Not a Good Time for the Speculators and Promoters
June 2022 Newsletter
Not a Good Time for the Promoters and Speculators
At Ballina Capital, we are stringent about our idea generation. New ideas have to come through our screens. There are no exceptions. And passing the screen is not easy since stocks need to pass all of the parameters. These parameters are discriminating on measures of quality (returns), valuation and tangible asset intensity. We spread our net far and wide, so we do have many more stocks qualifying in the screens than we need, usually in the range of 600 companies. We’re value investors, and this partly explains why we like the screens, but we also want to stay predictable and repeatable in style, and the screens keep us disciplined.
When and if we look around the landscape at other investment strategies, especially those that describes themselves as following a Value style, and based in the U.S., we have a few findings. 1) There is less mention of screens. They probably have them, as they are not hard to build. But it’s a good guess that they are not relied upon exclusively. 2) There is often mention of focusing on companies with “strong management”, “allocators”, and in some cases “compounders”. It is sometimes the case that the valuation characteristics of the groups with this latter focus can creep quite high. These findings lead us to want to open up a larger discussion of where we are at the moment in capital markets.
Inflation is the word of the day, and central banks have had to take notice. Financial conditions are tightening rapidly, in some cases at speeds that have rarely been seen before, especially from the very easy conditions we found ourselves enjoying a short while ago. Easy financial conditions have been the rule of the day for much of the last thirty years, especially in the United States. See below. Aside from mid 2007-2009, the Global Financial Crisis, or late 1998 to late 2001, or brief periods here and there, investors have been accustomed to a world of easy money. While we do not know what the future holds, it appears that the days of easy money are going to be gone for a more lengthy period again.
United States Financial Conditions Index
It makes me think of the investors, many of whom describe themselves as Value investors, that are only interested in strong management and allocators. The question that I consider is, how can you decipher who are the strong allocators? Now there are many ways to approach the market. And I am aware of some investors that look for strong management among companies that have underperformed. But I suspect that what has been going on is that some investors have been using the approach of looking for strong management because it allows them flexibility to buy what is in favor. It’s a process to do the work and trust the money you are investing on someone else’s behalf in a company. We could all “feel” quite a bit better if we could tell ourselves, and others, that this management is very good, and can be trusted. My guess is that this feeling of trust is more often than not backward looking, i.e. the company and stock have performed well in the past, and it is therefore “in favor”. They have delivered. This is why some go as far as labeling the management “compounders”, i.e. this management has performed, and will continue to do it. You can go to the investment cocktail party, if such things exist, and you can share the investment idea without embarrassment. Others will nod in approval. And if your company or stock price in question has delivered in the past, my question is how do you distinguish that strong performance as management driven, or was it actually just the right place, time, speculation and hype for the period of easy money that has been so present for the last thirty years?
Between the IPO in 1979 and 2003, Countrywide Financial outperformed the S&P 500 by 6,700x. See chart below. One long time shareholder, as early as 1999, anointed Countrywide to be the “Michael Jordan” of mortgages in an issue of Barron’s. Of course, we now know that things did not end up so well for CEO Angelo Mozilo and Countrywide Financial shareholders. Bank of America bought the company for just $4bn in 2008, and Mozilo later agreed to pay a $67 million fine to the SEC for “misleading investors”. The SEC drew attention to the fine as the largest ever levied against the Chief Executive of a public company. Of course, we now know that Countrywide was in the right place at the right time, at least when it was successful, because there was a housing bubble in the United States.
Countrywide Financial Share vs S&P 500 from 1979 to 2003
Easy money, however, did not cease with the financial crisis. When the Assets on the Balance Sheet of the Federal Reserve increase, cash is injected into the financial system. One can say that the Fed balance sheet expanding by roughly $6.5 trillion since the end of 2010 is all the proof one would need to know that the valuation of all financial assets, certainly Private Equity, Venture Capital, Commercial Real Estate, Public Equities, etc… have all been propped up to otherwise unsustainable levels. See chart below. Industry specific data for all of those sub sectors would confirm “extended” valuations. In such an environment, financial players and executives that benefit the most, like a Countrywide and Mozilo in a previous cycle, are the ones that are most leveraged into the easy money. Speculate and promote the most, and the biggest benefits will accrue. It is no accident that one of the most extreme forms of promotion and speculation, the SPAC, was a late cycle feature of 2020 and the early months of 2021. Here was a vehicle that was effectively saying, “I am so good at generating wealth, that I should be given a blank check.” Talk about found money. It should be no surprise that by the time the Fed started raising rates this year, most of these SPAC’s were already done for.
The environment has shifted most severely in the U.S. market, where valuations and returns from the prolonged easy money fueled bull market drove the cult like following for certain CEO’s to new levels. CEO’s stand to benefit the most in the U.S. from the incentives of the stock market. Once it was set in motion that the stock market was rewarding the CEO’s that were talking up the most growth potential, even at the expense of profit, there would be more visionary CEO’s. And this went on for years, for so long that Portfolio Managers in the U.S. that didn’t embrace visionary CEO’s underperformed or worse. This is not to say that U.S. corporates do not have some outstanding management talent (some of whom were born and raised in other countries by the way). But not every CEO is a Jeff Bezos, Tim Cook or Jensen Huang. And this is not to say that CEO’s outside the U.S. do not sometimes engage in excessive optimism. But CEO’s outside the U.S. do make less money, and therefore the incentive and reaction functions do not work as well.
