As markets continue to take three steps forward and two steps back there has not been much to talk about. Of course all the financial television channels are still in operation, as are the web sites, tabloids, newspapers, etc. Today it seems they are really in the noise business, not the news business – I don’t mean that disparagingly, it’s just reality. Most days there is not enough actual news to fill the 24/7 news cycle, so they must share all the extraneous noise to fill air time.

Last week one such piece of noise was what Federal Reserve Chair Janet Yellen thinks about the stock market. She said, “I would highlight that equity market valuations at this point generally are quite high.” Her comments caused some short-term traders to hit the sell button and we have seen a few days of volatility.

Her comments reminded me of a conversation I once had with the CEO of what was then INVESCO Retirement Services. He had spent a lengthy, storied career in finance and related industries. Among other positions he had been a banker; he headed up the Office of the Comptroller of the Currency during the Carter administration; and he was formerly the CFO of INVESCO before moving to their retirement division. He asked me to design an investment education program for the non-investment professional employees because, in his words, “Everyone thinks they are an expert in investing, but they really know very little.”

He went on to explain how only after working with real investment professionals had he realized how little he knew about investing. The outside world thinks that anything financially related is investing-related. Allow me to let you in on a secret:  Your CPA has no more training in investing than your plumber, and your friend at the bank knows no more about it than your friend at the florist. (And, by the way, I am neither a banker nor an accountant.)

In areas like law and medicine people seem to realize that their podiatrist is not the right person to ask about a heart condition. They don’t call their corporate lawyer on a criminal matter. They understand that we live in a specialized world and being knowledgeable in one field does not give one expertise in another. This is partly because there is a recognition of the education level required for those professions. The practitioners themselves are highly educated, and to paraphrase Albert Einstein, the more they know, the more they realize what they don’t know.

Investing is another story. Many people know a little about investing, and a little knowledge is a very dangerous thing. Many of the investment industry’s wounds are self-inflicted – we have allowed the sales clerk to be elevated to “financial adviser,” which leads many among the general public to think (often correctly) that they know just as much about investing as the average financial adviser. Dangerous indeed.

Back to Yellen. Ms. Yellen is undoubtedly a very bright economist, but there is nothing in her background that would suggest one should follow her investment advice. However, that does not answer the most important question:  Is she correct about equity market valuations? Well, it depends. Are you invested in the stock of Chinese Internet company Alibaba, which is selling at a price which is 47.43 times greater than its earnings, or are you invested in offshore drilling company Atwood, which is selling at a price which is 6.09 times its earnings?

Prudent investors invest from the bottom-up. Knowing if the stock market as a whole is correctly valued is a nearly impossible task. Knowing if a specific company is correctly valued is much easier. There are plenty of good opportunities in the market today. One just has to look, and perhaps have more than just a little knowledge.

Warm Regards,
Chuck Osborne, CFA

~Everyone Is an Expert

This is a great time of year for sports fans. The NCAA Basketball Tournament, better known as March Madness, is one of those events that transcends sports as a cultural phenomenon. People who have not watched a basketball game since last March will sign up to enter their office pools and fill out brackets. The tournament always produces great drama and wonderful background stories.

Of course, as most of our readers know, I like watching basketball all the time. I have coached youth basketball for the last few years, and just this past season I was explaining to a bright young woman with a feisty competitive demeanor that if she wanted to try and steal the ball away from the player she was guarding, she needed to reach straight out, and not slap down. I explained that the referee would call a foul if she slapped down, but likely would not if she reached straight out. She then asked a question which showed her youth and innocence, “Why would the referee call a foul if I don’t actually touch the other player?” I tried to explain how referees are just human, etc., but as her eyes glazed over I resorted to the same answer my coaches had given me so many years ago. “There is no why, it just is what it is.”

I have been reminded of that this past week in my day job as well. Oil has revisited its lows and everyone is on edge over the Federal Reserve (Fed) and the potential raising of interest rates.

Let’s tackle the Fed issue first. Every Fed meeting in recent years has been covered by the financial media as if it were some big event on the scale of March Madness. The pundits line up to talk about when they will raise rates. They all seem to think it is going to happen very soon. I heard one commentator this past week suggest the Fed would raise rates at every meeting this year. Then the Fed does not raise rates and tells everyone very clearly that it will not raise rates until inflation is higher than the Fed’s two percent target.  Inflation is nowhere near that level at the moment, but the financial channels are full of people pontificating on why the Fed’s measures for inflation are wrong or why the Fed’s policy in general has been wrong. They may be or may not correct, but the Fed isn’t going to change either way. It is just like that young man you will likely see on TV this weekend pleading his innocence as he is sent to the bench with his fifth foul. He may very well be innocent. In super slow motion we may be able to see that no foul actually occurred, but if he slapped at the ball, the foul will likely be called.

