Could selling a Jaguar have predicted Brexit? / July 22, 2016 by Chip Kent

This quarter’s defining feature was Brexit, which caused significant price movements for both the entire market as well as our portfolio. Clearly, none of the price movements were in a good direction. Over the long-term, however, I don’t expect Brexit to have a meaningful impact on the U.S. economy.

The E.U. is constructed in a manner very similar to the Articles of Confederation, which governed the U.S. in the 1780s. Just as the Articles of Confederation eventually failed because they lacked a strong central government, so too may the E.U. suffer the same fate.

As a personal example, about 15 years ago, I sold a vintage Jaguar XKE to a gentleman in Germany -- in his words, so he “could drive it very fast on the Autobahn.” Hans was extremely detail-oriented and discovered that he could dodge a 20% tax by importing the car into the Netherlands and having it trucked to Germany, rather than importing it directly into Germany. This clearly was a sign of a dysfunctional system.

One area of potential concern is banking in the E.U. After the 2008-2009 mess, the U.S. forced its banks to clean up their balance sheets and reduce leverage. The E.U. still has not completely addressed that problem.

Another aspect of the Brexit is the fate of banking in London. London maintains its position as the European global banking hub because treaties allow banks to locate in London and operate throughout Europe. With Brexit many of those treaties will need to be renegotiated. If the renegotiation is not successful, London-based banks will face challenges.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

Nothing contained in this article constitutes tax, legal or investment advice, nor does it constitute a solicitation or an offer to buy or sell any security or other financial instrument. Such offer may be made only by private placement memorandum or prospectus.

How does the current market compare to long-term history? / October 20, 2015 by Chip Kent

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Over the last few years, the market has put a premium on growth, momentum (industry “mumbo jumbo” for buying things that have gone up a lot recently), money-losing companies, passive investing in whatever indices have gone up the most recently, and money-losing IPOs. This environment is the antithesis of our fundamental approach. Consider that, over the last 12 months, buying only money-losing companies would have gained 20-50%. By contrast, for 2015, buying the cheapest value stocks and shorting the most expensive value stocks would have lost 13%. These outcomes are the opposite of what the businesses’ fundamentals dictate. Over the long-run, I do not believe that the current trends are sustainable.

The current period marks the longest duration on record where value has underperformed. Value has not been this cheap relative to growth since the peak of the dotcom bubble. The following table and plot provide some insight into the market’s current behavior.

Screen Shot 2017-08-22 at 2.22.25 PM.png

(Data from Fred Piard)

Despite the current market environment, I believe that the long-term will be kind to our value-investing strategy. As long as I continue to do a good job valuing companies, I believe our effort will be rewarded -- even if it takes some time. In the long-term, the market is efficient and businesses eventually trade around what they are worth. In the short-term, anything can -- and often does -- happen.

Although unpleasant, it is very important that value strategies sometimes underperform in the short-term. Historically, a value strategy underperforms in ⅓ of years and has a 10% chance of underperforming over a 2-year horizon. However, historically, over a 5+-year horizon, value-investing strategies have outperformed >75% of the time. In other words, value investing works, but it doesn’t always work.

We not only expect our value-investing strategy to underperform occasionally -- but more importantly, this fact works to our advantage. If value investing worked every year, every month, every day, and in every market environment, then everyone would be a value investor. If everyone were a value investor, then our opportunities to invest in mis-priced businesses would evaporate. However, the reality is that value investing doesn’t always work (like now). That reality keeps out competition, which allows the strategy to continue to work over the long-term.

Right now, many self-proclaimed value investors have thrown in the towel -- or their investors have thrown in the towel for them. Yes, the market’s current bumpiness is unpleasant, but it is this bumpiness that winnows out our competition. Less competition makes it easier for us to work towards our goal of above-average long-term returns, provided that we stay the course.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

Could simple arithmetic estimate when the oil glut will end? / October 20, 2015 by Chip Kent

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The price of oil is elastic over the long-term but inelastic over the short-term. Over the long-term, the price of oil is determined by the cost of extracting the last barrel of oil the world requires. Given enough time, oil production adjusts up or down in response to market prices; similarly, given enough time, demand adjusts up or down in response to market prices as consumers choose between a new SUV or a new hybrid car.

