Blacksmiths and Tesla
Many investors want to know if the market is going up or down. It doesn’t matter.
Many investors also want to know who is going to win in this era of disruption. That’s also hard to tell. But it is almost boringly easy to find those companies that will lose.
Many investors want to know whether the Federal Reserve in the US is going to raise rates. If you’re invested in extraordinary businesses with competitive advantages that are sustainable, that doesn’t matter either.
What does matter is remembering that as value investors your job is simply to buy at attractive prices, pieces of extraordinary businesses, whose earnings will be materially higher in ten or fifteen years time.
In this era of creative destruction, transition and disruption, finding the winners however can be a challenge so it’s worth exploring strategies that can win even if you cannot easily isolate the winners. And that’s where selling the losers might be worth discussing.
Here’s an example of the challenge of picking winners: It’s clear to us that investors are currently enamoured with the recent emergence of electric cars and with Tesla. The electric car company is changing the world one car at a time and having just installed their supercharging stations in Goulburn and Wodonga along the Hume Highway, it’s easy to get excited about the potential. But BMW who are also producing electric cars, sell a total of two million cars per year, while Tesla only sell 50,000 cars per year. It simply makes no sense that Tesla’s market cap is almost half that of BMW’s. It’s not unusual for many competitors to emerge in a new, world-changing industry but generating positive returns can be hard when there are so many potential winners and/or the prices are way too high.
When the “horseless carriage” first chugged past the blacksmith, it would have been impossible to know which start-up car manufacturer would survive and prosper. It would however have been far easier to conclude that the blacksmith was a goner no matter who won the race to automotive nirvana.
By building a portfolio of extraordinary global businesses and simultaneously selling a portfolio of blacksmiths not only can you add all-important alpha to your portfolio but you can also reduce your net exposure to the vicissitudes of the market. For example, if you buy $100 worth of outstanding businesses and sell a $60 portfolio of ‘blacksmiths’ your net exposure is $40. If the market fell ten per cent, you would expect to see your portfolio decline by only four per cent.
And here’s how selling the losers works: Suppose your neighbour owned a brand new Toyota Camry and you knew that the local Toyota dealership was going to hold a Christmas sale on Camrys at 50 per cent off. If you borrowed the neighbours car and sold it at, say $30,000 you’d put $30,000 in the bank. If you then later went along to the car yard sale and bought a new Camry for $15,000, you could return a new car to your neighbour and keep $15,000 profit. Everyone’s happy.
If you cannot find a prime broker willing to allow you to build a short portfolio of blacksmiths, find a fund manager that can do it for you The Montaka Global Access Fund might be an appropriate place to start). In this age of low returns, it is essential that investors find reliable ways of generating returns beyond those available from miserly yields on stable low growth companies.
Stocks are indeed the place to be. They generate a similar yield to bonds but in addition they offer the opportunity to grow income through their retained earnings. Obviously the less you pay for this upside optionality, the more likely you are to succeed. With that in mind, you can also add meaningfully to your returns by selling the blacksmiths.
So who might be the blacksmiths of the world?
McDonalds is struggling to find its mojo and franchisees are wanting out. Despite thousands more stores being added to the network over the last few years, revenue hasn’t risen a dollar.
The metallurgical coal company Teck Resources recently announced a long-term streaming agreement to forward sell silver production. The problem is that at the current rate of cash burn the money it earns from the deal will be gone in 12 months. At the same time the cash it raises only reduces its debt by eight per cent. Meanwhile met coal is in oversupply, China demand is weakening and costs are in a deflationary spiral meaning supply will not be cut for some time.
Over at Prada, the company has been using store growth to mask deterioration in per-store sales, which equates to a deterioration in margins as operating leverage works in reverse on a per-store basis. The company is also negatively exposed to the Beijing corruption crack-down. Despite reinvesting circa 80 per cent of Net Profit After Tax in new stores, earnings are declining. The rate of decline is equivalent to a negative return on invested capital of 113 per cent and is destroying value!
Most recently the company has started to postpone the opening of new stores.
Finally, at Barnes & Noble, the US based brick & Mortar retailer of books, CD’s DVD’s and Vinyl LPs , the company is in what appears to be structural decline.
Revenues are declining by about ten per cent year on year and the company is losing against competitors like Amazon, Apple and WalMart. This is not going to change any time soon. Some investors might point to the fact that company also has a digital e-Reader business but this product competes with the iPad and the Kindle and is declining at 28 per cent year on year. And despite all of this, negative same store sales growth and store closures, consensus analyst estimates still has Earnings Before Interest and Tax margins increasing.
The world is a dangerous place and investing your life savings is not easy. Instead of looking to predict the direction of markets, find and buy companies with the brightest of prospects and sell a portfolio of blacksmiths. You will not only profit from disruption but you can reduce your overall exposure to uncertain markets as well.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Joe
:
Yep, completely agree Roger! Seth was actually defending short-sellers, his article discusses how both short-sellers (in times of irrational exuberance), and traditional long-only value investors (in times of panic) play an overall beneficial role in dampening the extremes of market volatility.
