Friday, August 23, 2013

Alfidi Capital at MoneyShow San Francisco 2013

I had to attend the annual MoneyShow San Francisco last week.  This was more than just another conference for me.  I presented my first MoneyShow seminar ever.  This was something I've wanted to do ever since I attended my first MoneyShow in 2001 during my MBA program.  I spoke this year about my small-cap stock evaluation methodology on the first day of this year's show.  If you want to hear my thinking, you have to invite me to speak at your high-powered conference.  I paraphrase what a few other speakers said below.  My thinking in response to the presenters is noted in italics below, as per my usual style of commenting on major public events.

Thank you to Kim Githler and Charles Githler for allowing me time on your show's calendar.  Kim kicked off the conference in her usual way by covering her basic philosophies:  capital preservation, the big picture, and adapting to change.  She noted that strategies for handling inflation and deflation are different and that long-term stock market investors are rewarded.  Her take on an old adage was a classic:  "Finish your homework.  People in India and China are starving - for your job."  Charles spoke next; he thinks the US is at major risk of deflation (hence the Fed's QE goal of asset appreciation).  He interprets rising real 10-year yields as the result of investors demanding more reward for the risk they take.  Referring to the "2020 scenario" of energy independence for North America, Charles thinks materials and energy may outperform.  I appreciated his mention of GDX and GDXJ (the gold mining ETF tickers) as beaten-down value plays that may also be useful as inflation hedges.  There may be some life in my GDX holdings yet if other luminaries come around.

The first keynoter from TD Ameritrade covered his firm's Investor Movement Index (IMX), which I take to be a Big Data compilation of their clients' aggregate trade activity that measures market sentiment.  I don't use sentiment indicators because I consider most retail investors to be reactive rather than contemplative.  Some hedge fund somewhere can probably throw the IMX into one of their algorithms and measure its signal strength.

The keynoter from S&P Capital IQ said that bullish market action in January and February usually signals a positive twelve month total return, but I'm skeptical.  Ask anyone who was in the markets from late 2008 to early 2009 how the crisis impacted their annual returns.  He noted that the number of "all-time high days" in this bull market are below historical averages; once again, I'm skeptical that this is anything other than random noise.  He noted that narrow yield differentials between the S&P 500 and the 10-year Treasury are generally good for bull markets but I must caveat that with some kind of adjustment for risk.  Only in recent years have investors ignored risk and focused exclusively on total return, and that's only because QE has driven them out of cash and savings accounts.  IHS Global Insight believes that most developed countries have passed the troughs in their business cycles.  I'd like to see IHS's track record in forecasting economic turning points; it's not obvious from their product page.

Roger McNamee from Elevation Partners (and let's not forget his rock band, Moonalice, whom I've heard live) had ten hypotheses about tech that probably went over the heads of most MoneyShow attendees.  I think MoneyShow attendees are much more intelligent than the average American, but not all of them are the type of innovators who would launch or fund a tech startup.  He thinks there's no income overlap between mobile apps and the web, partly because apps are the search engines for mobile.  He thinks Apple should pivot to the cloud and the Google's Android has spawned incompatible systems that degrade app experiences.  He continued to pound Android, saying its OEMs often lose money on hardware.  I'd take a look at Samsung's sales before I count out Android makers.  Roger likes that HTML5 incorporates Flash, which gives it more design flexibility and makes monetization easier.  He predicts that "home cloud" architecture offering remote access to lifestyle devices is coming.  I see that as another manifestation of VCs going for IoT as the next funding trend, something I've blogged about this year.  He also predicts that content providers will have to move to broadband distribution to survive given the decline of cable and satellite channels.  His most alarming hypothesis is that the "sharing economy" allows consumers to imitate corporations' capital efficiency techniques (like outsourcing), his evidence being that Millennials are renting capital goods for short periods via Airbnb and Zipcar.  I hope he knows what's driving this phenomenon.  Millennials' income is constrained by student loan debt and lack of upward mobility.  They must rent cars because they can't afford to own them.  They must lease out their homes and apartments because they really need the extra income.  Check out Roger's slide show on Elevation Partners' mission page.

