CLIENT LETTER: MARKET OUTLOOK
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. The theme of small-cap outperformance is one that I highlighted specifically in the October client letter. Numerous statistical studies were presented at that time pointing to a small-cap market that had a tremendous amount of reward in exchange for an insignificant amount of risk going forward. Since the beginning of October the Russell has gained 13.71% vs. the S&P 500 which is up 4.87% On a purely technical basis, the Russell is equivalent to the Nasdaq in its demonstration of strength thus far in 2015. These are all signs of a healthy market advance that is predicated upon rotation among asset classes by investors. The fact that investors continue to remain discerning in their portfolio choices throughout the current bull market indicates a level of responsibility that should not be overlooked. It is in responsibility among investors that sustainable advances take place. It is in irresponsibility on the part of investors that unsustainable advances turn into intermediate to long-term market tops. The thinking behind this is that when you have all classes of investors simply throwing their cash at every asset class regardless of risk/reward then investors are disregarding risk, thus setting up the market for increased volatility that typically results in a mass realization, at some point in the near future, that an exit should be made from stocks into safer assets. There is not even an inkling of this foolhardy behavior among the current class of investors. For example, the technology sector is successfully separating robust business models from business models that are questionable in their ability to provide long-term growth. There is no blanket mentality towards investment that demands social media, software or mobile names regardless of price, growth prospects or management ability. Companies that deserve to experience growth in share price are experiencing growth in share price. Companies that do not, have been lagging behind. Additionally, the appetite for portfolio hedges remains undaunted despite one of the most steady increases in major averages over the past several decades. The combined put/call ratio is sitting at levels that aren't too far off where we started this bull market, in terms of the voracious hunger for put buying over exposure to calls. In the chart above, the 50 day moving average of the put/call ratio is at its highest point in more than 2 years. The longer-term 200 day moving average is at its highest point in nearly 3 years, with only the European crisis of...
CLIENT LETTER: IF AT FIRST YOU SUCCEED, QUIT TRYING
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. 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 I thought it appropriate to rename this section after feeling that the obligation to "Look Ahead" was preventing me from discussing various thoughts, analysis and philosophies that are an important parts of my process. It is also true that as an investor in the markets, I don't want to necessarily be sidetracked by short-term analysis, although I have been relatively immune from confusing short-term thoughts with long-term objectives. I have no desire to risk my immunity, however. Just as there are various imperceptible laws that govern human affairs, it can only be assumed that similar laws will also dictate the affairs of the financial markets. After all, financial markets are simply a reflection of the perception of a particular group at any given moment. This group, as opposed to the popular perception of seeking a balanced state, remains in the constant realm of disequilibrium. Markets are never balanced in nature, as balance inherently suggests predictability of an outcome. Proportionately as it applies to the financial markets dictates that disproportionate cause will lead to disproportionate effects. There has been no better proof of this law at work than what we have experienced with the near vertical run that has taken place since the 2009 bottom. The current bull market was born from a disproportionately negative circumstance that was singular in its scope and breadth. The accompanying reaction that took place in terms of monetary policy was also disproportionate and singular in nature. The law of proportionately will dictate that the effect of such disproportionate negative circumstances should be equally disproportionate on the positive end. This is simply how proportionately works. The further you stretch the rubber band to one side, the more powerful the reaction will be to the opposite side. The greater force you use to hit a tennis ball into a wall, the greater force it will exert on its return to your racket. This is proportionately in its simplest terms. Already we are seeing clues in the form of the extraordinary persistence this market has had on the upside. There have been numerous reports of record stretches without a 5% pullback in the major averages. There has been a record stretch of months without a touch...
