MAY CLIENT LETTER: THE HAUNTED HOUSE OF ZIRP & NIRP; MAY EDITION OF “I’D RATHER EAT ROCKS THAN BUY STOCKS”
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. The Haunted House of ZIRP and NIRP Zero interest rate policy, more commonly referred to by the acronym ZIRP, has worked its way into the financial lexicon over the past year in a rather eloquent manner, followed closely by negative interest rate policy or NIRP. Financial pundits of all types have taken to the airwaves proclaiming ZIRP and NIRP as something that is an inevitable conclusion to the massive global monetary stimulus that continues to take place. Denmark, Sweden, Switzerland and Japan are all wandering into the haunted house of ZIRP and NIRP currently, wondering what lies in its hollow corridors and narrow passages. There is no guidepost for ZIRP and NIRP, as it has never been attempted in such a globally coordinated fashion. What lies at the essence of ZIRP and NIRP policy is a proclamation by global central bankers that cash is essentially worthless unless invested in a risk asset. This proclamation comes against a backdrop of investor skepticism of risk assets moving progressively higher on the curve based on the substance of the asset in question, with stocks being seen as the least substantive taking a backseat to tangible assets such as gold and real estate. Most recently, even centers of reliable increases in real estate prices that have attracted global assets, such as New York and San Francisco, have seen a general softness in prices develop as the uncertainty of this experiment in global monetary policy has taken its toll. What must be considered is that against a backdrop of enormous uncertainty created by a never before attempted policy of ZIRP and NIRP, will investor mentality begin converging along the lines of low or no returns available in all asset classes causing them to simply refuse to participate in all but cash for an indefinite period of time? Already global cash levels are at 15 year highs according to some measures such as the Bank of America Merrill Lynch Global Fund Manager Survey: Global investors' cash levels are currently pegged at 5.6% of their total portfolio, which is the highest in the past 15 years as many have opted for capital protection amid a volatile global market. This mentality towards capital preservation in the face of an attempt by global central banks to force investors out of cash tells us at a very basic level that investors see no returns as a better option than a negative return. We have to assume then that investor expectations for future returns are being tempered by the...
APRIL CLIENT LETTER: REVERSIONS; TEPID BULLS ABOUND; HEDGEAPOOLZA
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Reversions In stepping back and looking closely at the current portfolio during what has been a disappointing 2016 to date, I am reminded of a method of testing conviction in each portfolio holding as described by Lee Ainslie of Maverick Capital: When Mr. Ainslie reviews the overall plan, he is thinking about the size of every position. Mr. Robertson [for whom Mr. Ainslie worked in the early 1990s] taught him to test his conviction by asking himself if the stock is a buy or a sell. A hold isn't an option. This is how I've come to think of it over the years: Either this security deserves incremental capital at the current price point or it doesn't — in which case, let's sell it and put the money to work in a security that deserves that incremental capital," Mr. Ainslie said. At T11 Capital, I very much utilize a similar methodology in portfolio decisions. If at any point an investment gets to the point where I wouldn't consider adding to the position, then the investment should be sold. This has been one of the components behind our timely exit in investments like CIDM close to $3 per share, IMH near $21 and many others over the years, that have declined significantly following our exit. Not to say this methodology is foolproof (nothing is, of course) by any means. We have also exited SPNS near $7, it is now at $12. I decided to let go of MITL near $3 years ago, it is now trading at $7, after going as high as $12. Overall, however, this level of thinking with respect to allocation decisions rewards conviction brought about by depth in research. It forces an investor to constantly evaluate whether a holding is exhibiting the same positive attributes that caused an allocation in the first place, mitigating the numerous gray areas that often times end up being a weak or compromised thesis disguised as indecision. In closely reviewing our current portfolio positioning on an everyday basis, there isn't a position in our portfolio with the exception of our investment in the illiquid Lehman Capital Trust shares, that I wouldn't consider a buy at current levels. We are in possession of extreme value within a market that is playing a game of reversion to the mean of my particular method of investment. A situation, by the way, that is a natural phenomenon of investing, as well as being a component in the demise of many talented investors who feel the need to...