Steve Forbes was the next keynoter.  He's still pretty sharp but sooner or late the next generation of handsome, intelligent keynoters will have to replace the old guard, and that's exactly why I'm appearing at these conferences.  Steve noted that middle class incomes are still declining after four years of so-called economic recovery, similar to a pattern in the 1930s.  The MoneyShow audience applauded his prediction that the Democratic Party would lose the US Senate due to the Affordable Care Act's implosion.  I'm sad to note that such a reversal is probably a pipe dream.  Americans are addicted to entitlements at all levels of our society.  These programs and their political sponsors will remain in place until a hyperinflationary depression eliminates their funding sources.  Steve thinks fixing federal spending to a percentage of GDP is a more effective budgeting tool than a legislated debt ceiling.  I don't think that is going to work.  Government statistics are already significantly altered, gamed, adjusted, and otherwise misused as to be unreliable, according to Shadow Government Statistics.  Targeting GDP will just incentivize the policy apparatus to artificially inflate GDP so the government can collect more revenue.  The best guide for targeting federal revenue collection and spending IMHO is Hauser's Law.  Steve went back to his advocacy for the gold standard, another impossibility because it's too inflexible as a rule.  The Rentenmark is a better example because it was backed by a broad range of hard assets.  

Jim Rogers was the final keynoter.  He's still pretty sharp but he was starting to show his age while wandering all over the stage.  He's proud of his young daughters for speaking Mandarin and showed off their videos from a speech exhibition.  The guy has been a relentless China bull for something like forever.  Someone needs to tell him that China's most important economic figures are falsified and that English is the international language of business.  I could beat the ground about how China will get old before it will get rich, its resource shortages and little arable land, its economy's fixation on the pork cycle, and the insolvency of its shadow banking system.  I do concur with the rest of his general advocacy of mining, energy, and agriculture.  Jim set up his family's bank accounts in Asia because he doesn't trust the US dollar.  I hope he calculated those banks' Basel capital adequacy ratios first.  He noted that simultaneous monetary stimulus in the largest developed economies is unprecedented and that we should prepare for that to end.  I've been saying that too but I don't think Jim reads my blog.  He's shorting junk bonds.  I'm not, because I don't want to pay the bonds' interest to a counterparty in addition to the margin interest I'd have to pay.  He's still bullish on agriculture because a dearth of farmers will make farming careers more lucrative.  Jim likes Canada's economy and currency but doesn't like US TIPS due to their tax consequences at maturity.  He then rolled into a rambling Q&A and was very friendly with Asian women in the audience.

The vendor booths on the expo floor had more representation from hard assets companies and investment projects than I've ever seen at a MoneyShow.  Big Oil (supermajors), Little Oil (prospectors), pipeline MLPs, timber, REITs, BDCs, and non-US agriculture were all there.  I'll cover these selectively, in pretty broad swaths, working backwards.

Let's consider farmland.  I can understand investing in agribusiness stocks with an international presence because they must publish detailed financial statements.  A pure-play deal in Latin America or the Baltics requires a different kind of due diligence.  Investors would have to physically travel to the country in question to see the land, meet the farmers, and examine the title document in the native language.  That's more effort than I can make just for one potential investment.  Please don't pitch me on the ability of coconut oil to treat Alzheimer's disease.  Please don't tell me that a bunch of neem trees are a miracle without explaining the plan to cultivate them outside their native habitat.  Plants have natural pests and predators.  I'd say investors have natural predators too.  I'd much rather invest in permaculture, which I can do right here at home.

Let's talk about business development companies (BDCs).  I picked up flyers for a couple of these at the MoneyShow.  In normal times BDCs are useful additions to a fixed income portfolio.  These are not normal times.  The likelihood of hyperinflation in the US means any security based on fixed income flows is the kiss of death.  Too many BDCs have portfolios structured as loan funds.  The companies owing those loans to the BDCs will pay them off with worthless dollars in hyperinflation.  Structuring the loans as secured with liens on assets won't matter; the indebted companies will end hyperinflation much healthier as their liabilities are inflated away.  BDCs that structure their investments as convertible debt or project equity might fare better in hyperinflation for a little while.

Let's mention REITs.  John T. Reed's anticipation of nationwide rent control laws puts the kibosh on whatever refuge I might have found in commercial REITs.  Residential REITs are similarly out of my consideration.  The remaining option would be storage REITs, and I found a suitable candidate for my own money in my blog article earlier this week.

