Tag Archives: Paul Tudor Jones

Still Dancing

The latest market wobble this week comes under the guise of the endless Trump soap opera and the first widespread use of the impeachment word. I doubt it will be the last time we hear that word! The bookies are now offering even odds of impeachment. My guess is that Trump’s biggest stumble will come over some business conflict of interest and/or a re-emergence of proof of his caveman behaviour towards woman. The prospect of a President Pence is unlikely to deeply upset (the non-crazy) republicans or the market. The issue is likely “when not if” and the impact will depend upon whether the republicans still control Congress.

Despite the week’s wobble, the S&P500 is still up over 6% this year. May is always a good month to assess market valuation and revisit the on-going debate on whether historical metrics or forward looking metrics are valid in this low interest rate/elevated profit margin world. Examples of recent posts on this topic include this post one highlighted McKinsey’s work on the changing nature of earnings and this post looked at the impact of technology on profit profiles.

The hedge fund guru Paul Tudor Jones recently stated that a chart of the market’s value relative to US GDP, sometimes called the Buffet indicator as below, should be “terrifying” to central bankers and an indicator that investors are unrealistically valuing future growth in the economy.

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Other historical indicators such as the S&P500 trailing 12 month PE or the PE10 (aka Shiller CAPE) suggest the market is 60% to 75% overvalued (this old post outlines some of the on-going arguments around CAPE).

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So, it was fascinating to see a value investor as respected as Jeremy Grantham of GMO recently issue a piece called “This time seems very very different” stating that “the single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage” and that “pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower”. Graham argues that low interest rates, relative to historical levels, are here for some time to come due to structural reasons including income inequality and aging populations resulting in more aged savers and less younger spenders. Increased monopoly, political, and brand power in modern business models have, according to Graham, reduced the normal competitive pressures and created a new stickiness in profits that has sustained higher margins.

The ever-cautious John Hussman is disgusted that such a person as Jeremy Grantham would dare join the “this time it’s different” crowd. In a rebuttal piece, Hussman discounts interest rates as the reason for elevated profits (he points out that debt of U.S. corporations as a ratio to revenues is more than double its historical median) and firmly puts the reason down to declining labour compensation as a share of output prices, as illustrated by the Hussman graph below.

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Hussman argues that labour costs and profit margins are in the process of being normalised as the labour market tightens. Bloomberg had an interesting article recently on wage growth and whether the Phillips Curve is still valid. Hussman states that “valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average [profit margin] would easily take the S&P 500 35-40% lower over the completion of the current market cycle”. Hussman favoured valuation metric of the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), shown below, predicts a rocky road ahead.

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The bulls point to a growing economy and ongoing earnings growth, as illustrated by the S&P figures below on operating EPS projections, particularly in the technology, industrials, energy, healthcare and consumer sectors.

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Taking operating earnings as a valid valuation metric, the S&P figures show that EPS estimates for 2017 and 2018 (with a small haircut increasing in time to discount the consistent over optimism of analyst forward estimates) support the bull argument that current valuations will be justified by earnings growth over the coming quarters, as shown below.

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The IMF Global Financial Stability report from April contains some interesting stuff on risks facing the corporate sector. They highlight that financial risk taking (defined as purchases of financial assets, M&A and shareholder pay-outs) has averaged $940 billion a year over the past three years for S&P 500 firms representing more than half of free corporate cash flow, with the health care and information technology sectors being the biggest culprits. The IMF point to elevated leverage levels, as seen in the graph below, reflective of a mature credit cycle which could end badly if interest rates rise above the historical low levels of recent times.

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The report highlights that debt levels are uneven with particularly exposed sectors being energy, real estate and utilities, as can be seen below.

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The IMF looked beyond the S&P500 to a broader set of nearly 4,000 US firms to show a similar rise in leverage and capability to service debt, as illustrated below.

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Another graph I found interesting from the IMF report was the one below on the level of historical capital expenditure relative to total assets, as below. A possible explanation is the growth in technology driven business models which don’t require large plant & property investments. The IMF report does point out that tax cuts or offshore tax holidays will, based upon past examples, likely result in more financial risk taking actions rather than increased investment.

