My Thoughts on the Yield Curve Inversion (3m/10yr)

So it finally happened. The “most reliable recession indicator is finally flashing red.”

Last week the 10-year yield fell off a cliff and dropped below the 3-month yield for the first time since 2007. Gasp! That was just before The Great Financial Crisis. Data from the National Bureau of Economic Research tells us that the yield curve has inverted before each of the last seven recessions. (This time the inversion was brief- only part of a day) Many analysts firmly hold the belief that the yield curve is the best forecasting tool for recessions. Yes, that is true, I suppose. So now what? Is it time to sell out of the markets? Should I put my feet up and sit back on the sidelines waiting for stocks to fall? What if they don’t? If they do, when should I re-enter the market? The answers to these questions presume that I know when, exactly, a recession is coming and how bad it is going to be. Truth is, I have no idea.

Even I could tell you, without any economic data at all, that we’re going to have another recession. In fact, I guarantee we will. There might be (probably will) multiple in my lifetime. How does it make sense that the price of borrowed money (because that is what interest rates are) in 3-months is more expensive than 10-years? The answer is complex and I’m not about to turn this post into an essay in an attempt to explain it. But I’m sure many of your friends and colleagues know exactly what is causing the inversion and what to do about it. However, unless your friends and colleagues are noted economists, I am skeptical. Even if they are, well, given economist track records, I am still skeptical. Did you know economists have predicted 7 out of the last 5 recessions?

So what am I going to do about it?

Nothing.

I’m not going to rush to judgement and assume a huge recession is right around the corner and that equities are going to come crashing down in a fiery ball of fury to reign hell on my portfolio and turn my cash to ash. This would be an emotional response to new information. Emotions are an investors biggest foe. I will not sell out of any positions unless I believe the decision is warranted based on fundamentals. Nor am I going to rush into cash or buy more gold. Why? Because I am a conservative, value investor that is structuring an equity portfolio so that its manager (me) can ignore what is happening in the broad market. In other words, I intend to keep my portfolio ready for a recession (more specifically-a stock market crash) at all times. There’s mainly two ways I do this.

1.) High liquidity.

I will admit, in a slightly hypocritic way, as someone who says they do not try to “time the market”, I do tactically adjust my cash position based on the over/undervaluation of stock prices. Usually this happens naturally, such as right now, where I am finding it difficult to find investments that warrant my hard earned money. The dividends keep rolling in, I do my best to remain consistent in putting aside money each month, and I have not found opportunities to re-invest. But the point here is that I always keep a cash buffer. Currently at ~17% of the satellite portfolio, my cash position is on the high end since inception. I hold a cash position that I can deploy when I find opportunities that fit what I deem to be strong investments. Currently, I can’t find any! I think most value investors are having the same issue and, as a result, my cash position continues to grow.

2.) Bottom-up Fundamental Analysis.

Said another way, I am not making bets based on macroeconomic or geopolitical factors. The inversion of the yield curve is not part of my decision making process. Neither are trade tariffs, political uncertainty, GDP forecasts, nor the undertones in Jerome Powell’s speeches. Sure, I follow these items. I read the WSJ on a daily basis. I have my thoughts on the economy, different asset classes, and even the yield curve inversion. But this is done for no other reason than to help build context of the investment environment I am operating within. I try to be aware of all sorts of risks, but if I made trades based on how the newspaper made me feel about the economy, I would constantly be making trades. Execution costs would have zeroed-out any investment returns. I look at each investment opportunity on a stand alone basis. I look for a sustainable competitive advantage that can withstand a recession and an incentivized management team, amongst many other boxes that need to be checked. Then I calculate the value of a company and compare it to the price, only buying when there is a significant discount. This “margin of safety” is intended to protect my portfolio against broad market drawdowns. Strong companies will continue to do business regardless of a recession and the stock market will fluctuate regardless of what the economy is doing. What matters to me are finding companies that provide a good or service that will be in demand even if the economy comes to a screeching halt. But even more important, is buying these companies when they’re cheap. I already mentioned that I’m finding it difficult to put my money to work. I would welcome a sale on the stock market.