CLIENT LETTER: DESPERATELY SEEKING IMBALANCE
What follows is a portion from the monthly client letter I send out to investors at T11. The seeds planted in 2014 are already bearing fruit in the form of significant gains to begin 2015. Throughout the years I have been a part of enough January jubilation, if you will, to realize that while a strong start to the year is certainly the best possible outcome, the market is fickle mistress that can quickly decide that castration may be the next best course. To reiterate the review for December, the market of 2014 did afford a great deal of opportunity in terms of situations that were simply not being recognized. Discovery of those situations followed by the strength of conviction to take a substantial position has dictated our gains to begin the year. There are a number of factors at work that lead me to the belief that we will see a minimal amount of turnover in the portfolios over the next eleven months. The evolution of a bull market dictates that in the middle of the cycle attractive opportunities become scarce due to the recognition of what is occurring by investors. That recognition disallows an investor from receiving an appropriate amount of reward for the risk they are taking. The situation for investors moves into a balanced phase that very obviously creates volatility in returns as an investor decides to settle for less than ideal circumstances expressed through the act of taking on investments that can be best described as “discovered.” It is only through imbalance that significant returns are possible. The counter-intuitive nature of the markets dictate that balance is an adverse circumstance that should be summarily avoided. However, it is all too common that investors find comfort in the intuitive act of investing into a balanced situation. In the current phase of the bull market there are very few perfectly imbalanced situations. I like to think that our portfolio is an amalgamation of the most attractive imbalanced investment situations remaining in the marketplace. Of course, I come across a handful of potentially imbalanced investment situations every month. There are degrees to imbalance, however, that cause those situations to be filtered out. In reality, I scan through literally hundreds of names per month. Over the course of the year, that number jumps into the thousands. In 2014, five of those thousands of candidates made it onto the big screen instead of being discarded onto the cutting room floor, to borrow a phrase from Hollywood. In fact, each successive year from 2012 on has caused a more discriminating process of allowing for investments to actually make into the...
CLIENT LETTER: A MARKET OF ABUNDANTLY FAVORABLE ODDS
What follows is a portion from the monthly client letter I send out to investors. A Marathon, Not a Sprint In the spirit of welcoming the new year with a sense of forthrightness that seems to be lacking on Wall Street, I found the second half of 2014 to be agonizing. Perhaps my agony stems from the fact that I was caught in the malaise that was small-cap trading during this period. Or maybe it lies in the fact that the major benchmarks just kept going up while I couldn't figure out which names were driving the market forward. In any case, the narrow market of 2014 left all but a chosen few scratching their heads wondering out loud, “what can I do to keep up?” Although yearly performance is an important statistic that I take pride in, all investors are prone to forget the fact that this is marathon, not a sprint. There is no strategy that can be asked to outperform under all market conditions. Within any strategy there are times that a digestion period takes place. The investments within a portfolio don't know or pay attention to the same calendar you and I do. They are driven by events, both macro and micro, that are sometimes immediately reflected in the stock price and other times take many months to be realized. In either case, patience is the determining factor as to who ends up successful and who ends up in misery. The Antithesis of Euphoria Why exactly were small-cap companies such underperformers in 2014? The broad stroke version of the answer lies in the fact that small-cap names required a break. They had been moving at breakneck speeds over the past few years, with double digit up years every year since the 2009 bottom with the exception of 2011. In fact, the preceding year (2013) was the strongest year of all with a gain of near 40% for the Russell. So it turns out to be a well deserved break, in fact. The most pressing question, at this point, is how can a market be in any type of euphoric stage when entire swaths of speculative sectors, whether small-cap or otherwise, are left for dead in the midst of a narrow advance? If anything, this reveals a market that is timid in nature, as a small group of well heeled, sophisticated investors bid up companies that are well-researched, extremely liquid and fairly reliable with respect to earnings. This is the antithesis of euphoria as it demonstrates responsibility in the face of increasingly frequent record highs in major indices. Euphoric markets are characterized by...
