry. The goal of the shell is to raise money so that management can exercise their expertise through an acquisition that will prove profitable to the investors of the SPAC.
As a result of the JOBs Act and a particular provision contained within the act called “Initial Public Offering On-Ramp” that is meant to facilitate a streamlined, simple and cost-effective means for small companies to IPO, SPACs are attracting substantial capital and more importantly, experienced names to cultivate the capital through acquisition.
The loophole, if you will, in the JOBs Act that provides an advantage to the SPAC is that when you utilize the IPO On-Ramp provision to go public, reporting requirements upon consummation of a merger (the ultimate purpose of any successful SPAC) are minimal. IPO On-Ramp status under the JOBS Act last for five years. During those five years, as long as certain financial provisions are met, disclosures are scaled back greatly, executive-compensation disclosure is minimal and auditor requirements are also reduced.
So when a company merges with an SPAC that meets these provisions of the JOBs Act, their disclosure requirements and costs, will be vastly reduced, providing an attractive proposition for the private company to trade in the public domain via the SPAC, in addition, of course, to management expertise offered and access to capital.
For those wanting to put capital into a public SPAC, there are a number of advantages, as well. The most important comes from the fact that risk is capped during the time the company is a shell, up until an acquisition candidate is announced. Even when acquisition target is announced, the investor in an SPAC gets the opportunity to decide whether they want to continue with the investment. If they decide to withdraw after reviewing the merger candidate, recovery is typically 98%-100%, meaning no more than a 2% loss on capital. There are also instances that the SPAC is unable to find a merger target in the two years (typical allotted time period per offering documents) time given, at which time 98% recovery is the average for investors in the SPAC.
Effectively, the structure of the SPAC gives the investor a free look at a potential merger candidate while capital remains in escrow. Additionally, management has substantial skin in the game, creating incentives to consummate the proper merger, instead of one that simply creates the illusion of success when the long-term prospects are less than promising. The SPAC structure does not pay a salary to management. Therefore, their only incentive is to create an appreciation in share price through the proper merger. The fact that a typically knowledgeable investor base can strike down the merger also provides management with incentives for THE proper candidate, instead of simply A candidate.
Over the past few months, I have discovered a couple SPACs that seem to have the right sponsors to insure a successful outcome. My only reason for not allocating into these opportunities is that (1) SPACs typically use the full two years allotted to take on a merger candidate. I don't mind paying slightly above “par” to wait until the SPAC is further along the road to evolving out of shell status (2) there are opportunities still remaining in the market that exceed the potential of any SPAC over the long-term.
With that said, I see SPACs as a mid to late stage bull market investment vehicle as they serve the important purpose of mitigating risk while allowing an investor to participate in substantial upside should the sponsor discover the proper opportunity. In other words, during a time when downside risk will inevitably be disproportionate relative to potential upside for the general market, SPACs will provide an opportunity that will counteract this natural progression of skewed risk/reward during a maturing bull market. However, we are not at that point yet.
For those interested in specifics, I will going over opportunities in SPACs during investor meetings in the months ahead.
Onto the current market environment, which can best be summed up as tedious in nature with a substantial degree of risk moving into August. The extended gains we have experienced in the Dow and S&P over the past few months have come at the expense of the SOX (Semiconductor Index) and much more so, the Russell. It also didn't help the Russell to have Fed Chair Janet Yellen single out small cap valuations as being “substantially stretched” during a recent congressional testimony.
Both the Russell and the SOX have essentially broken down over the past month. These are two significant leadership issues that the market will have a difficult time overcoming during the often tumultuous month of August, which is marked by a gap in both news and volume, allowing investors to jostle around company shares without much effort.
The question investors should be asking themselves here is whether the breakdown in the Russell, especially, mitigates or aggravates downside risk in the major averages (S&P/Nasdaq/Dow) going forward? It is a basic question of whether small-cap performance, at this juncture in particular, is indicative of a healthy rotation from overvalued names (small-cap) into more reasonably valued names (industrials, consumer-cyclicals etc.) or a precursor to broad overall weakness in the markets?
It has become commonplace for investors to associate unfavorable small-cap performance with unhealthy overall market conditions. There is, however, a time and a place for every phenomenon on Wall Street. No condition in the markets is static. Everything is subject to change at a moments notice.
The market has made it a point to experience healthy rotation from the onset of of this rally, which has caused the more important market averages to experience shallow corrections of no more than 5-6 percent during periods of time that market participants were expecting much greater troughs. There is no reason to believe that this will suddenly change because this rally is “mature” (it is not) or valuations are stretched.
The overall market has made it a point to remind investors of the fact that it is perfectly content with shallow corrections that create more worry than they are worth. A shallow correction, in my opinion, is anything not exceeding 10 percent on the downside.
With the S&P 500 up close to 5% year to date, it is not out of the question to believe that the entirety of that gain can be taken back in the months ahead. I started 2014 by mentioning the following in my January “Looking Ahead” portion of the monthly summary. If you'll remember January was unusual in that it was a down January following a strong previous year in 2013:
Allow me to present some data: I went back to 1980, looking over years where the S&P 500 had
a gain in excess of 25% (we were up 29% in 2013) for the year. I then looked at whether
January was up or down in the following year after that type of outstanding performance.
25% plus years: 1980, 1985, 1989, 1995, 1997, 1998, 2003, 2013
Of these years, there were only two Januarys that were negative following such a strong year:
January 1981 & January 1990.
1981 & 1990 were the only years that finished down -9.73% & -6.56% respectively out of all those years.
I haven't forgotten about this study. In fact, I think it may prove accurate. Although I expect 2014 to finish somewhere around unchanged for the S&P 500. If you look further into this study, in particular at 1990 (remember, this was the last January that was negative following a +25% year), you will find a market that made its peak in July, followed by a tumultuous August, leading to an October bottom and a correction that ended up being 20% from the July peak.
The most glaring difference between 1990 and today is that economic conditions were vastly different. The economy was sluggish. The markets were stuck in mud. There wasn't nearly as enthusiastic and well-defined uptrend as we are experiencing today.
While I don't expect an exact repeat of 1990 to take place in 2014, I do expect 1990-lite if you will. A 10% correction, with the possibility of an outlier to 15% on the downside. It will be extremely fast paced. Fast paced enough, in fact, to setup what will be one of the better buying opportunities of this bull market. The gains from that point should be virtually uninterrupted throughout 2015 as the amount of fear that this event creates alone will be enough to keep speculative funds away from the market for sometime.
This means that there isn't much incentive here to be overly exposed to anything that has the potential to prove malicious during adverse periods. The risk in the market is to the downside. It's simply a matter of how much downside the market wants to offer up.
Regards,
Ali Meshkati