Let's check out timber.  I sat through one timber pitch recently.  It was (of course) for a project outside the US.  No thanks.  Timber is a hard asset and thus a potential inflation hedge but it must be structured correctly if it wants my respect.  I suspect that much of the infatuation with timber in recent years is the result of timber's correlation with the housing market.  Housing booms drive demand for lumber and pulp.  The financial sector started to take timber seriously when the Harvard Management Company hired a lumberjack to evaluate timber farms all over the world.  The strikes me as analytical overkill.  There are simpler and cheaper tools around for evaluating timber.  The NCREIF Timberland Index shows the return history for timber investments.  The index's declines since the housing bust are a contraindicator to contemporary claims that the housing sector is strong, but those declines may also indicate that the timber sector is underpriced.  Institutional investors hire timber investment management organizations (TIMOs) to care for their trees but those structures aren't available to ordinary retail investors.  The best the rest of us can do is evaluate timber REITs like Rayonier (RYN), Potlatch Corp. (PCH), and Plum Creek Timber (PCL).  Compare them to the timber REIT ETFs with the adorable tickers CUT and WOOD.

Let's look at pipeline MLPs.  The only thing preventing me from going long one of these babies (aside from finding one at a decent bargain) is the unresolved question of whether they can raise their rates at will or are limited by FERC to rate increases at set intervals.  Pricing power counts for everything in hyperinflation.  I'm still digging for the answer.

Let's wrap up my digression by mentioning oil and gas.  You've heard me talk about energy many times already on this blog.  I've discovered that there's a specialized part of the finance sector called "oil and gas lease banks" that provide capital specifically to drillers.  Even oil and gas royalty trusts need access to capital because wells will mechanically fail over time.  They must spend capex on maintenance and restoration of production.  I don't invest in these tiny little well plays or their lease banks but some people just love the tax advantages.  The IRS has an entire handbook devoted oil and gas, and there's a cottage industry of accountants and attorneys devoted to figuring it out.  There's also a cottage industry of community banks with internal offices devoted to helping oil and gas royalty owners manage their income streams.

Okay, enough of my fixation with oddball asset plays.  I'm switching back to the MoneyShow speakers.  There were so many talks that I couldn't possibly cover them all, so I only attended those that mattered for my own portfolio or professional development.

Serial entrepreneur Bill Harris of Personal Capital explained how money meets tech in financial services.  His three requirements for a money management service are that it should be virtual, secure, and personal.  Virtualization should be a disruptive force in a sector that has four times as many bank branches now as it did before the ATM, especially now that digitization has transformed financial projects into intangibles. The security of vaults and access can now be delivered with smartphone 3-factor authentication (password / phone activation / voiceprint).  Technology now allows for mass personalization that obliterates the old crasftsperson model of wealth advisory.  Much of his talk hit the strengths of his finance startup, Personal Capital, without being a blatant sales pitch.  Great presentation, Bill!

The MoneyShow promoters displayed their own proprietary investment sentiment indicator, collated from attendee responses.  Attendees still expect a rising S&P 500 in 2013 and a steady unemployment rate at 7%.  They plan on buying more stocks.  Okay folks, but your due diligence needs to be as robust as mine.  My own seminar presented a detailed due diligence checklist that I've spent years developing.

The Everbank folks think we're paused at a crossroads.  They presented a FRED chart of nominal GDP growing, but to me that's more an indicator of inflation than economic growth.  Their stats on just how little money most Americans have were depressing, like the median figure for financial holdings at $6000.  I'm not in the top 1% but I feel like I should be compared to people at that level.  Everbank noted that the only real job growth in the 2000s was defense-related.  Manufacturing is no longer a job creating sector because it isn't labor intensive.