MARCH CLIENT LETTER: RUNNING THROUGH MOLASSES; SECOND TERM ELECTION CYCLE; WHAT TO DO WHEN FEELING BLUE
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Running Through Molasses Being a bit of a stats nerd, it is not lost upon me that the past two years have been a run through molasses. We have seen periods of outperformance that quickly turn into periods of underperformance, leading to a whole lot of nothing accomplished when all is said and done. New ideas have been extremely difficult to successfully implement as the market simply doesn't care. Most recently I have run through a host of investments that have turned out to be net losers, almost from the outset. Of course, the most beneficial decision when observed in hindsight would have been less activity in order to preserve profits. However, the decision to forgo opportunities I deem as being attractive can only be made in hindsight as there were no macro scenarios in my book of outcomes that had small companies underperforming in the manner they have over the past two years. Since April of 2014, the Russell 2000 is down 5%. Worse still is IWC, which is the Ishares Russell Micro-Cap ETF down 12% over the same time period. Further, our longest running investment in the portfolios is down 29% since April 1st, 2014. At the root of the two year malaise is a growing liquidity problem that has become increasingly apparent in recent months. There simply isn't market participation down past a certain level of capitalization. The lower down the capitalization scale you go, the less liquidity you face as an investor. I like to say that T11 Capital is a discovery firm first. Meaning that my system of sifting through the thousands of names that populate the small-cap space occasionally turns up opportunities that very simply aren't on the radar of other investors, institutional or otherwise. This allows us to be first on the scene of companies that are sometimes selling at absurd valuations due to a series of transformative events that have gone unnoticed by investors. What is occurring presently that hasn't occurred at anytime since the 2009 bottom is that the bar for taking notice of how these transformative events change the value proposition of the company has been set inordinately high. It used to be that growth in earnings while tempering fears of a negative event was enough to peak investor interest to create exceptional volume and some upside price movement. In today's market environment, it simply doesn't create the impetus for investors to act. These are very few bidding parties and the offers are extraordinarily heavy relative to how cheap some of...
JANUARY CLIENT LETTER: STOCK MARKET POST-TRAUMATIC STRESS DISORDER; SOME FACTS; ADOPT A SMALL-CAP SECURITY TODAY
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Stock Market Post-Traumatic Stress Disorder If you are to believe the flock of market pundits currently making the rounds then you would have no other choice but to believe that a new world order is in place. This new world order does not rely on any common sense measures of economic progress or stability but rather dwells in sorrow of past crisis situations in order to arrive at current conclusions. If you have been reading my monthly letters with some frequency then you will recall the dozen or so times I have stated that the the years between 2000-2009, marked by the dual “once in a lifetime” crisis situations of the internet bubble bursting and the mortgage debt bubble following relatively closely behind, has caused post-traumatic stress disorder to become apparent among the current generation of investors. This post-traumatic stress disorder is marked by a near obsession with calamity resembling calamities of the past decade. We have not had a pullback, macro induced or otherwise, that hasn't been a precursor to either a recession, secondary debt crisis or complete global economic collapse since the 2009 bottom. And of course the word “bubble” has now become ingrained in financial vocabulary as a means of describing anything that moves up in a straight line for a period exceeding 12 months. The point being that a majority of the analysis being pressed upon the impressionable minds of a naive and uniformed investor base, institutional or otherwise, is being formed using past traumatic experiences that incorrectly shape future expectations. This current form of thinking is not isolated by any stretch but rather an epidemic. If you are to believe this line of thinking with respect to prevailing market psychology to be true then two things become immediately apparent: Pullbacks will appear calamitous in nature as the feedback loop of past trauma induced psychology meets with current perceived negative developments in the markets. This will express itself through momentum on the downside. Pullbacks will bottom suddenly, with a majority of them being shallow in nature, as a result of a convergence of selling taking place around the same areas due to near identical mental output of a majority of participants. What we have experienced over the past few months has resulted in a pullback of some 15% from peak to trough for the S&P 500. This has been excessive for the current bull market as measured by pullbacks experienced since the 2009 bottom. The reason for the dramatic price action to the downside is that the...