Over the short-term, however, market prices react dramatically to small perceived changes in supply and demand. Over short periods, oil production remains relatively constant while demand also remains constant as consumers continue driving the same cars. If more oil is produced than is demanded, the oil ends up in storage, driving down the price; by contrast, if less oil is produced than is demanded, then prices skyrocket.

As a physicist, I like to do back-of-the-envelope calculations to understand the world around me. These calculations are very crude but often yield important insights. Let’s look at the current oversupply of oil.

The world produces 96.6M barrels/day of oil. For the sake of simplicity, let’s use 100M barrels/day. If the world stopped drilling new wells, oil production would fall 5-8%/year as existing oil fields become less productive. At the same time, oil demand grows by 1-2%/year. Combining these two factors, the world needs to produce 6-10% more oil each and every year. This 6-10M barrels/day of new production is roughly equivalent to the production of the U.S., Russia, or Saudi Arabia -- and it must come online each and every year.

Billions are invested each and every year to achieve the new 6-10M barrels/day of production. As the price of oil has fallen, investment has fallen as well. Currently, oil producers are only investing 65-75% of what they would have invested during a normal year. As a result, instead of producing 6-10M barrels/day of new production, we should only expect 3.9-7.5M barrels/day of new production -- basically a 2.1-2.5M barrels/day shortfall.

In October 2014, the oil market was estimated to be oversupplied by 1-2M barrels/day. With the decreased level of investment by oil producers, this market should take roughly 6-12 months to come back into balance. Add on another 6 months for the time it took to wind down existing drilling. This would indicate the oil market should come back into balance in the October 2015 to April 2016 range. Using up excess global inventories will extend the estimate a few more months.

These calculations are clearly very crude, but they do indicate that global production and demand should balance out over the coming months. Because short-term prices are highly influenced by emotions, oil prices may take more or less time to adjust.

Just as a baby can’t be created in one month by getting nine women pregnant, only time will stabilize the oil market. However, once demand exceeds supply, oil prices may react sharply.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

Does your stomach trump your brain? / October 20, 2015 by Chip Kent

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I’ll begin this article with two quotes by Peter Lynch. Lynch, a value-investor who ran Fidelity’s Magellan Fund, averaged a 29% annual return between 1977-1990.

“The key organ for the stock market is not the brain, but the stomach.

I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”

This quarter, the overall market experienced a correction of more than 10% within 5 trading days -- “correction” being industry jargon for losing a lot of money very quickly. We haven’t experienced such a move for a few years, but during the last 115 years, investors experienced on average:

-5% market correction: 3x / year
-10% market correction: 1x / year
-20% market correction: 1x / 3.5 years
-30% market correction: 1x / 8 years

Such fluctuations are a fact of life in equity investment. The last few years of tranquility were unusual, while, in fact, the recent fluctuation was very usual. Since market fluctuations are much larger than fluctuations in the economics of the underlying businesses, these market fluctuations present opportunities for value investors. Although unnerving, such volatility is our friend.

The other fact of life is that human beings are emotional animals. We crave certainty, especially in financial markets, where such certainty cannot possibly exist. Psychologically, we are programmed to panic at wild market swings. Dealing with market swings rationally is a learned response.

Screen Shot 2017-08-22 at 2.17.45 PM.png

A market loss of 10% in only five trading days is unusual. Since 1976, there have been only six times where the market has fallen 10% or more in five trading days:

The recovery time for the previous declines was relatively short. Even in the 1987 case, which appears long, the market ended up for the year.

Going forward, I expect precipitous drops to become much more common than what we’ve seen before. Over the last two decades, computers have taken over the operation of the markets. As I discussed in a previous article, “The High Cost of High Frequency Trading,” these computers are very dumb. The computers know the price of everything and the value of nothing. As a result, markets appear to be well-functioning and liquid -- until they are not.