The Fed has told us clearly what they will do. All one has to do is look at that same information they have and one will understand that no meaningful interest rate hike is on the horizon. If they do anything this year at all it will likely be a token move to test the market reaction.

The other interesting story in my world has been that oil has revisited its lows – and has once again bounced, but that isn’t as interesting so it won’t be discussed. As with the Fed and interest rates, the fascinating part of this story is the reason given. Wall Street is determined to make this about actual supply and demand for oil. They are now focusing on the amount of oil being stored. More people are storing oil today because futures markets indicate that the price will be much higher in a few months than they are now, but somehow in TV land this means that prices will be down. While this negative story is being fleshed out and everyday there is another negative oil story, the price of oil has already bounced back approximately 12 percent.

Oil revisited its low because oil is a commodity, and commodities have no fundamentals, no earnings and no intrinsic value. Securities are traded in the market based on two theories. One is fundamental analysis – what is a company actually worth; the other is technical analysis, which is the study of price movements. Technical analysis is not highly regarded outside of Wall Street because it has no intellectual underpinning. Prices don’t actually move in patterns, but humans are hard wired to see patterns even when no pattern exists. Technical analysis should not work, but it sometimes does because of the laws of self-fulfilling prophesy. Enough people think technical analysis works to make it work for short periods. There are many technical rules which have this attribute, but the one in question here is that lows must be “tested”. The stocks of companies have real fundamentals which often override technical mumbo jumbo, but technical analysis is all commodity traders have, so the lows are bound to be tested. There is no other reason why oil prices revisited their previous lows and are now seemingly on their way back up.

Sometimes it is good to not over-think things. Sometimes “it is what it is” is a valid answer. Interest rates are not going anywhere anytime soon, oil prices are going to go back up, and over the next two weekends we will see some mystery fouls called because a defender made that dreaded slapping move. It is what it is.

Chuck Osborne, CFA
Managing Director

~It Is What It Is.

This past week all anyone wants to talk about seems to be Pete Carroll’s judgment, or lack thereof. For those who may have missed it, Pete Carroll is the head coach of the Seattle Seahawks who many think would have won the Super Bowl if he had simply called a run instead of a pass on their last offensive play of the game. As it was he said to throw, and throw it they did – right into the arms of the New England Patriots.

We’ve spoken about this before, but it is always amazing to me how coaches are judged by the outcome of their decisions. I played football through high school and have been a fan all my life, and I know that I do not know enough about football to have an informed opinion. From what I have seen most knowledgeable people think that the decision wasn’t the problem; it was just poor execution. However, according to the masses it didn’t work so Carroll is an idiot. Had it worked, he would be a genius and they would be saying how brilliant it was to throw it when everyone expected a run. Many fans seem to believe that whatever happened was the only possible outcome and should have been foreseen.

Some people have the same outlook on financial markets; they believe what happens in the markets must always be the only outcome that could have happened and, perhaps more importantly, the “right” outcome. However, that is not the case at all. Markets are irrational and subject to overreacting. While this has always been the case, there are two modern phenomena that seem to be making it worse.

The first is the increasing influence of computerized trading. Computers can do lots of things well, but judgment really isn’t one of them. My wife and I saw a now-favorite sign on a pub wall in Scotland that read, “Good judgment comes from experience. Experience comes from poor judgment.” In other words, as one ages and learns from mistakes one starts to realize the importance of things like context. For example, it turns out that during the course of the NFL season more than 100 passes from the one yard line had been attempted. Not one of those passes was intercepted until that very last pass. Context changes things a bit, doesn’t it?

Increasingly in the financial world we see this lack of context and I believe it is because of the increased use of computerized trading. For example, take the drop in oil prices. The price of oil has gone from more than $100 per barrel to the $40 range and is now in the low- to mid-$50 range. Last week data came out showing a slight increase in the supply of oil, and the price immediately dropped more than four percent. In the past news like this would have been put into context. Yes, oil supplies are higher, but only slightly, and we have had a more than 50 percent drop in the price already. But, computers don’t do that. They do “supplies up equals sell” orders.