OCTOBER CLIENT LETTER: LEARNING TO LOVE LUMPY, THEY HATE US
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Learning To Love Lumpy Generally speaking, markets are sadistic tools for separating capital from those who are both emotionally and intellectually unprepared for the challenge at hand. As emotional individuals we are inherently unprepared for the primary challenge of inverting greed and fear instead of falling victim to the burdensome exertion of their influence during the most inopportune moments. Secondarily, as individuals in an ever fast paced society, we are unprepared to remain patient in the face of constantly shifting value equations reflected in green and red ticks on a minute to minute basis five days per week. Equity investors would be much better off, if like the real estate market, values were only available through expert appraisal which would only take place on occasion of a sale or borrowing on the asset. This type of structure would eliminate the need to obsess over price, which for the most part is inconsequential except for a few times per year. The liquidity afforded by the equity markets, while being one of its most attractive attributes is also its greatest force for manipulation and the ultimate failure of the investor who dreams of Buffett like riches. Buffett is famous for saying, "the stock market is a device for transferring money from the impatient to the patient." Patience takes on a different meaning based on which sector you are invested in. For example, in large cap, widely traded equity names, patience means that you are subject to price manipulation on a much more frequent basis than the thinly traded, deserted names that I happen to favor. When the markets swoon as they recently did, large cap investors take on correlation risk as securities are largely lumped in same basket with the classic dumping of the baby with the bathwater taking place. This correlation risk is a much less prominent feature of the micro/small-cap marketplace. The more off the run the security, the less an investor has to worry about correlation to the broad market indices. There is a trade off, however. The lack of influence created by the broad market creates long periods of relative inactivity in small company names. And when the gains do come, they show up in lumps that total a few weeks of movement per year. The rest of their time is spent effectively grazing on a pasture waiting for a regrettable trip to abattoir or preferably, a blue ribbon at the state fair. This tendency towards lumpy gains is as much a form of manipulation running counter-intuitive to prevailing...
SEPTEMBER CLIENT LETTER: DEFENSIVELY OPTIMISTIC, A GAME OF RISK OBFUSCATION
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Defensively Optimistic We are at a point in the bull market cycle where macro fears are at a level that has not been experienced since the entirety of the developed world thought that the global economy was headed towards a Fred Flintstone period of stone wheels and wooly mammoth vacuum cleaners. Fortunately, we managed to avoid such a dreadful fate, returning to prosperity post-2009 much more persistently than most would have expected. The persistence of this new cycle of prosperity has managed to catch the stewards of capital across our global economy somewhat flatfooted. As a result, we are now witnessing a reallocation of capital away from asset classes such as commodities and emerging markets. The instability created from this reallocation of assets is effecting emerging market economies, such as China and Brazil, with the vibrations from those shocks creating the illusion of instability in the U.S. economy. While we are certainly experiencing a contraction in revenue/earnings growth, Wall Street analysts have a tendency to overreact on the downside. That overreaction sets the markets up for generally positive surprises from companies that are less weighted towards global industrial exposure. Those surprises to the upside should come from financials and technology, which I expect to lead the markets out of this correction beginning in October. It is important to remain defensively optimistic in the face of such unjustified pessimism during what has been one of the strongest secular bull markets on record. Defensively optimistic means that there is a controlled tendency towards long positions, as opposed to a leveraged, let it ride mentality that leads so many investors astray. Skilled stock picking alongside generally rudimentary risk control practices goes a long ways towards stabilizing a portfolio within such an environment. The tendency towards excessive hedges and an overabundance of cash in a portfolio at this juncture of the bull market is a conventional stance that will invariably lead to conventional results. Those who participate in this type of fear based investing that is curve fitted around seemingly relevant fundamental data points will very simply be left in a cloud of dust, as they have been during the entirety of this bull market. Being defensively optimistic as opposed to chronically defensive continues to separate the outperforming portfolios from the rest of the bunch. A Game Of Risk Obfuscation For all the resources and time spent on obtaining the pedigree necessary to thrive on Wall Street, the true professional after years of perfecting their craft does not become a master of interpreting company fundamentals,...