Real-time financial media has enabled financial panic to spread faster than ever before, while internet trading, cell phone trading, and algorithmic trading have allowed that panic to be acted upon with unprecedented speed. For example, during the recent correction, “investors” were willing to pay almost 5% of their portfolio to insure against losses over the next 30 days! That is panic.

Fear of loss drives a lot of investor behavior and leads people to make short-term and irrational decisions in order to ease their fear of loss. Suddenly, self-professed long-term investors are unable to control their fear of loss and decide that the only sensible thing to do is become a “market timer.” These decisions will hurt their long-term return outcomes and provide opportunity for those who are prepared to focus their energies on the things that count and that can be controlled.

“Emotion is one of the investor’s greatest enemies. Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning. Superior investors may not be insulated, but they manage to act as if they are. ”

— Howard Marks

Market corrections always raise the question of hedging. Running a hedged portfolio at all times is obvious, right? Not quite. What’s clear to the broad consensus of investors is almost always wrong. When the costs of hedging are considered, hedging is much less attractive -- at least in the current market.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves. ”

— Peter Lynch

An investor could hedge by (1) shorting a broad market index, (2) buying puts on a broad market index, or (3) shorting a basket of the most toxic stocks he can find. Currently the S&P 500 is cheap relative to bonds. If an investor shorts the S&P or buys puts on the S&P, and bond yields stay low, he will likely lose money on the hege. Bond yields would have to rise above 5% -- which I think is unlikely -- or the market would need to appreciate significantly before shorting the index would seem like a good idea. Similarly, shorting a basket of terrible businesses tends to cost a few percent per year. And don’t forget that toxic sludge went up 20%-50% in the last 12 months.

In the current environment, I estimate that each of the three hedging strategies would cost on the order of 5%/year. While a smoother ride would be nice, I personally don’t think it is worth the cost. I would prefer a lumpy 15% return instead of a smooth 10% return -- the 5%/year drag would end up costing 66% over 10 years.

Having said that, there are situations where an investor could make money on a hedge. For example, in both 1987 and 2000, stocks were very expensive relative to bonds, so hedging stock exposure would have made sense.

Most long/short hedge funds have significantly underperformed since 2009 because they insisted on running short positions even though the market was historically undervalued. While I’m certain the smooth performance of these funds made them easy to sell to prospective investors after the preceding tumultuous years, being market-neutral ended up costing those investors a lot of money.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

How are interest rates like a thermostat? / July 29, 2015 by Chip Kent

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As I write this, my basement office is quite cold while my upstairs family room is quite comfortable. A single thermostat controls both parts of the house. I could choose to make my office very comfortable while making my family room very hot, but there is no way to make both my office and the family room comfortable. It is just not possible.

The Federal Reserve faces a similar dilemma. It has one knob (interest rates) which impacts multiple parts of the economy. Any tweak to the knob will improve some areas of the economy while making other areas worse.

Since 2008, the Fed has set interest rates extremely low -- at least I consider zero to be low. These low rates have stimulated spending and economic growth. As you would expect, low interest rates have encouraged buyers to take on debt to buy couches, clothes, cars, stocks, and homes, etc. After 7 years of this policy, debt levels have grown, and asset prices have started to become concerning. Increasing interest rates would curb the growth of US debt and asset prices, helping us to avoid another 2008-like event.

At the same time that the Fed wants to raise rates, Europe has lowered rates in an effort to stimulate its economy. Currently 10-year US government debt pays 2.3% while German debt pays only 0.7%. This interest rate differential has lead many Europeans to convert their euros to dollars in an effort to take advantage of higher US interest rates. The increased demand for dollars relative to euros has driven up the value of the dollar, making US products more expensive overseas. Because about half of sales for the largest US businesses originate overseas, a decrease in overseas sales significantly impacts corporate profitability.