Richard
:
Hi Roger,
One of the difficult things with regard to Australia is that there is a issue with the ability of the aging population to actively participate with their $$$ in the new economy. As an example take NetFlix subscriptions in Australia. Older household penetration is just 1.5% and there are more older households than any other type, they also hold that vast majority of wealth in the country. I’m confident there will be some fantastic disruptive technology built by the younger generations in years to come – the challenge will be getting the baby boomers actually using their $$$ in this economy. Otherwise identifying local dinosaur businesses will prove very difficult. It seems that they are on a different product cycle to the rest of us.
Roger Montgomery
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Hi Richard, Interesting point. A counter point would be that many of these new-world businesses do just fine without their dollars.
Hedley Calvert
:
If picking the losers is easier than picking winners, is it fair to say that the fund that can pick winners and losers is more likely to outperform a fund that can only pick winners (i.e. Montaka v Global Fund)? Also is there much of a difference in net currency exposure between your Global Fund and Montaka Fund. Just after investing in your Global Fund, you opened up the Montaka Fund to smaller investors, something I’m very interested in and would like to understand the key differences from a risk and return perspective.
Roger Montgomery
:
The Global Fund can also protect capital by retaining a flexible amount of cash. The Montaka Fund can do the same and hold a sold portfolio. I think its fair to say both have the ability to outperform but the pattern and profile of returns will be different. Call the office Hedley and request a MONTAKA GLOBAL ACCESS FUND FACT SHEET and the most recent Performance Report for The Montaka Global Fund, that should answer many of your questions and probably a few more. Of course if anything is unclear be sure to seek and take personal professional advice.
Joe
:
Hi Roger,
Continuing from Carlos & your response, I tend to agree with Carlos.
In a negative performing equity market, you are correct but for over 100+ years the average return of the market has been at least 5% so in effect you are rewarded handsomely for some capital protection but the investors are being charged excessively when the markets are performing well e.g. in years when share markets perform at 30%+
Regards,
Joe
Roger Montgomery
:
Hey Joe, Lets not use averages over 100 years to distract investors from the fact that are many 10, 15 and 20 years periods where the market has provided a zero return. Lets also remember that the Montaka Global Fund’s 13.87% return for the first quarter is AFTER all fees and expenses. Yes in a strongly rising market you might expect the sold portfolio to provide some drag – just as cash does in a conventional managed fund. But the benefits of downside protection is important to investors who need to preserve capital in all market conditions that are likely to eventuate. Remember if you lose 50% you need to make a 100% return on the remaining capital just to get back to square. By protecting the downside in negative years, you have a higher platform from which to move onwards. The Montaka Global Access Fund is a fund you might consider to compliment other investments. Finally it is worth pointing out that the best returns in the stock market have occurred when interest rates have been falling and corporate profits as a percentage of GDP have been rising. The worst returns have been when rates have been rising and profits have been declining. We are now at record low interest rates (they can only rise from zero) and corporate profit margins are at record highs (and these are mean reverting). That suggests low returns are likely in the future from markets generally (the new normal). Montaka appears to be a fund for the times. Of course be sure to seek and take personal professional advice.
Joe
:
Hi Roger,
Any tips/tricks on how the average small investor can actually go about executing a short-selling strategy? Also, how does one make sure that poor future prospects aren’t already reflected in the price of the security?
On a random note, here’s an interesting article for other blog readers – Seth Klarman (famous value investor) talking about the benefits to the overall market of short-sellers.
http://www.businessinsider.com.au/seth-klarman-the-demonization-of-short-seller-2011-3
Cheers,
Joe
Roger Montgomery
:
As value investors we have more of a problem with the nonsense that is index investing than we ever have with short selling. Even as value investors we have a tough time picking the winners from disruption for example, but we can easily identify the losers. Klarmans approach to value investing (asset plays for example) is different to ours and may be one reasons e differ on the short selling philosophy. When you buy a car you are supporting an industry that caused the demise of blacksmiths and yet we all happily own and drive cars. In a business world of competitive pressures and disruption, short sellers aren’t putting anyone out of business – and certainly not the brand we practice.
Carlos
:
agree with you that stocks are the place to be and about buying quality businesses but it really surprises me that the Montaka fund uses as its performance fee hurdle the US 10 yr bond rate ( currently about 2%…). I find it very hard to understand using that as a performance benchmark when investing in stocks. So for example if the stockmarket rises 20% in a year but Montaka returns only 10%, the investors are charged performance fees because Montaka beat the 10 yr bond rate by 8% ! …….
Roger Montgomery
:
Hi Carlos,
Think capital protection with a portfolio of as many sold stocks as those that are purchased. In the last quarter the US was down 7%, Australia Down 6.5%, China down 28% and Hong Kong down 21%. Montaka was up 13.87%. We are using a return benchmark that is positive even in negative equity markets.