AUGUST CLIENT LETTER: EVACUATION STATION, DECISIONS OR A LACK THEREOF
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Evacuation Station Equities have experienced nothing less than absolute evacuation during the month of August. The intolerance of individual and institutional investors for increased volatility and risk is abundantly apparent as memories of past crisis situations incinerating capital are still fresh in the mind of many. It has been quite sometime since I have witnessed such a symphony of fear as measured by various indicators and surveys. Here is a brief list along with the appropriate matching illustration: 1. Inflows into money market funds are skyrocketing. 2. Flows out of equities have been massive during August. This has been the largest 5 day outflow in 15 years. 3. Investor exposure to U.S. equities has only twice been lower in the past eight years according to Bank of America. 4. This according to Bespoke: “Following this week’s decline, bullish sentiment has now been below its bull market average of 38.1% for 21 straight weeks, which is the longest streak of the entire bull market. Taking a longer term look, bullish sentiment has been below 40% for 25 straight weeks now. We haven’t seen that long of a streak since August of 1994! “ https://www.bespokepremium.com/think-big-blog/bullish-sentiment-back-on-the-decline/ 5. The put/call ratio has now recorded the most bearish reading of this entire bull market to date as expressed by the 2 & 5 day moving averages of the ratio. What we have experienced is a wholesale evacuation of stocks into illiquid trading conditions brought about by late summer disinterest. A vicious cycle, if you will, of self-fulfilling despondency that is more based upon nightmares of past investor experiences than any semblance of economic reality. What this means for investors is very simply opportunity. Contrarian theory works exceedingly well during secular bull markets, both in terms of predicting points in fear that deserve additional allocation AND points of greed that require the raising of cash in a portfolio. To date we have experienced numerous points of excessive fear, with August being the most substantial example. We have, however, been reluctant to witness any real greed driven, speculative excess as is the hallmark of true market tops. Given the rapidity with which investors are prone to terror, it may be some years yet before we experience such excesses in greed warranting any...
JULY CLIENT LETTER: BLURRED LINES, THE ART OF SAYING NO, THE MACRO
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Blurred Lines The line between trading and investing is an often debated element of successful methodology within a portfolio. There are some who consistently blur the line, which is perfectly acceptable as long as an investor realizes the “why” behind the action. It is only when a market participant cannot identify whether they are a trader or investor due to inconsistencies in their methodology that trouble follows. I have often said that not enough investors embrace simple trading methods that can enhance their performance. Likewise, not enough traders embrace investment philosophies that can also enhance performance over the long-term. Our unsuccessful investment in EMAN highlights the trading and investment hybrid philosophy that has been a key element in overall performance. That philosophy can be summed up as one of being an investor on the upside and being a trader on the downside. It is true that far too many value investors take their investment thesis to heart, which damages overall performance through a stubborn resilience that is based on adhering to fundamental data points that are lagging indicators of earnings or corporate performance. This causes excessive volatility within a portfolio and absolutely atrocious performance during cyclical or secular bear markets. Within a bear market scenario, as an example, your typical Ben Graham value investor will suffer drawdowns that are often times irrecoverable. Without a tangible exit or risk-control methodology the valuation proposition increases in attraction as price declines which leads to overexposure in an underperforming asset. This consequently will lead to two eventualities: 1) The investor must wait an inordinate amount of time to achieve profitability 2) The investor in the meanwhile suffers opportunity cost as capital achieves more substantial returns elsewhere. This all occurs because of a value methodology that has no counterbalance other than the intellect of the individual operating the strategy. That intellect, of course, is severely biased and utterly incapable of separating itself from the tenets of the philosophy that are rooted in deceptive fundamental data points. The only counterbalance that I know of to properly peel away often erroneous conclusions of the intellect from an individual is the study of price, which is rooted in trading. Thus, one must be a hybrid trader and investor. When the downside becomes excessive or misbehaves in certain predetermined forms, the trading methodology separates an individual from their intellect, essentially overriding all other considerations but price action. Otherwise, individuals become prone to all matters of erroneous decision making based on data points that we are ill-equipped to decipher during...