The Fed is confronted with a tough dilemma. Raising interest rates can get US debt levels and asset prices under control. Unfortunately, raising interest rates will also drive up the US dollar and therefore drive down exports and corporate profitability. Just as I have to choose between discomfort in either my office or the family room, the Fed must choose between discomfort in different parts of the economy. Any adjustment the Fed makes to interest rates will create discomfort. The question is: “Who will be comfortable?”

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

How do taxes engineer your future? / May 7, 2015 by Chip Kent

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By reading hundreds of annual reports a year, I see many trends. One interesting trend is the globalization of revenue. Over the last few decades, US-based businesses have steadily grown their revenue overseas. In fact, the largest 500 US businesses now generate about half of their sales overseas.

The growth of overseas sales combined with US tax law has produced a peculiar situation. When a US business generates a profit overseas, it is first taxed by the country where the revenue was generated. When the business finally decides to bring the cash it has generated back to the US, the US government slaps it with a 35% tax.

CEOs are not stupid. When faced with the 35% repatriation tax, they decide to create factories and hire employees overseas. Furthermore, US businesses have been migrating headquarters to countries with lower corporate tax rates. As an example, a recent merger of a US and an Italian business placed the headquarters in England in order to minimize the combined businesses’ tax rate.

In a world with easy travel and fast communications, taxation becomes yet another variable to tweak in order to optimize a business’s profitability. Unfortunately, the incentives created by the current US tax law move economic and job growth from the US to countries with more favorable tax treatment. Future US economic and job growth is being engineered, either for the good or bad, by our tax law.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

Can you bargain hunt in an expensive market? / October 8, 2014 by Chip Kent

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Several partners and potential partners have asked me about how value investing works in an expensive market.

Since the 2009 bottom, the market has run-up considerably. This run-up creates angst and anxiety among investors. The natural question is: in an expensive market, do opportunities still exist for value investors? Absolutely.

In the United States, there are roughly 5,000 listed stocks that are large and liquid enough to invest in. Of these 5,000 stocks, at any given moment, some will be undervalued, some will be fairly valued, and some will be overvalued.

Our fund targets an absolute, long-term return. As a result, all stocks we purchase must clear an absolute return hurdle, before we will invest in them. Our return hurdle is simple: for us to buy a stock, we must believe that it has the potential to double to triple in price over the next 2-3 years, while posing a minimal risk of permanent loss of capital.

In a cheap market, many stocks will clear this return hurdle, making my job easy. In an expensive market, like our current one, very few stocks will clear this return hurdle, making my job more difficult. (See the chart below.)

In both situations, however, some securities exist which meet our buying criteria. Even when an expensive market narrows our pool of prospects, we still have some bargain securities to choose from. Remember, out of the 5,000 U.S. listed stocks, we only need to find 10 bargains to fill our portfolio. We can accomplish this even in an expensive market. There is a bear market somewhere.

Over time, undervalued stocks move towards fair value, overvalued stocks move towards fair value, and fairly valued stocks become either overvalued or undervalued. Stock prices fluctuate up and down. For instance, for the average stock, its yearly high is 30% above its yearly low. Clearly, the value of the underlying business did not fluctuate this much, but the stock price did.

To put value-investing in an everyday context, imagine that your neighbor Joe approaches you. Joe offers to sell you his home for half of what you know you could sell Joe’s home for in three years. Without hesitation, you immediately accept Joe’s offer. You don’t stop to check the price of the S&P 500, nor do you consider the status of any global military conflicts. You don’t even look up what changes to the Federal Reserve policy might occur. You see Joe’s bargain for what it is, and you capitalize on it.

Now imagine that a different neighbor, Paul, stops by the day after you buy Joe’s home. Paul offers to sell you his home for one-third of what you could sell it for in three years. Probably, you regret that you weren’t lucky enough to receive Paul’s offer first, but still, you never question that you got a good bargain in buying Joe’s home.