Legendary stock analyst Laszlo Birinyi spoke on inefficiency in the stock market.  He had a couple of truisms, like "don't sell into strength," which I didn't quite grok.  Maybe this WSJ data set is what he meant.  He thinks money flows are the best tools for understanding the stock market but he didn't mention any sources.  Maybe he means data like this money flows report in the WSJ's Market Data Center.  It seems like a pretty raw supply/demand technique but I'll have more to say about it after I've studied Birinyi's own money flow methodology.  He also uses a cyclically adjusted P/E to make buy/sell decisions and call market turning points.  I've been wrong when I've tried to call market turning points so I'll check out his system.  I agree with him that technical analysis doesn't work, but some speakers here will swear by it.  Laszlo lamented that investors today are on their own because institutional money managers don't read, think, study, or practice.  He said other money managers never asked him how he outperformed because they thought he was just lucky.  I witnessed all of that behavior inside investment firms where I worked.  I want nothing to do with those people.  

Next up was Doug Roberts' Channel Capital Research speaking on the QE-driven rally.  Follow the Fed to Investment Success lays out Doug's thesis.  The Fed has driven down bond yields and boosted bond valuations, forcing investors to take on more risk.  QE3 is different from previous rounds because of its indefinite size and duration.  Hew drew a brilliant analogy with markets in the 1930s, where low to negative real interest rates and violent bear markets in equities destroyed investors.  The oil shocks of the 1970s had similar effects, where inflation rose and equities dropped.  Accommodative Fed policy can last longer than rational investors can expect.  Crises and shocks can always surprise policymakers.  Mean regression will penalize long-term returns.  I asked Doug what could cause a run on the US dollar by foreign investors.  He answered that a Middle East conflict could cause autocratic leaders to take power, or that China's internal conflict between its military leaders and its Western-educated business elite could become a power grab that sparks open military conflict.  His basic analogy was with political turmoil in Germany in the 1930s.

Ronald Muhlenkamp, the patriarch of Muhlenkamp, gave his first talk on natural gas an an energy game changer.  I'll cover his second talk farther down this article.  He noted that natural gas at $3/mcf equals coal's price.  Natural gas has always been a local commodity because it can't be shipped economically without being compressed into LNG or constructing pipelines.  He gave an example of how the shale gas boom is lowering consumers' commodity charges on home heating bills.  The cost spread of crude oil versus natural gas is currently too wide to be sustained.  Changing the fuel mix of over-the-road trucks to NG will lower the price of diesel fuel.  Steel plants now use NG as a feedstock.  Comparing NG to other energy sources reveals that it takes seven or eight wind turbines to equal the energy output of one typical NG well.  He also noted that NG wells have a much lower acreage footprint that solar or wind installations.  Ron said that coal has gotten a lot cleaner and US carbon emissions are now below the levels specified in the Kyoto Protocols even though we never ratified that treaty.  Other Kyoto signatories are still above the limits.  Ron said that the concerns about water use in NG fracking are overblown because using 1M gallons on 40 acres is the equivalent of less than an inch of rain on said property.  He mentioned that T. Boone Pickens' Clean Energy Fuels is building coast-to-coast NG filling stations for long-haul trucks.  I asked Ron if the Henry Hub price is a decent proxy for world NG prices.  He said not necessarily because NG prices really are discrete by region.  Ron closed by saying that he likes Sam Walton's book on retailing because that's how the guy got rich as a middleman; as a purchasing agent, he delivered goods to markets more cheaply.  I guess that's the analogy with NG distribution.

I listened briefly to a presentation on managed futures but departed because I'd heard the main points before, and I even gave a pitch like this once when I was a licensed broker at a large firm trying to sell a managed futures product.  The CFTC has regulations governing futures commission merchants (FCMs) and introducing brokers.  Alfidi Capital doesn't fall into either of those categories.  The CME Group is a popular market for futures traders.  I don't trade futures.  I believe futures are only relevant for businesses that want to hedge against adverse price movements for commodities they produce or transport.  Turning the futures market into just another casino for retail investors is IMHO an exercise in futility.  How deep is a given futures market's liquidity?  Can an investor really unwind positions instantly?  What is the counterparty risk?  I'll look for answers to these questions in a future blog article, with the sad case histories of Long Term Capital Management and MF Global as examples of what can go wrong.  Oh yeah, one more thing on managed futures.  Reg FD on selective disclosure pretty much eliminated the ability of actively managed futures to generate alpha.