This phenomenon is causing greater price swings than in the past. Human traders may still have a short-term mentality, but they would look at that situation and say that the bad news is already baked into the price. In fact two days later that is what has happened as oil prices have rebounded and then some, but on that day, one data point taken out of context created market volatility.

The second phenomenon is the trading of Exchange Traded Funds (ETF) as a replacement for individual stocks. Many traders are trading entire industry groups through the use of ETFs instead of just the stock of a single company. When a company reports poor earnings, the computer says “poor earnings equals sell,” and instead of selling the stock of that company the computer sells the ETF of the company’s industry.

The problem is that there are at least two different reasons a company may have poor earnings. First, their entire industry is down, in which case selling the ETF may be logical. Second, and more often, they are getting beaten up by one of their competitors. In that case selling the ETF does not make any sense because what you have is not a bad industry but a winning company and a losing company. The winner is also in that ETF, so why would one sell them? Poor judgment.

Both of these phenomena are causing increased volatility at the individual stock level. Both are very annoying to long-term investors, but they are also creating opportunities. Traders see the buying and selling of financial instruments the same way they see a football game. They believe the game ends and you either won or lost.

That is not how investors see the world. The game never ends, the outcome is never certain, and one knows only where they are along the journey at that moment. The traders don’t really care how illogical their actions are as long as they are able to get out fast enough to make a small profit…which means these phenomena are not going away. As investors we have a choice: we can cry about it, or take advantage of it.

Fortunately for investors our entire season never rests on one throw; we get to diversify. No official ever blows the whistle; we get to keep playing and exercise patience. If one makes calls that work more than one hundred times before not working once, then over time he will do very well. Good judgment – prudent decision-making – does not guarantee instant success, but it does produce lasting success.

Warm Regards,

Chuck Osborne, CFA
Managing Director

~Judgment

Anyone who has been reading our Insights and “The Quarterly Report” for a long time knows that I love sports. I especially love college basketball, which is easy to do when you are born in the middle of what college basketball fans refer to as Tobacco Road. Readers are also aware that my favorite team is the Wake Forest Demon Deacons.

It has been a tough few years to be a Deacon fan, but this year there is hope. Wake hired Danny Manning as the new head coach of the Wake Forest basketball program, and for the first time in a long time, the future appears bright. Last year at this time the Deacons had won 11 games and lost five, while this year they have won nine games and lost eight. This year they are a much better team.

That may seem like a strange comment to some, since 11-5 is a better record than 9-8, but while the record may be the headline (and to some the bottom line), it doesn’t tell us everything. Last year’s team played a very weak schedule up to this point. This year’s team has not run away from any challenges. More importantly, however, this year’s team is getting better with every game. They learned from those losses and they are improving. Last year’s team had potential, but time and time again failed to live up to that potential. They did not improve and from this point on in the season won only five more games and lost 10. The future is always uncertain, but that does not seem very likely to happen again this year.

Headlines are often misleading, and that is certainly true in investing. Throughout 2014 we kept hearing about the major market indices reaching record highs. Many people then believe that means the market is doing great and it is a wonderful year, but that is not entirely true.

It was a good year for the S&P 500, which ended up 4.93 percent, but that is just the average of the 500 largest companies in the U.S. and even that average is skewed by the few who did really well. Small company stocks did end the year in positive territory, but they were up only 4.89 percent as based on the Russell 2000 index. International stocks were negative for the year, with the MSCI EAFE Index ending the year down 4.48 percent. Over the last six months international stocks are down 9.16 percent, while small company stocks are up only 1.65 percent over that time period. Bonds have been flat, returning 1.96 percent for the last six months based on the Barclays Capital U.S. aggregate bond index. The Merrill Lynch High Yield index is showing a loss of 2.94 percent.

Under the surface of a few headline indices, 2014 turned out to be not such a great year. Unlike basketball teams, that does not mean more losses ahead. In fact it is often the opposite in investing. Not-so-great returns often provide better opportunities. Remember, the stock market is simply a store, and when prices go down, the merchandise becomes more attractive to buyers.

The year 2015 starts out with what appears to be some fantastic long-term opportunities in areas like energy-related companies where the market has overreacted. So maybe the stock market is like my beloved Deacons: the 2014 season ended with a record that was worse than it appeared on the surface, but the future appears bright.

Happy New Year!