So there you have it. My profound thoughts on the yield curve inversion. I’m not doing a damn thing besides continuing to scour the investment universe for the next addition. High liquidity, good companies, and a margin of safety should insulate the portfolio from irreparable mistakes. As a gambler would say, “make sure you can live to play another day.” I intend to. So bring on a stock market crash. I wont be swimming naked.

Uncle Pennybags

P.S. Where’s the term premium?

Recent Sell: Omega Healthcare Investors (OHI)

Omega Healthcare Investors, Inc (“OHI”) is a Real Estate Investment Trust (“REIT”) that invests in income-producing healthcare facilities, including long-term care facilities located in the United States and United Kingdom. Its portfolio focuses on long-term healthcare facilities with contractual rent escalations under long-term leases, along with fixed-rate mortgage loans.

I built my position throughout 2015 and held on to the position mainly for the following reasons:

  • The firm is facing long-term tail winds due to an aging baby boomer population that should see demand growth for skilled nursing facilities
  • Operator reliance on Medicare & Medicaid reimbursements provide rent support and a barrier to entry to new competition
  • The dividend yielded over 6%, was growing on a quarterly basis, and was covered by FFO

My thesis was that a combination of the bullet points above should create strong compounding potential and long-term share growth. The company’s main growth strategy focuses on M&A and OHI has grown its asset base from $850 million to $8.6 billion since 2004. During that same time frame the firm was able to increase its Funds From Operations (“FFO”) from $36.8 million to $575 million. This translated to an FFO/Share annual growth rate of 14%. Management had been raising the dividend on a quarterly basis, the dividend yield was greater than 6% and the payout was fully covered by FFO. Dividend growth has been 9.3%, 8.4% and 7.9% over the past 10 years, 5 years, and 3 years, respectively. I believed that the financials were directly indicative of a competent management team taking advantage of industry tailwinds and making value-add investment decisions. However, over the past year cracks have started to appear in Omega’s financials. Though management has continued to raise the dividend throughout 2018, as of Q3 and Q4 FFO no longer covers the dividend. There are negative pressures on FFO due to a couple major tenants that have been struggling to make their rent payments.

In 2013 OHI closed a $529 million purchase/leaseback transaction in connection with the Ark Holding Company, acquiring 55 skilled nursing facilities operating under the name “Orianna.” OHI has not been recognizing any direct financing lease income from Orianna since July 2017 as they continue to not satisfy their rent payments. In Q4 OHI further wrote down their investment in Orianna by $27 million. Though I do believe that OHI can restructure their agreement with Orianna and navigate through this situation without significant detriment to their financials, management is no longer including Orianna’s rental income given their bankruptcy status (See note 3 in figure below).  I was afraid that this was not a one-off event, but rather a sign of a broader market that is struggling and that Orianna was the first sign of trouble.

Sure enough, on the latest earnings call, the management team mentioned troubles forming on another top 10 tenant, Daybreak. Daybreak represents 3.8% of OHI’s portfolio and 57 total properties. During the last quarter OHI received approximately $4MM in underpayments from Daybreak and is expecting reduced payments moving forward. Management has made comments that leads me to believe that more operator troubles are on the horizon. In the latest earnings call they mentioned potentially issuing equity to de-leverage, and, though possibly a prudent move, this would be dilutive to shareholders. Furthermore, management “currently anticipates maintaining our current quarterly dividend level for the next several quarters with the goal of increasing the dividend in the relatively near future.” Given that many investors hold this stock for the dividend, I am afraid that a dividend freeze, and in a worst-case scenario – a dividend cut, would have investors selling the stock thus putting negative pressure on the stock price. Also, I tried to analyze the financials for the top-10 operators to get a better idea of their relative health, but given that most of these companies are private, I found it difficult to compile any meaningful information. I decided I would rather not hold my shares and hope for the best.

