Flying Blind, Undated Call Options And Emmylou
The following was originally published on Tim Melvin's Community Bank Investor Monthly.
Frank Martin of Martin Capital recently penned a shareholder letter to investors in his Hummingbird Value Fund and as always, his thoughts are a worthwhile read. If you have never read his book A Decade of Delusions: From Speculative Contagion to the Great Recession, it should be on your must read list.
No less than Warren Buffett is a Martin fan, saying “For many years I've enjoyed reading Frank Martin's letters. This collection contains much investment wisdom and, just as important, sets a standard for the advisor-client relationship." Mr. Martin refers to his style of investing as "Winning by not losing" and has pretty much achieved that lofty goal during his career. He side-stepped the crash of 1987 after getting long near the early 1980s bottom, and he was profitable in the internet bust.
In the last market debacle he started shorting investment banks like Bear Stearns, Merrill Lynch and Goldman Sachs Group Inc (NYSE: GS) in 2007. In an interview in the fall 2013 edition of Graham and Doddsville, the excellent publication from the Columbia Business School where value investing was born, he said “It was pretty easy to see that what I called 'The easy money fool’s rally' of 2003 -2007 was going to end badly. You couldn’t describe it exactly. Ben Graham said 'You don’t have to know a man’s exact weight to know if he’s obese.'”
Mr. Martin’s latest letter is once again waving a bit of a red flag. He writes that “Our policymakers are flying blind and if we, as risk-averse, absolute-return investors, fall into lockstep with our peers we are certain to join them as all-too-witting victims in a loser’s game. Harking back to career risk, the irony is that we can only win individually if in the long run our clients win collectively. Otherwise, when months become years, the outcome will be mutually assured misery. The quarter-to quarter performance battle is not so easy. Winning the war rests in large measure with the patience and understanding of the clients we serve. In pursuit of our mutual gain, we must leave the false security of the herd and reject Keynes’ admonition, 'It is better to fail conventionally than to succeed unconventionally.' In the simplest of truisms, if we think and act like everyone else, we cannot expect to be above average. We have no choice but to take the lonely road less traveled.”
Mr. Martin also suggests that markets are overheated and overvalued here. He wrote in is letter “No matter what reputable valuation metric one chooses, whether Tobin’s Q, the ratio of the total market of U.S. equities to corporate net worth, or Bob Shiller’s CAPE (cyclically adjusted price-earnings ratio), the message is the same. In the aggregate, the S&P 500 is very expensive and, as we will willingly acknowledge, can remain so for an uncomfortably long time. But we can also unequivocally state that following every other secular bull market since 1900 when the market was as expensive as today’s, real compounded annual returns, including dividends, sank to 3% or less by the time the subsequent market trough was reached.
Although rarely mentioned by other longview investors, it is the psychological trauma that is the undoing of most investors during agonizingly long bear markets. The six months between September 15, 2008, and March 19, 2009, hardly qualify, when prices seem inexorably to recede with no end in sight, in a pattern of one step forward, two steps back. Hope soon fades to despair, and during vicious selling episodes it morphs to fear. Finally, it all ends in capitulation for many.”
He suggests that the way to avoid unforced errors and "win but not losing" is to resist the urge to jump on the equities bandwagon. He writes in his conclusion that “This is a sad story, the mother of all unforced errors, except for the investor who refuses to overpay or overstay. In this refusal to overpay, we value cash as more than an asset that currently yields zero. In fact, it is those very low interest rates and the low expected returns from equities that make the opportunity cost of holding cash incredibly low. Cash effectively becomes a valuable call option on any asset with no expiration date and no strike price.”
Based in Elkhart Indiana about as far from the big city bustle as you can get Mr. Martin has applied logic and common sense and avoided just about every market disaster. Just to add to his cred, his staff put together a piece in 2013 suggesting that MLPs should be avoided and possibly even shorted based on their fundamental outlook. It was published just about 6 months before MLPs stopped going up and spiraled lower by more than 50%. Frank Martin is very good at spotting excessive risk and at a minimum avoiding it thereby winning at the investing game by not losing.
I find myself very much in line with has thinking. Someone asked me yesterday if I was getting more bullish since we have had a few consecutive down days. When I was done laughing I pointed out that we are only about 1% off all-time highs. According to my copy of Barrons the S&P 500 is still trading at 25 times earnings. In the Deep Value and International Portfolios we have lots of cash and are looking actively to sell stocks that have either reached higher valuations or have declining fundamentals to increase that cash stockpile. If I am not in love with it I don’t think I want to own it at this level.
I love the idea of cash as an undated call option on asset prices and think this is exactly the right way to look at it. The next time I head to the bank I am going to tell my wife to write me a check made out to undated call option so I can get some pocket money for the weekend.
When it comes to markets its often a case of this. But right now, I think it is best to err on the side of caution
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