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I also found a paper referenced in the report on pensions (“Pension Fund Asset Allocation and Liability Discount Rates” by Aleksandar Andonov, Rob Bauer and Martijn Cremers) interesting as I had suspected that low interest rates have encouraged baby boomers to be over-invested in equities relative to historical fixed income allocations. The paper defines risky assets as investments in public equity, alternative assets, and high-yield bonds. The authors state that “a 10% increase in the percentage of retired members of U.S. public pension funds is associated with a 5.93% increase in their allocation to risky assets” and for all other funds “a 10% increase in the percentage of retired members is associated with a 1.67% lower allocation to risky assets”.  The graph below shows public pension higher allocation to risky assets up to 2012. It would be fascinating to see if this trend has continued to today.

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They further conclude that “this increased risk-taking enables more mature U.S. public funds to use higher discount rates, as a 10% increase in their percentage of retired members is associated with a 75 basis point increase in their discount rate” and that “our regulatory incentives hypothesis argues that the GASB guidelines give U.S. public funds an incentive to increase their allocation to risky assets with higher expected returns in order to justify a higher discount rate and report a lower value of liabilities”. The graph below illustrates the stark difference between the US and Europe.

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So, in conclusion, unless Mr Trump does something really stupid (currently around 50:50 in my opinion) like start a war, current valuations can be justified within a +/- 10% range by bulls assuming the possibility of fiscal stimulus and/or tax cuts is still on the table. However, there are cracks in the system and as interest rates start to increase over the medium term, I suspect vulnerabilities will be exposed in the current bull argument. I am happy to take some profits here and have reduced by equity exposure to around 35% of my portfolio to see how things go over the summer (sell in May and go away if you like). The ability of Trump to deliver tax cuts and/or fiscal stimulus has to be question given his erratic behaviour.

Anecdotally my impression is that aging investors are more exposed to equities than historically or than prudent risk management would dictate, even in this interest rate environment, and this is a contributing factor behind current sunny valuations. Any serious or sudden wobble in equity markets may be magnified by a stampede of such investors trying to protect their savings and the mammoth gains of the 8 year old bull market. For the moment through, to misquote Chuck Price, as long as the music is playing investors are still dancing.

Disappointing TRIB

Every investor knows the feeling of wondering what to do when a stock they have invested in falls unexpectedly in value. Although some may not be aware of the term “disposition effect” in behavioural economics, it reflects the widely observed tendency of investors to ride losses and lock in gains (a previous post touched on more behaviour economic concepts). I have been guilty in the past of just such a tendency, all too often I’m afraid! Bitter experience, maturity and the advice of many successful professional investors has caused me to now try to proactively act against such instincts. [On the latter point, the books of Jack Schwager and Steven Drobny with wide ranging professional investor interviews are must reads.]

Averaging down when a stock you hold falls, particularly when there is no obvious explanation, is another strategy that rarely ends well. Instead of looking at the situation as an opportunity to buy more of a stock at a reduced price, I now question why I would invest more in a situation that I have clearly misread. I only allow myself to consider averaging down where I clearly understand the reason behind any decrease and where the market itself has reduced (for the sector or as a whole). Experience has taught me that focusing on reducing the losers is critical to longer term success. Paul Tudor Jones put it well when he said: “I am always thinking about losing money as opposed to making money”.

This brings me to the case in point of my investment in Trinity Biotech (TRIB). I first posted about TRIB in September 2013 (here) where I looked at the history of the firm and concluded that “TRIB is a quality company with hard won experiences and an exciting product pipeline” but “it’s a pity about the frothy valuation” (the stock was trading around $19 at the time). The exciting pipeline included autoimmune products from the Immco acquisition, the launch of the new Premier diabetes instruments from the Primus acquisition, and the blockbuster potential of Troponin point-of-care cardiac tests going through FDA trials from the Fiomi deal.

Almost immediately after the September 2013 post, the stock climbed to a high of over $27 in Q1 2014, amidst some volatility. Fidelity built its position to over 12% during this time (I don’t know if that was on its own behalf or for an investor) before proceeding to dump its position over the remainder of 2014. This may simply have been a build up and a subsequent unwinding of an inverse tax play which was in, and then out, of vogue at the time. The rise of the stock after my over-valued call may have had a subconscious impact on my future actions.