Value investing functions in the same way, but with one twist. Suppose that you receive bids, every single day, from potential buyers of Joe’s home. You don’t have to sell them Joe’s home, but you do have to look at their daily bids. Undoubtedly, these bids will fluctuate up and down (sometimes drastically), depending on which people bid, or on how many people bid, or on how the people felt when they bid. Often, their daily bids will not reflect the intrinsic value of Joe’s home. As the owner of Joe’s home, your job is to only accept the bids, once they reflect what you know Joe’s home is worth. Until you receive a bid above the intrinsic value of Joe’s home, it is best to tune out the noise of the daily auction.

As value investors, we do not buy pieces of paper (“stocks”). Instead, we buy pieces of businesses. Our job is to seek out an above-average business being sold at a below-average price, then wait for the business’s market price to reflect its intrinsic value. With 5,000 U.S. businesses being auctioned off each and every day, there will always be a few screaming deals.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent

How much does high-frequency trading cost you? / September 9, 2013 by Chip Kent

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I spent more than 7 years deeply involved in high-frequency trading (HFT). During this time, I was a senior quantitative analyst and a portfolio manager at a leading option market-making hedge fund, which engaged in HFT. This position gave me a unique view of how current incentives in the electronic securities markets encourage an HFT arms race, which hurts investors in the long term.

The securities markets began so that two parties could meet and exchange an object of economic value at a price established by market participants. In all of these markets, parties with better information had a competitive advantage, because they could adjust their supply or their demand in response to the information they received.

The telegraph’s invention ushered in a new, electronic era in which those with better technology also possessed better information. The speed of this electronic communication increased as we progressed from the telegraph, to the telephone, to standalone computers, to networked computers connected to electronic exchanges.

This last evolution -- networked computers connected to electronic exchanges -- gave birth to HFT. In simplest terms, HFT is an automated trading platform. It uses powerful computers to transact a very large number of orders at speeds faster than a human can process. By 2013, HFT accounted for about 50%, by volume, of all U.S. equities trades.

Today’s state-of-the-art computing hardware is so good that we have approached the physical limits imposed by the speed of light. A good HFT system makes decisions in a few millionths of a second. During such a short time, light can travel only a few thousand feet. This physical limitation necessitates the use of exotic, special-purpose hardware which HFT companies co-locate at the exchanges.

HFT is a double-edged sword. On the positive side, electronic trading, and HFT in particular, has significantly narrowed the bid/ask spread that market participants pay to transact, and that reduces costs to investors. On the negative side, compressing the bid/ask spread has decreased the quantity available to trade at the bid/ask, and that makes it difficult to purchase more than a few hundred shares at the bid/ask. This small quoted size leads to very thin markets. In turn, these thin markets are extremely susceptible to supply/demand dislocations, as we observed during the May 2010 “flash crash” and during similar mini flash crashes which occur in a few securities each week.

HFT contributes to these flash crashes because of the computer hardware and software that it requires. Consider how this plays out: when an HFT system receives data from the exchange, it must react instantly, adjust its calculations, and send new trading instructions back to the exchange, all within a few millionths of a second. By contrast, a human eye blink takes 300 milliseconds. That is over 1,000 times longer than the microsecond turnaround that HFT systems require.

To achieve this microsecond turn around, state-of-the-art HFT systems minimize how many computations they perform. The exotic hardware that HFT firms employ to reduce latency further constrains the number of computations. The limited silicon available on FPGAs (field-programmable gate arrays) and ASICs (application-specific integrated circuits) limits how many computations this exotic hardware can perform.

Unfortunately, minimizing computations means throwing out a great deal of error-checking, and that makes our markets very brittle. HFT contributes to problems in the markets, because it represents a huge hidden liability for the companies that practice it, as well as for their counterparties in the markets.

Knight Capital is one well-known example of HFT’s effects. In August 2012, Knight Capital’s HFT trading platform went haywire, quoting absurd prices for 148 NYSE stocks. This incident cost Knight $440M, and ultimately, its business.

