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?

I hope everyone had a nice Thanksgiving! While we were eating our turkey the leaders of OPEC met to discuss their plan for oil production. As the price of oil has dropped dramatically many traders had expected OPEC to drop its production in an attempt to lower supply and get prices moving upward once more. They did not, and while most were shopping on Black Friday, the markets we follow here at Iron Capital were getting hit, especially in the energy sector.

For those who have not noticed, there has been an energy boom going on in North America. New technology has allowed oil production in the U.S. and Canada to reach record levels, which has changed the balance of power in the world of energy. One of the reasons OPEC did not cut production is that they knew doing so would only allow non-OPEC members, mainly us, to gain even more market share. Some assume this means OPEC wishes to crush U.S. and Canadian oil producers in a price war, but I don’t believe that is the case. If that were true, OPEC could have voted to increase production; at least they claim they could do so.

No, OPEC’s move is a realization that they are losing their power to control oil markets, and as a result also losing their ability to use oil as a political bargaining chip. Had they cut production, the gap would simply be filled from the West. This has happened in spite of anti-energy government policy; imagine what could be done if we had more balanced policy.

Alas, we are not here to discuss government policy, we are here to invest. What does this mean for investors? Short-term traders seem to think it means an end to oil production and the entire energy sector in the U.S. We think that is a typical Wall Street overreaction. Oil prices were bound to drop with all the new production; the real surprise is that it has taken this long. While the lower price of oil may hurt those directly selling oil, it is not likely to stop the drilling. Most wells that are producing today were planned and started years ago. As recently as 2009 oil prices averaged $61 per barrel. The vast majority of oil operations in the U.S. and Canada are still very profitable with oil at these levels, and as long as they are profitable they are going to keep pumping oil. As an investor we have long recommended that the prudent way to take advantage of this environment is by owning the companies that are selling the shovels, not the prospectors looking for gold (or oil).

The knee-jerk trading response has been to hurt these companies as well. It is times like this that provide the greatest opportunity to long-term investors. It is also times like this that test the investor’s discipline. It is difficult to invest in companies that are temporarily out of favor with the trading crowd, but that is exactly where long-term opportunities are the best. Nothing has changed in the energy world that impacts the long-term reality. The companies that we follow have all continued to exceed our expectations in their real-world operations even as traders attack their stock. These types of disconnects are the cloth from which long-term opportunity is cut.

I was unfortunately under the weather last week, so this Insight did not get out before the Thanksgiving feast. However, even in bed with a fever I have much to be thankful for and this is the annual list:

1. I am thankful for irrational traders that bestow long-term opportunity on those of us who are willing to see it.

2. I am thankful for the opportunity to coach my son and his teammates (the Whale Sharks) in basketball for another season.

3. I am thankful that my beloved Wake Forest has a new coach and this rebuilding year may actually be just that, a year upon which they can build.

4. I am thankful for my family, immediate and extended.

5. Of course I am still grateful for Mama’s pumpkin cheese cake even if I didn’t feel well enough to partake as freely as I would prefer.

6. Last but certainly not least, I am thankful for you, our clients and friends of the firm. Your trust in Iron Capital is our greatest asset and we value you every day of the year.

Warmest Regards,

Chuck Osborne, CFA
Managing Director

~OPEC Turkey

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”
~ John Maynard Keynes

Our instincts on the market downturn seem to be correct. We touched the magic ten percent correction threshold and the market has been rallying since. Predicting the future is impossible of course, but the odds favor a continued rally from this point. There are two questions which we received during the course of this downturn that deserve to be addressed.

The first is, “If you knew the market was going to go down ten percent, why not get out the then back in?” The second related question is, “How are you so sure this isn’t something more serious than a correction?” The answer to the first question is that if we could time that type of thing perfectly we would, but we can’t, and no one else can either. Timing market corrections is a fool’s errand. It is always tempting and it always seems like it would have been so easy in hindsight. That is because in hindsight we see only what did happen and we tend to believe, incorrectly, that what did happen was the only possible outcome.

In reality lots of things could have happened. It is never exactly clear in real time when corrections have begun or when they are over; that becomes clear only after the fact. The market could have bounced back after dropping four or five percent, as happened several times since the last correction. The market could have gone down twelve or fifteen percent; the ten percent rule of thumb only holds true because it is a self -fulfilling prophecy. The text books say ten percent, so people expect ten percent, so the traders come back in at ten percent. It is self-fulfilling, and usually holds, but the few times it doesn’t tend to be bad, so jumping back in just because the market hit the magic ten percent rule is risky. The best thing to do during corrections and in their immediate aftermath is ride them out and look for opportunities to potentially rebalance.

The second question has to do with our fundamental belief in investing from the ground-up, one security at a time. For prudent investors investing is all about the price one pays for the future cash flow one is likely to receive. In the stock market that means the earnings of the companies whose stock one owns. For a bear market to occur there must be a disconnect between stock prices and actual company earnings. In 2000 it was the prices that had gotten crazy. That was a fairly easy thing to predict, although most who predicted it did so two or three years before the actual bursting of the bubble.

In 2008 the prices seemed fine; it was the earnings that disappeared. Those markets are harder to predict. We predicted it in January of that year when unemployment began its rise. The poor market had actually begun in the fall of 2007, but it got worse because the real economy was deteriorating.

This time prices are once again okay, so for the market to really tank, earnings would have to take a big hit. For that to happen the economy must shrink, and that is not happening. Having said that, one of the catalysts for this latest downturn was the International Monetary Fund (IMF) revising their economic outlook downward. That sounds, bad doesn’t it? Until one realizes that the IMF has had to lower their economic outlook 100 percent of the time since 2011 – the approximate end of the European Debt Crisis.

What has happened over the last few years is that the economy itself has been extremely stable. It has been sluggish for sure, but the slow crawl has been very steady. During this same period, however, the forecasts have continued to swing wildly. Central bankers, the IMF, and economists in general have not adjusted to the reality of this slow economy. This is largely due to their unswerving belief in the power of government to steer an economy through fiscal and monetary policy.

Many of those believers call themselves Keynesians, after John Maynard Keynes who was the source of many of their beliefs. Keynes himself had a very nimble mind. In his career as both an economist and a money manager he allowed new information to change his mind. I have often wondered, if Keynes were alive today would he be a Keynesian? I rather doubt it. The man who once said, “The difficulty lies not so much in developing new ideas as in escaping from old ones,” must be laughing in his grave at the idea that his ideas are now the old ones.

Regardless, nothing of substance has changed in our economic reality from the beginning of October until now. Prices are reasonable, the economy is not tanking, and investors are still well-served staying invested.

Chuck Osborne, CFA
Managing Director

~The New Math, Same as The Old