Here are a few snippets of the kind of sound bites U.S. CEO’s have become known for:
“Positioning (blank) as the best digital consumer shopping experience for financial products in the market. I founded the company over 25 years ago, and (blank) has continued to evolve and expand its product offerings to address almost every personal finance need a customer has.” CEO during Q1 22 results call
“Our foundation is something that we’ve built over a ten year period of time and it started with an incredible R&D team and amazing science. And then we’ve built the largest commercial organization in diagnostics. And then on top of that, you have clinical trial capabilities second to none, and regulatory experience, and market access capabilities, a quarter of a million square feet of lab space, the most advanced in the world, an IT infrastructure second to none with a wraparound customer service that is a differentiator, and an international team that is unique in customer diagnostics.”, CEO at Jefferies Healthcare conference, November 2020
The two CEO’s that are quoted above share four attributes beyond optimism : 1) they presided over share price returns of more than 10,000% before the year 2020, 2) their stock prices have declined by at least 70% since the start of 2021, 3) their companies are expected to lose money in 2022, and 4) they took home $18.8 million and $6.3 million in CEO compensation for the year 2020, although much of this was in stock. (source: Factset) I understand that the world needs visionaries, and the U.S. equity market has supported some tremendous forward thinkers over the years. I just think that the valuations of those with a more speculative and promotional message got way too far out of control due to the period of easy money. See the graphic that we created below for the way the incentives take over under easy money. For Institutional investors that may have been attracted to optimism and great stories, I wonder what they are doing now. Are they buying more? Or looking for better allocators and compounders?
source: Ballina Capital
I know from experience that when you trust in a very carefully crafted corporate message, you can be disappointed. When your investment idea and thesis were largely predicated on management quality, and then management lets you down, what do you do at that point? This is why at Ballina Capital, our ideas only come from our investment screens. We then do our own bottom up work on the fundamentals. We have little access to the sellside. If there is a “groupthink” that is dismissive of our company’s prospects, it is not an integral part of our information gathering process. We prefer to have good management. We speak to management late in our process to check some assumptions. We are certain that we do not want a Board with interests diametrically opposed to those of minority shareholders. Most of all we are looking for good free cash flow potential, good balance sheets, profits and margins that can improve, low expectations versus what we believe can be achieved, and a valuation with conservative upside. If we can find companies with all of those factors present, it is more likely than not that a management team with the right incentives can be attracted to the company, and this team will then grow value for shareholders.
International All Cap Value returned -4.27% on a gross basis, and -4.35% on a net basis, in June 2022 versus -7.96% for the benchmark. Year to date performance was -9.18% on a gross basis, and -9.63% on a net basis, versus -17.75% for the benchmark.
Global Small Cap Value returned -4.1% on a gross basis, and -4.18% on a net basis, in June 2022 versus -9.39% for the benchmark. Year to date performance was -8.75% on a gross basis, and -9.21% on a net basis, versus -23.07% for the benchmark.
Top Contributors and Detractors
International All Cap Value’s top contributor in June was Tianneng International Power. The Chinese electric battery manufacturer benefited from improved sentiment around long term energy technology development in China. The strategy’s top detractor in June was Ferrexpo. The Iron Ore pellet producer is struggling with transport logistics from Ukraine, and falling global Iron Ore prices.
Global Small Cap Value’s top contributor in June was LSR Group. The Russian property company’s stock price has stabilized after the worst GDP decline fears for Russia did not materialize. The strategy’s top detractor was Italian financial Banca IFIS. Italian BTP spreads have been increasing, and more investors are worried about Italy’s struggles to manage public debt under higher interest rates.
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Returns are presented gross and net of fees and include the reinvestment of income. The benchmarks being shown for comparison purposes are: a) for International All Cap Value - the Vanguard Total International Stock ETF (VXUS), and b) for Global Small Cap Value – a 50/50 weight on each of the iShares Russell 2000 ETF (IWM) and the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS). The information contained herein is not investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
For the Top and Bottom Contributors: Contribution reflects the impact of performance and the portfolio weight to total portfolio return. Data show is from a representative account of the International All Cap Value and Global Small Cap Composites. All returns are Gross of Fees. Timing differences of purchases and sales may have a modest impact on the actual contribution numbers presented. The calculation methodology along with detail on all holding’s contribution to the overall accounts performance during the measurement period are available upon request.
 Barron’s Weekday Trader, April 8, 1999.  “Angelo Mozilo and his doomed mortgage machine”, CNN, June 6, 2018.  On 12/29/2010 the Total Assets of the Federal Reserve were $2,420,570 million. On 6/15/2022 the Total Assets of the Federal Reserve were $8,932,420 million. Source: Board of Governors of the Federal Reserve System