The Forbes columnist roundtable was a fun panel, primarily because bond guru Marilyn Cohen was on it.  The panel seemed to hold a consensus that the Fed's tapering is inevitable.  IMHO the Fed is already losing control of the long end of the yield curve.  The panel hinted that this is happening by noting big drops in the value of long term bonds and mortgage REITs.  Every panelist had their own approach to ideal portfolio construction but Marilyn likes split-rated bonds (i.e. bonds where rating agencies differ on the ultimate rating, implying the bond may be undervalued) and individual junk bonds from firms that have pricing power.  She also thinks the Detroit bankruptcy will be a seminal event for the muni bond market, predicting the case will go to the US Supreme Court and contagion coming to other states' bonds.  The stock picking columnists on this panel mentioned stocks that are driven by consumers' disposable income.  Those are stocks I avoid.  They also mentioned some new spinoff ETF (maybe Guggenheim's CSD, I didn't catch the ticker), which is another thing I'll avoid because spinoffs are the result of active decision rules and don't belong in a passive index.  One panelist said that some large gold miners tie their dividends to the price of gold.  I didn't know that, but it makes some sense because the price of gold determines how much cash miners can get for their metal.  The panelists discussed their sell disciplines.  They all have price level rules except Marilyn.  Her sell rule for a bond is to sell upon discovering any accounting discrepancy in the issuer, any private equity buyout attempt of an issuer (because the target issues new bonds that denigrate the existing bondholders' interest coverage), and any denigration of yield when rolling down the yield curve.  Marilyn Cohen is brilliant, and I told her so after the panel was over.  I heard her speak at the first MoneyShow I attended in 2001 and she's as sharp as ever.  I respect her because she understands fundamental drivers of a bond's value.  Marilyn shared a couple of her corporate bond picks and said bondholders don't like share repurchases because those actions divert cash flow from potential bond interest payments.  The panel let the audience chew on the arbitrage potential between GDX and GLD by going long miners and short paper bullion.  It's not a perfect arbitrage because it's an apples-to-oranges comparison, but it's a useful mental exercise in demonstrating that the price of gold has outrun the profitability of gold miners.  Marilyn's final zinger was to say that I Savings Bonds are a bomb due to lack of inflation, but even she is skeptical of the US government's reported inflation numbers.  Just wait, Marilyn, because when hyperinflation really takes off those I-Bonds will be even worse bombs.

I got to hear more from Marilyn Cohen when she held her own seminar on remedies for situations when management disregards bondholders.  Check out her work at Envision Capital Management.  Marilyn reiterated that M&A and spinoffs affect bonds, and that accounting improprieties are sell triggers for corporate bonds.  Acquirers issue bonds to fund their takeovers, but a failed acquisition makes these newer bonds less desirable than older bonds.  Private equity buyouts hurt existing bondholders if they don't have covenants with change of control provisions in their bonds.  She said the median equity in private equity buyouts is 40%, and any less means existing bondholders suffer.  She warned us all to stay away from covenant-light bonds and to read prospectuses for covenants.  Bond indentures with change of control provisions ensure that your bonds are taken out at a premium to par.  High coupon bonds deserve attention in buyouts; she sells them upon a buyout's announcement.  Bond clawbacks can happen if an issuer has the right to buy back a percentage of bonds issued.  A clawback action is more typical of junk bonds and not so much for investment grade bonds.  Buyout targets take on the acquirer's bond rating.  The bond indenture will describe the make-whole provision of any potential clawback offer.  Bond buyers must beware of these clawback provisions!  Marilyn also advised us all not to buy bonds in private equity companies themselves, because they use those bond issues to pay themselves dividends.  She also told us not to buy pension obligation bonds, because they're taxable.  She wants us to stay away from general obligation munis issued in problem areas (I'm thinking Detroit, Stockton, etc.) or that need appropriations.  She really likes senior lien airport revenue bonds, personal income tax (PIT) bonds, sales tax revenue bonds, and water/sewer bonds.  She also likes bonds of companies that just emerged from bankruptcy because they have clean balance sheets.  Way to go, Marilyn!