CLIENT LETTER: AN IMPORTANT MARKET BOTTOM & THE TRUTH ABOUT TIGHTENING LIQUIDITY
What follows is a section from the “Looking Ahead” portion of my monthly letter to investors at T11. In order to look forward with any sensible appreciation for what is going to occur, let's look back at an excerpt from last month's “Looking Ahead.” We are presently in the midst of the aforementioned “reset.” One of the fortunate features of any bull market is its ability to swiftly move through periods of bearish adjustment. I don’t assume that this adjustment will move past mid-November. However, during that time the damage on the downside could be fairly extensive (5%+) for the major averages. At its worst during October, the S&P was down 7.71% for the month. This swift period of downward adjustment came to an abrupt end on October 15th, with what is likely to be a significant low for all major averages. In fact, according to the evidence presented by the market, the low that was created in October is as important as the October 2011 and March 2009 lows. Let's look at the evidence: 1. The short-term moving averages for the combined put/call ratio hit levels not seen in more than two years, signaling an extreme bearish stance by market participants during the beginning to mid-October. On October 13th, two days from the ultimate low, the CBOE combined put/call hit 1.53 to close the day. This was the highest recorded close on the put/call in more than four years, signaling an extraordinary amount of put buying among market participants. 2. The Russell 2000 of 2014 has a very significant correlation with the Russell 2000 of 1994. I outlined this correlation in an article on Zenolytics. The chart can be found by clicking here. In 1994 the max downside for the year in the Russell occurred in Q4 with a decline of 9.55%. In 2014, the max downside for the year in the Russell has been 10.58%. Both 1994 and 2014 were preceded by multiple years of significant gains in the Russell. In other words, they turned out to be periods of digestion within a larger run for the average. Following the digestion period in 1994, the Russell went onto gain nearly 30% in 1995. I expect 2015 gains to be similar in nature. 3.We have now experienced a 10% correction in the S&P. This qualifies as a “reset” of the bull market. Especially in the face of the fear it created during mid-October. Resets of this type are significant events, preparing the markets for their next cycle up. For examples look no further than the 1990s bull market that was filled with short-term violent resets that threw investors off...
CLIENT LETTER: THE SIGNIFICANT OPPORTUNITY BEING ALLOWED IN SMALL-CAP STOCKS
What follows is a section from 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 The Macro Small company investing has taken on a malicious slant in 2014. In what has become a prosperous time for the S&P, Dow and Nasdaq, the Russell 2000 has been stuck in the mud for a significant portion of the year, elegantly reminding investors that Wall Street takes joy in changing locks to doors that investors become all too familiar in passing through with great ease. For a good deal of the year we managed to avoid any correlation to small-cap indices as our holdings functioned independently of the averages. However, in Q3 it became apparent that our holdings were not immune. The immunity was not compromised by any company specific events. In nearly every case, our names are simply in a mode of “wait and see” what happens with respect to developing special situations. Rather, the holdings that occupy the portfolios have become victimized by a distinct environment of disinterest. The cyclical nature of disinterest that exists in the small-cap world is not just a micro phenomenon that causes bids to trickle lower as trading thins out over a period of time. It also speaks to a more macro issue of general investor disinterest in equities. At the core of illiquidity in companies with market caps under $500 million is the simple reality that there is not enough interest in the markets and therefore, not enough capital to spread itself into issues that require a deeper process of discovery. What does that disinterest signify in a broader sense and how does it influence the markets in the years to follow? Let's look at some statistics going back to 1980. The first study will look at periods of disinterest in the Russell 2000 as defined by a Russell that is either positive or negative by no greater than 3%. Essentially a sideways trading range, similar to what we have experienced in 2014: Periods of Disinterest (Russell +/- 3% for year) What Happens to S&P 500 in Following Year? What Happens to Russell in Following Year? 1981 +2.03% 1982 +21.55% 1982 +24.95% 1994 -1.82% 1995 +37.58% 1995 +28.45% 1998 -2.85% 1999 +21.04% 1999 +21.26% 2007 – 1.57% 2008 -37% 2008 -33.79% The second study will focus on periods of small-cap...
