Other Eclectic Musings

What’s more comfortable than wondering when Google or Facebook growth will slow, or when their valuations might contract?
Marine drilling and shipping are among the most depressed industries in the world. Lease rates for transporting various raw materials are down over 40% from year-end 2013. The number of offshore drilling rigs has declined by over 80% since 2004. Many shipping companies have become either insolvent or are in great danger of being insolvent. The industry is consolidating and most participants cannot possibly replace their vessels.
Yet, given its importance to global trade, the shipping industry is here to stay. The stronger companies with staying power can improve their competitive positions and will emerge from this prolonged down-cycle more dominant, having acquired competitors and streamlined their businesses. Either the crisis will continue, in which case the strongest companies will only become more dominant, or the crisis does not continue, in which case they will see increased profitability. That is a powerful combination if they presently trade at prices that are not reflective of any recovery, because it means one can hold, effectively, a long term call on what would typically be a multiplicative set of increases in recovery mode (order increases x price increases x margin increases and valuation multiple expansion).

Many people presume that gold mining companies are good hedges against inflation. It’s not actually true, historically. The major problem is that when the gold price is higher, miners all increase production. Therefore, they also need to acquire new properties to replace depleting reserves, but at a cost that is rising with both inflation and competition for resources. The same applies to their need for increasingly scarce mining equipment and labor. Rising costs limited the potential for margin expansion.

A more elegant approach to earn money from gold is via a royalty company. The gold price doesn’t even need to go up. It can even go down. Royalty companies solve a problem that miners run into, which is that when gold prices are low and there might be development opportunities, the miner often can’t get funding. For one thing, the stock price is usually depressed, such that share issuance would be too dilutive. As to debt funding, the mining business is too cyclical and risky to take on much leverage, particularly since a new mine might take several years to become operational. A royalty buyer, in contrast, makes an upfront cash payment to a miner to develop a particular resource; it doesn’t require a share of the miner’s equity, nor require interest or principal payments. It does entitle the royalty company to buy a certain proportion of future production at today’s price, but deeply discounted for the time value of money. That has very interesting properties. The royalty company is really akin to an investment bank, even though it is lumped, for classification purposes, with mining companies.

Electric Utility stocks fell 15% between January 2015 and the end of July. Given the serious structural decline facing this sector and how important it is to many income investors, we republish our late 2014 white paper on the threats facing these companies, including the first instance of reduced demand in the history of the industry. The modest stock price drop thus far may well be just the tip of the iceberg – the Electric Utility sector should be approached with great caution.

This month’s commentary revisits the importance of a buy and hold strategy, especially during periods of market volatility. While the temptation may be strong to pull assets from the market during pullbacks, historical data show that, over the long run, attempting to time the market is detrimental to an investor’s long run returns.

From year-end 1994 through year-end 2013, the Russell 2000 outperformed the S&P 500 by only 23 basis points per annum. Extend the time period by only eight months to August 29, 2014, and the Russell 2000 underperforms the S&P 500 by 20 basis points over an almost 20-year period. We discuss the relative valuations of the two indexes, and the flows into and out of the exchange-traded funds that track them.

This month, we discuss large capitalization companies. In the past, large capitalization companies tended to be stable, established firms. Recently, however, some nascent firms have rapidly expanded their business such that a large market capitalization is warranted, and are investing in their business at a rate that may justify a high price to earnings ratio. We consider the implications of this shift on investment decisions.

As investor biases increasingly emphasize liquidity needs over investment, the largest companies continue to prioritize cash balances at the expense of long-term value creation. Along with other headwinds, the unwillingness to deploy cash reserves seems likely to adversely impact earnings for the largest companies and indexes going forward, such that the companies and sectors with the most attractive predictive attributes will be found outside of the major stock indexes.

With tax season fast approaching, K-1-generating securities come up frequently in client discussions. It is timely, then, to review why we hold publicly-traded private equity companies, a number of which are structured as LPs, in some of the portfolios. You might find some of the reasons surprising.

This month, we discuss the discrepancy in valuations between Canadian-listed companies and their US-listed peers, highlighting real estate investment trusts and real estate developers.

In this month’s commentary, we discuss the recent introduction of high- and low-volatility exchange-traded funds (ETFs). For a selection of high- and low- volatility ETFs, we review their performance in the year following launch and opine on the inferences, if any, that may be drawn from the valuations reflected in these securities.

The current industry sector diversification system used frequently by individuals, professional money managers, and risk managers is based on Securities Industry Classifications (SIC codes), which have very obvious deficiencies. We will advance the proposition that examining portfolios on an ecosystem basis rather than a position basis, using a measure of diversity called the Herfindahl Index, is a better approach to diversification.

We offer our thoughts on recent market conditions as compared to those experienced during the last period of high volatility: the financial crisis of 2008.

We explore how the rapid proliferation of open architecture, specifically through the development of various application (“app”) stores, is having a profound impact on cellular phone companies, computer manufacturers, video game developers and a host of other businesses.

We examine the standard calculation of the Price to Book Ratio of the S&P 500 Index, address the shortcomings of various methods of computing the metric, and discuss implications for market analysis.