More recently, in August 2013, Goldman’s HFT system quoted absurd prices to the U.S. equity options markets. Had the exchanges not nullified these trades, Goldman would have lost approximately $500M. In this instance, the ones who truly lost were Goldman’s counterparties in these trades. These counterparties traded with Goldman based on the absurd, HFT-generated prices. After the counterparties received confirmation from the exchanges of these trades, they hedged their positions with stock. The exchanges nullified Goldman’s trades, but they did not nullify these hedges. This left Goldman’s counterparties with most of the loss.

In both the Goldman and the Knight cases, error-checking was sufficiently lax for the problems to persist for an eternity in trading terms: 17 minutes for Goldman and 30 minutes for Knight. Such persistent, recurrent failures destroy trust in the robustness of the marketplace.

Our current electronic exchanges encourage HFT by design. HFT provides an enormous revenue stream for the exchanges, because the exchanges charge HFT firms fees for trading, fees for colocating hardware, and fees for data feeds. Consider just the fees for data feeds. The exchanges sell multiple data feeds of varying speeds, and the price for the fastest feeds, which HFT firms demand, is several times the price of the slowest feed. The exchanges further encourage HFT by offering volume discounts; with these volume discounts, trading more leads to a lower cost per trade.

Between exchange fees, exotic hardware, and specialized software developers, it is easy for HFT shops to spend well in excess of $20M/year just to keep their systems competitive. Indeed, some HFT firms spend well over $100M/year. Not only that, but the required overhead is growing rapidly. A technological arms race exists between the HFT firms: all firms must invest in the latest and greatest technology, as soon as one competitor does.

For a $100M firm, this overhead of $20M/year amounts to an annualized expenditure of 20%. However, for a $1B firm, this overhead represents only 2% annually. Clearly, this puts better capitalized firms at an advantage.

If we allow this technological arms race to continue, it will significantly decrease competitiveness in the marketplace. Quite simply, smaller HFT firms will be unable to bear the overhead to stay in business. We are on an unfortunate trajectory to have just the four most capitalized HFT firms provide liquidity on the exchanges. This decreased competition is not good for investors.

The current paradigm is one of brittle, thin markets with little competition. Shouldn’t we change this paradigm for the better? Change starts by recognizing that a difference exists between HFT and electronic trading. In the computer age, we should expect our markets to be electronic. Computers are much more efficient than a bunch of men yelling at each other on the exchange floor. On the other hand, these yelling men can pause to think before mindlessly executing a trade. If we choose to slow down the electronic speed game, then we could (1) give the machines more time to contemplate the consequences of their actions before submitting an order, and (2) increase the competition between firms providing liquidity in the market, since reducing the speed would likewise reduce the required overhead.

If the SEC enacted a few simple exchange requirements, it would have these results: (1) it would drastically slow down the pace of trading, (2) it would provide electronic trading systems with sufficient time to check for errors, and (3) it would not put careful firms at a disadvantage to their competitors.

What might these exchange requirements be? First, the exchanges should add a random delay to all submitted orders before it activates them. Second, the exchanges should enforce a minimum lifetime for all orders before they can be canceled. Third, the exchanges should remove volume discounts for trading. This would reduce the back-and-forth churn in the market.

A delay of 0.1 seconds is unnoticeable to a human, but it is an eternity for a computer. To us, this delay is microscopic, but it would provide sufficient time for error-checking for an HFT system running on even low-cost hardware.

The exchanges are now publicly traded companies, so they must answer ultimately to their shareholders. If we slow down HFT trading, it will kill the exchanges’ HFT revenue stream, and that will be bad for their businesses. As a result, we should not expect the exchanges to initiate or to go along with reduced-speed trading. Instead, it is most likely that change will have to be forced upon them.

Before the rise of HFT, each communication improvement came with error-checking by humans. However, the current generation of HFT technology has less and less error-checking, both by humans and by computers. We can have markets which are robust, electronic, and competitive, but to achieve this goal, we have to end the HFT arms race. Slowing down the speed of trading will not be easy, but ultimately, it will produce the best results for investors and for the markets.

David R. “Chip” Kent IV, PhD
Portfolio Manager / General Partner
Cecropia Capital
Twitter: @chip_kent