Chuck Osborne, CFA
Managing Director

~Behind the Headlines

I am getting a lot of questions about the price of oil these days. Mainly people want to know how low we think it can go. Of course, the investing world seems to have a very short memory; it was only a few years ago when people were asking how high it could fly. The answer to those two questions is the same: I have no idea, and neither does anyone else.

The bigger issue here is why in the world is anyone who is not in the oil business, buying and or selling oil? Why would anyone invest directly in a commodity? The problem with investing in oil is that it is just oil. It produces no cash flow, it is not dynamic; it is simply oil. Just a few years ago I noted that if you buy a barrel of oil and bury it in your backyard, then dig it up twenty years later, it is still just a barrel of oil. You are just hoping someone will pay more for it. That does not make for a very good investment.

Few listened. Investing in commodities has been a big fad over the last several years. It is hard to find a “model portfolio” being pushed by any Wall Street firm that does not have at least a five percent allocation to commodities. Institutional investors have bent over backwards to get so-called hard assets, i.e. commodities, into their portfolios. The extent to which this was successful is demonstrated by what has happened.

OPEC reported earlier this week that they expect the demand for oil, from those planning to actually use it, to drop by 200,000 barrels a day. That sounds like a lot, but the world’s daily consumption of oil is approximately 90,000,000 barrels. That 200,000 barrel drop is less than one quarter of one percent. In other words, the demand for oil has not materially changed.

It is true that the western hemisphere’s energy boom has increased the supply of oil, but that has occurred over many years, not since July 2014. So, demand has not changed and supply has not changed, yet the price of oil dropped 40 percent? This tells us that the actual price of oil is being set by commodity speculators (and there is no such thing as a commodity investor), not by the actual supply and demand for oil.

As we discussed when the price of oil was going in the other direction, investing in oil-related companies is another matter. Stock in a company is much different than a commodity, even if that company’s business is related to a commodity. Companies are dynamic; they change. Twenty years ago Amazon was a hot dot-com book seller, while Sears and Kmart were big blue chip retailers. Today Amazon is a blue chip “old tech” retailer of everything and many believe that Sears, which has since purchased Kmart, will cease to exist as a retailer within a few years.

But how does one know which companies are worthy of investment? One knows by exercising prudence, selecting companies from the bottom-up – meaning he invests in a company because of the growth and financial strength of the company, not because he thinks he knows what the price of their products will be next week. The drop in oil prices has shown this. In the short term all energy-related companies have been hurt in the stock market as speculators are either panicking or taking advantage of other people’s panic. Some of those companies are getting what they deserve and others are babies being thrown out with the bath water.

Seadrill is an offshore drilling company whose stock price has gone from $41.29 per share to $11.56 per share. This company was extremely aggressive in expanding and has done so primarily from borrowing money. Investors who look from the bottom-up see a company that is very risky because of its debt level. Sure enough, they have had to cease their dividend payments, and if oil stays down they may have to restructure the company in bankruptcy.

Helmrich and Payne is another driller, mostly on land in this case. They have managed their growth in a more balanced way. They have a strategic advantage in fracking technology, which lowers cost, and they have a strong balance sheet. Their net income per rig is still correlated to oil prices, but in 2009 when oil’s price was where it is today they made $1.4 million in net income per rig. This year they make $1.9 million in net income per rig and they have 135 more rigs than they did in 2009. Even if per-rig net income goes back to 2009 levels that is still solid growth over that time period. They have a strong balance sheet with a debt level that would be manageable in the worst of scenarios. This company has  been strong and if anything will likely benefit from the increased demand from oil – which is what happens when prices fall – and the increased market share as more aggressive competitors are unable to whether the storm.

I have often spoken about prudent investors avoiding loss. The loss of which I speak is the permanent loss of capital. Those who invested directly in oil have likely just experienced such a loss; so too have top-down investors who invested in highly leveraged companies. Prudent investors, while not immune to short-term nonsense, will nonetheless come out even stronger in the end. The carefully selected companies are strong enough not only to maintain in any environment, but also to gain market share as less prudently managed competitors meet their fates.

There is much to be learned here. The companies I highlighted are for educational purposes; these are not specific recommendations. It is the big picture one needs to see here. Prudent investing is done from the ground-up. It is absolute return-oriented and it is risk averse. This drop in oil prices is a good example of why those three things are so important to long-term success.

Chuck Osborne, CFA
Managing Director

~How Low Can it Go?