OHI was 2.8% of my satellite equity portfolio and generating 6.6% of the portfolio income. In light of the recent updates, I decided to do another deep dive into the financials to get a better understanding of the risks I was exposed to. I realized, rather humbly, that the business model and industry sit outside my circle of competence. I did not feel that my due diligence and understanding of the company was thorough enough and, as a result, I determined that I did not feel comfortable holding the position through tougher times. I do believe that the long-term thesis may still be in play, however I decided to exit the position so that I can reallocate the capital to opportunities that I understand with better clarity and can get comfortable with the risk exposure. Since initiating my position in 2015 my total return from OHI was 24% or about 8.4% annualized.

-Hedgehog

New Buy: JM Smucker [SJM]

      JM Smucker (“SJM”) is a smaller-sized, large-cap stock that is historically well-run, delivers consistent returns on capital and produces significant cash flow. The business is focused on a diversified portfolio of simple brand names that are found in most kitchens throughout the United States. SJM is at an inflection point in which its top line growth has decelerated, margins have compressed, and management is optimizing their product portfolio through prudent balance sheet management and strategic initiatives. Management incentives are aligned with shareholders and their CEO has been purchasing the stock recently. I believe investors have been overly pessimistic given the firm’s recent headwinds and have oversold the stock, leading to an attractive price to initiate a long-term position in a quality company. You can find my analysis here:

Buy_ SJM_November 2018

Comments? Questions? What do you think about the purchase?
  • Uncle PennyBags

2019 Financial Goals

  • Investment objective: to own the cheapest and most misunderstood stocks with high insider ownership, low institutional ownership, and a catalyst in place so as to avoid value traps.
  • Move away from a “core satellite” approach by getting rid of the “core”
    • From this, a concentrated portfolio should be established
  • Max out IRA contribution for the year ($6,000.00)
  • Pay off existing credit card and auto related debt
  • Spend less, save more
  • Porcupine

Portfolio Update: Recent Sell

September 2018 – Sale of Flower’s Foods, Inc. (FLO)

Over the past couple of weeks I have spent time checking on the health of my active equity portfolio. This included a review of my asset allocation to see if it warranted any rebalancing, as well as individually scrutinizing each of my holdings. While this will not be a post that delves into my overall strategic asset allocation decisions, it is a review of why I made some recent tactical moves. I recognized that my cash position was a bit light given the current valuation of equities and at roughly 5% of my portfolio I did not feel as though I had enough fire power to take advantage of a sell off.

I have no interest in timing the market and realize that it is a sucker’s game for most. I do not believe I have the time, nor resources at my disposal to do the type of due diligence necessary to make informed “market-timing” decisions. Even then, it would most likely be a horrendous attempt. I do, however, pay attention to the macro-environment that I am investing in and make tactical adjustments in an attempt to manage risk. After a decade long bull-market I have noticed that it is becoming harder to find value in today’s equity market.

The economic indicator first made famous by Warrant Buffet that is used consistently by value investors, known as the “Buffet Indicator”, or total market cap (TMC) relative to gross national product (GNP), is pointing to a stretched US equity market. At the time of writing, the Wilshire 5000 Total Market Index sits at 30,091.3 billion, or 150% of the latest report on US GNP. That is the highest that the ratio has ever been dating back to 1971, reaching only 141% just prior to the bursting of the tech bubble in 2000. There are reasons one could allude to in an attempt to explain why the equity markets are at these levels. Analysts point to strong earnings growth, low unemployment and tax cuts, and, while speaking out of both sides of their mouth, remind us of trade wars and geopolitical risks that could derail the economy. Meanwhile, the schiller ratio for the S&P 500 sits at 33.1x, much closer to  the 43x it hit just before the tech bubble burst than the 7x level seen in the early 1980’s. In my opinion, US equities seem rich and prices could revert if there is a significant shock to the economy. I can’t say for certain what will happen when a significant amount of liquidity is pulled out of the market by the Federal Reserve unwinding their balance sheet. What would be the impact of a rise in interest rates have on the portfolio? Investments compete for investor money and if rates rise, other assets will adjust accordingly. At 2.9%, the 10yr yield has been bumping up against 3% for some time now. What if the yield curve were to adjust and rates move to 5%? 7%? Should we be worried about inflation? What would hyper-inflation, or even stagflation do to the equity markets? Quite frankly we don’t know which direction equity markets or interest rates will go, but I’m seeing that there is a lot more room to the downside and I want to be prepared to put money to work at more favorable implied returns.