By August 2014, the stock traded around the low $20s after results showed a slightly reduced EPS on lower Lyme sales and reduced gross margins on higher Premier instrument sales and lagging higher margin reagent sales. Thinking that the selling pressure had stopped after a drop by TRIB from the high $20 level to the low $20s, I revised my assessment (here) and established an initial position in TRIB around $21 on the basis of a pick-up in operating results from the acquisitions in future quarters plus the $8-$10 a share embedded option estimated by analysts on a successful outcome of the Troponin trials. As a follow-on post in October admitted, my timing in August was way off as the stock continued its downward path through September and October.

With the announcement of a suspension of the FDA Troponin trials in late October due to unreliable chemical agent supplied by a 3rd party, the stock headed towards $16 at the end of October. Despite my public admission of mistiming on TRIB in the October post and my proclamations of discipline in the introduction to this post, I made a classic investing mistake at this point: I did nothing. As the trading psychologist Dr Van Tharp put it: “a common decision that people make under stress is not to decide”. After a period of indecision, some positive news on a CLIA waiver of rapid syphilis test in December combined with the strength of the dollar cut my losses on paper so I eventually sold half my position at a small loss at the end of January. I would like to claim this was due to my disciplined approach but, in reality, it was primarily due to luck given the dollar move.

Further positive news on the resumption of the Troponin trials in February, despite pushing out the timing of any FDA approval, was damped by disappointing Q4 results with lacklustre operating results (GM reduction, revenue pressures on legacy products). The continued rise in the dollar again cushioned my paper loss.  It wasn’t until TRIB announced and closed a $115 million exchangeable debt offering in April that I started to get really concerned (my thoughts on convertible debt are in this post) about the impact such debt can have on shareholder value. I decided to wait until the Q1 call at the end of April to see what TRIB’s rationale was for the debt issuance (both the timing and the debt type). I was dissatisfied with the firm’s explanation on the use of funds (no M&A target has been yet identified) and when TRIB traded sharply down last week, I eventually acted and sold all of my remaining position around $16 per share, an approximate 15% loss in € terms after the benefits on the dollar strength. The graph below illustrates the events of the recent past.

click to enlargeTRIB Share Price + Short Interest

My experience with TRIB only re-enforces the need to be disciplined in cutting losses early. On the positive side, I did scale into the position (I only initially invested a third of my allocation) and avoided the pitfall of averaging down. Joe Vidich of Manalapan Oracle Capital Management puts it well by highlighting the need for strong risk management in relation to the importance of position sizing and scaling into and out of positions when he said “the idea is don’t try to be 100% right”. Although my inaction was tempered by the dollar strength, the reality is that I should have cut my losses at the time of the October post. Eventually, I forced myself into action by strict portfolio management when faced with a market currently stretched valuation wise, as my previous post hightlights.

As for TRIB, I can now look at its development from a detached perspective without the emotional baggage of trying to justify an investment mistake. The analysts have being progressively downgrading their EPS estimates over recent months with the average EPS estimates now at $0.16 and $0.69 for Q2 and FY2015 respectively. My estimates (excluding and including the P&L cost of the new debt of $6.3 million per year, as per the management estimate on the Q1 call) are in the graph below.

click to enlargeTRIB Quarterly Revenue+EPS 2011 to Q42015

In terms of the prospects for TRIB in the short term, I am concerned about the lack of progress on the operational results from the acquisitions of recent years and the risks (timing and costs) associated with the Troponin approval. I also do not believe management should be looking at further M&A until they address the current issues (unless they have a compelling target). The cost of the debt will negatively impact EPS in 2015. One cynical explanation for the timing on the debt issuance is that management need to find new revenues to counter weakness in legacy products that can no longer be ignored. Longer term TRIB may have a positive future, it may even climb from last week’s low over the coming weeks. That’s not my concern anymore, I am much happier to take my loss and watch it from the side-lines for now.

Ray Dalio of Brightwater has consistently stressed the need to learn from investing mistakes: “whilst most others seem to believe that mistakes are bad things, I believe mistakes are good things because I believe that most learning comes via making mistakes and reflecting on them”. This post is my reflection on my timing on TRIB, my inaction in the face of a falling position, and my current perspective on TRIB as an investment (now hopefully free of any emotive bias!).