CLIENT LETTER: THE FAILURE OF HUMAN INTUITION IN FINANCE & POSITIVE EXPECTED VALUE IN DECISION MAKING
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 With a profession such as investing, people see the “doing” as the buying and selling. It is difficult to come home from work, and answer your spouse’s question, “what did you do today?” with “well, I read a lot, and I talked a little.” If you’re not buying or selling, you may feel you aren’t doing anything. We believe in diversification for risk reducing, but we don’t want to diversify ourselves into ignorance. If we can do three smart things a year and nothing dumb, we will be very successful. If we can do five, that’s a home run. – David Abrams, worked under Seth Klarman, now runs Abrams Capital Management The business of investing has caused madness in some men who thought they were on the precipice of financial immortality, only to later find that the theories they placed their faith in had fatal flaws revealing the desolate terrain lying beneath the beautiful mirage. It has brought incomparable joy to others who have achieved great success whether through sheer luck or unique skill. The ability to achieve consistent success in the business of investing automatically vaults the individual into a category of analytical genius whose words can be relied upon to navigate the often random waters of day to day or month to month market movements. At its essence, what drives one individual down the path of madness and another individual down the path of genius are slight degrees of separation along the very same path. It is indeed a game of inches where the quality of decisions made means everything. It is also a game where quality will always trump quantity. It is, in fact, true that the more decisions one is forced to make in any speculative venture, the more their results will fall towards the mean and eventually far below it. Speculation, in any form, does not agree with attention deficit disorder as it applies to decision or indecision. The counter-intuitive nature of speculation is perhaps the biggest stumbling block that an investor will consistently face during their career. Everything that one is taught to function in normal society leads to madness, sorrow and depression in finance. If you were to see a large crowd running away from something...
CLIENT LETTER: ON THE SUBJECT OF THE RETURN OF SPACS & A PAST STUDY THAT SHOULDN’T BE FORGOTTEN
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...
CLIENT LETTER: ON THE SUBJECTS OF CAPITALIZING ON CORPORATE GREED & IMAGINATION
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 It goes without saying that U.S. corporations have become increasingly profitable over the past several years, generating record profits that seem to have a great deal of longevity following the efficiencies brought about by the financial crisis. Hand in hand with the record corporate profits has come a determination by corporations to use every tax loophole possible to either avoid or reduce what is the highest corporate tax in the world at 35%. When you take into account local and state taxes, corporations are paying upwards of 40% to the government. What has become increasingly popular over the past few years is a practice called a corporate inversion, where a U.S. based corporation re-registers outside of the U.S. through a merger or acquisition. The most recent case of a corporate inversion was on June 16th, with Medtronic and Covidien. The merger then causes the company to become domiciled offshore, allowing the corporation to access cash that is generated through foreign subsidiaries. Repatriating large amounts of cash that companies such Apple, Google, Medtronic and Pfizer have stashed offshore incurs massive tax liability that most corporations are unwilling to take on. As a result, a corporate inversion will allow the company to redomicile and repatriate the funds without much of a tax liability at all. Research firm Audit Analytics recently estimated that the amount of profit being moved offshore by U.S. corporations has risen by 70% in the last five years, hitting $2 trillion in 2013. What this says is that U.S. corporate management is more infatuated than ever, not just with operational efficiency, but also tax efficiency as a means of creating the bottom-line results that shareholders demand. The future of tax avoidance by U.S. corporations is murky, however, as Congress has caught onto the amount of governmental revenue being lost. Just recently, Senator Carl Levin proposed a bill to all but stop corporate inversions through a set of rules that would effectively close the loophole. According to Bloomberg: “The bill would consider inverted companies to be domestic for U.S. tax purposes if executive control remains in the U.S. and if 25 percent of sales, employees or assets remain in the U.S. The measure would be retroactive to May 8 and be in place...
APRIL PERFORMANCE SUMMARY AND LOOKING AHEAD TO MAY
*This is my monthly letter to investors summarizing the month. The full PDF version of the summary, including managed account performance data as well as a few added components is only available via email. Return data will no longer be published as a part of the summary. If you would like to be added to the monthly email list, please contact me at mail@t11capital.com Download (PDF,...