As such, I have decided to take some chips off the table and increase my cash holding. I sold all my shares in Flowers Foods, Inc. (FLO), netting a solid 17% annualized return since I purchased the stock in Late 2016. This will almost double my cash position to roughly 10% of the portfolio giving me a decent war chest, relatively speaking. I only held FLO for about 2 years and was sitting on a 35% total gain. Typically, I don’t like to sell my holdings at the first sign of trouble or overvaluation because I believe that letting the winner’s run has worked for several successful investors. It’s simple, good company’s continue to produce quality earnings that fuel growth.

But the decision was two-fold. The first consideration being my desire to increase cash and the second being the fundamentals of the company. The company has now been moved to my watchlist and I’ll continue to check back on it from time to time. Here are some of the main drivers that lead me to believe the company’s growth may be tepid moving forward:

·       Revenues have been pretty flat over the last 3 years

·       Operating margin has declined roughly 2.6% annually over the last 5 years

·       Net Margin has fallen to its lowest point since 2005

·       Dividend payout ratio has steadily climbed and is currently greater than 100%

·       FCF as a percent of revenues has declined over 200 bps, falling to 4.5% on TTM basis

·       ROE & ROA have steadily declined over the past couple of years

·       P/E and P/FCF ratios are stretched on a historical basis at 30x and 23x respectively

This was not what I had anticipated when I bought FLO. Essentially, growth has slowed, margins are being compressed and this is having a negative impact on free cash flow. The dividend isn’t as sustainable as I had originally thought and could potentially be frozen. Without much growth in the business or the dividend, my returns are susceptible to a compression in multiples, which are on the higher end of the company’s averages from the last decade and tend to revert over time. I’m comfortable taking profits here to de-risk and not to chase other investments. 

One last piece to note is that I do intend to hold roughly a 10% cash position for the foreseeable future. This means that new purchases will need to come from fresh capital that I save or that is provided through my dividend income. I will have an updated portfolio displayed in the author’s section.

Thoughts? Questions? What does your cash position look like? How do you decide when is a good time to sell?

 

A Quick Gain on Rubicon Technology, Inc.?

Disclosure: I have no position in any securities mentioned below.

Short post here…

Rubicon Technology, Inc. (RBCN) sold off their Batavia, IL property today (8/20/2018). They are expecting to receive $6.35 mil after paying various expenses related to the sale of the property.[1]

After adding this figure to their June 30th, 2018 net cash position, we arrive at a per share price of around $9.05. The stock last traded hands after hours at $8.55.

RBCN

Be very wary of stocks trading below net cash, as there is likely a reason for this. Optimally, the cash proceeds from the sale of this property would be allocated towards profitable projects. The market clearly does not think that this will be the case. On one hand, you have a company with a ton of cash on hand with a new CEO and a plan to liquidate its assets related to LED manufacturing to focus more on the optical and industrial sapphire markets. On the other, you have had a company that has had negative cash flow from operations for the past 4 years.

Another risk is the risk that the company’s balance sheet changes significantly from this quarter to the next.

Can this company make a turnaround?… who knows… but I think it at least warrants further attention at this valuation.

  • Porcupine

[1] https://www.sec.gov/Archives/edgar/data/1410172/000121390018011430/f8k082018_rubicontechno.htm