JUNE CLIENT LETTER: OBSESSION & A NEAR PERFECT MARKET
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Obsession An obsession with endings is something deeply rooted in human psychology. We fear endings to such a great degree that we forget to recognize what is occurring here and now. The fear creates an impetus to agonize, slowly dissolving into a misery-inducing, melancholy study of psychological frailty and worry. The fear of a relationship ending. The fear of a prosperous period coming to a close. The fear of health suddenly disappearing. But most of all, the fear of death. The ultimate ending, I suppose. Reluctance to participate in a bull market because it will one day end is akin to not getting out of bed in the morning because one day you will die. There is a whole generation of current investors who are refusing to get out of bed because they see death as being the inevitable destination of the current march upwards. Much as the man who refuses to get out of bed because of the inevitability of life ending, investors who refuse to participate in the current bull market are missing out on all the creation occurring around them. The fact that investors have been scorned with great repetition over the past 15 years has created a psychological aversion with respect to equities to the point where the specter of an eventual ending supersedes the benefits gained in the meantime. That aversion shows no signs of abating as the ever faithful long-term moving average of the put/call ratio is just now beginning to drop off of 3 year highs. Meaning that investors, as a whole, have been prone to put buying in order to either hedge their portfolios or outright speculation on the downside at a pace not seen in 3 years. Then there is the AAII survey which seems to be populated with investors who prefer not to get out of bed in the morning. AAII is a survey of investor opinion about the direction of the stock market and economy. In a recent June survey, investor's bullish sentiment remained below the historical average of 30% for a seventh consecutive week. You have to go back 12 years to January-February of 2003 to find a similar stretch. But you know what the difference was between January-February of 2003 and now? In the 3 years prior from 2000-2003 the S&P 500 had fallen 39%. Investors had every right to be bearish. Their hopes of Pets.com and JDS Uniphase providing for retirement in Bordeaux, France had been replaced with the reality of having their jet-skis repossessed while worrying...
MAY CLIENT LETTER: ACKMAN IS BRILLIANT & LEVERAGING YEAR TO DATE PERFORMANCE
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. Ackman Is Brilliant Research on Wall Street has effectively become commoditized. Analysts and portfolio managers bring very little in the way of originality. In fact, a majority of hedge funds are simply platforms built to emulate one another through strategies that employ capital on a copycat basis. The research that is performed at the institutional level uses the same information, derived from the same sources to build the same models that are taught in the same business schools. And when investors in these funds do not receive the returns represented by this menagerie of mediocrity, they blame everyone but themselves. Never have investors stopped to think about how a group as a whole can outperform the markets when their methods, analysis and employees are all linear thinkers, schooled in linear thinking, operating within a completely nonlinear environment. That is why when an idea comes up from a well established fund manager that is both original and thought provoking in nature, it should be discussed. Bill Ackman at the Sohn Conference in May gave a presentation regarding platform companies. Platform companies are essentially shell companies that act as a platform for future acquisitions. Ackman argues that Wall Street cannot accurately value these companies. In fact, Wall Street undervalues these platforms on a consistent basis. When the intangible nature of future acquisitions takes precedent over current earnings, then Wall Street simply ignores the opportunity because it cannot be modeled or simplified through a traditional multiple of earnings approach. Instead, as Bill Ackman points out in his presentation," investors must value the company based on both the earnings potential of the company's current asset base, as well as the potential to generate additional earnings through future, value enhancing investments. " This line of thinking delves into the non-linear realm of securities analysis that isn't taught at business school. It involves abstract concepts and probability that are more entrepreneurial in nature. In other words, it's the type of concept that causes smoke to begin funneling out of your typical analysts ears, with the eventual outcome being a complete cessation of brain activity. When a corporation cannot be easily analyzed then inherently there will be inefficiencies in pricing that asset. Whenever an investment is dominated by abstract, non-linear business concepts, then the markets have no choice but to either a) ignore or b) sell. There is rarely, if ever, a premium given to such a situation. The inefficiencies become all the more pronounced once an investor decides to move into subsets of the market, such...