I attended Ron Muhlenkamp's second seminar on the squeeze effects of taxes and interest rates.  When someone impresses me, I elect to learn everything I can from them.  He noted that government has never collected more than 20% of GDP as taxes; please refer to Hauser's Law for confirmation.  If the federal deficit grows less than GDP, the debt-to-GDP ratio gets healthier.  Ron also gave us a hint on how frugal lifestyles beget wealth.  He said buying used cars helps you get rich, and one should never borrow to buy a depreciating asset.  I'd caveat that by saying that a depreciating asset that generates cash flow may be worth the debt needed to buy it.  Entrepreneurs who buy taxi cabs, dump trucks, limousines, or hearses should at least calculate the NPV including the periodic negative outlays for debt repayments.  Ron noted that higher taxes won't cure the federal deficit because people will just work less.  Defined benefit pension plans will bankrupt employers.  I'm pretty sure I blogged about that at some point and that's why I read balance sheets to identify underfunded pension liabilities.

I attended Marilyn Cohen's second seminar on how the bond crisis is moving at glacial speed.  Like I said before, I pay attention to people who know what they're talking about.  She borrowed the term "Global Thermonuclear Devaluation" from finance guru Mark Grant to describe what happens after QE.  The best thing Marilyn did for her audience today was to share a method for minimizing taxes.  The Affordable Care Act's tax on capital gains from high earners is unpopular but bondholders can amortize premiums to avoid it.  Amortize the premium of a taxable bond by taking it as an annual deduction on your income tax returns, rather than using it as a capital loss at maturity or sale.  The Form 1099 from a brokerage will show the adjusted cost and premium only for the last year an investor owned a bond.  Amortizing it annually will reduce the ACA's tax.  Competent CPAs know how to calculate this amortization.  I think the risk in this approach lies in the ability of the IRS to change allowable amortization on a whim.  Marilyn thinks it's unique that all new bond issues are at premiums now because ZIRP keeps short term rates at zero.  You'll never find bonds at par or discount anymore because of ZIRP.  She thinks Payment-In-Kind (PIK) bonds are horrible because the issuer (usually distressed) can keep paying in PIKs like an eternal Ponzi.  She noted that even private equity firms are now issuing PIKs.  Which ones?!  I don't think I want to find out.  She admonished us to get more selective on munis, because Detroit really has changed everything.  Many other muni issuers are just as troubled.  Investors in general obligation (GO) bonds may become unsecured creditors.  She said any bonds whose revenues rest partly on federal grants are risky, with Build America Bonds (BABs) as a prime example.  The BAB indentures state that they can be called at par if the federal government cuts its subsidy.  Sequestration puts all grants and subsidies at risk.  She thought GARVEE bonds for highways were usually safe, until now.  The Treasury Offset Program (TOP) can withhold money from these bonds' repayments.  The federal assistance built into some munis is part of Marilyn's glacial crisis picture.  She disparages "yield hogs," investors who just chase high yields with no concern for covenant risks.  I saw a variant of the yield hog breed in some writers who extolled the value of high-interest savings accounts in Cyprus before that country's banking system went into lockdown.  Marilyn thinks California's high speed rail project is a boondoggle and that's part of the reason she now prefers revenue bonds; GO issues are funding useless projects.  She likes "intercept bonds" but I don't think those originate with California issuers.  Marilyn uses Investing In Bonds for research and thinks everyone should use it too.  Okay, I sure will.

That's the exhaustive summary, with pithy italicized Alfidi Capital commentary, of all the seminars I attended.  I already blogged about John T. Reed's MoneyShow seminar because it was too good to delay.

I want to impart a few more random but related Alfidi Capital observations before I wrap up this report.

#1) I am really starting to suspect that oil and gas royalty trusts belong in tax advantaged accounts but I need to look into some rules to be sure.  The payouts from a royalty trust include both return of principal and additional yield.  Eventually the principal will be zero as wells deplete.

#2) IMHO rising real interest rates will eventually crash the value of bonds (particularly Treasuries) that banks hold on their balance sheets, destroying their capital adequacy ratios.

#3) Pension liability analysis must be part of any public company valuation.

#4) The normal interest rate for a 10-year Treasury may very well be its average since 1962, which is 6.58%.  The impact of a mean reversion to this figure from where we are now will be hugely adverse for stocks, bonds, and housing.

These four observations, plus everything else I learned at the MoneyShow San Francisco 2013, play a huge role in how I invest my own money.  I'm totally convinced that the investing public is better off for reading my synopses of investment conferences and that my own seminar added tremendous value to MoneyShow 2013.  I'll see you again next year.