Many market strategists and traders began the year accepting the premise that the United States was experiencing a self-sustaining recovery. Nearly every economic release was interpreted with a positive tilt. The inclination was to herd into the more cyclically sensitive companies because of their sensitivity to economic fluctuations and tendency to exhibit more radical swings, correlated with the overall business cycle. The second quarter appears to have reintroduced a bit of reality as the May jobs report – the third disappointing release in a row – was dismal in virtually every respect. Even a Nobel-prize winning economist can now discern the downward direction of economic growth for the latter half of 2012.
In the book The Science of Sherlock Holmes, E.J. Wagner recounts the true tale of Sir Roger Tichborne. In 1854, Sir Roger was reported lost at sea. His mother refused to believe that her son, whom she had lovingly raised in France, was gone forever. She kept putting out inquiries, asking for any news on her son. Twelve years after Sir Roger went missing; Lady Tichborne received a letter from an attorney in Australia claiming to have found her son. The letter explained that having been shipwrecked, Sir Roger eventually made his way to Australia, where he was involved in a number of business ventures. Unfortunately, the business ventures did not succeed as he had hoped and that he was too embarrassed to contact his mother.
Supposedly Sir Roger had recently seen her inquiries and was filled with remorse for the worry he caused his mother over the years. The letter concluded with a request to send money for travel fare for Sir Roger, his wife and children. Lady Tichborne was overjoyed to hear the wonderful news and sent the necessary funds to allow for the family reunion. When Sir Roger arrived in England he was received by Lady Tichborne as her long lost son and granted a very generous annual stipend.
However, not all the Tichborne family was convinced that this new arrival was the real Sir Roger. Where Sir Roger had been a man of slim frame, the new arrival from Australia was obese. Other discrepancies were noticed – Sir Roger had some tattoos, the new arrival had none. Sir Roger had blue eyes while the new arrival had brown eyes. The new arrival was an inch taller than Sir Roger had been, did not speak French (which Sir Roger did) and had a birth mark on his body which Sir Roger did not have. Somehow Lady Tichborne managed to ignore all this evidence and continued to accept the Australian as her son. It was only after her death that the Tichborne family finally managed to demonstrate that the Australian was an imposter.
In other words, we see what we want to believe. When Wall Street sees signs of an economic recovery, they accept it on faith that it is the real Sir Roger rather than just the reappearance of central bank liquidity. Federal Reserve Chairman Ben Bernanke’s track record certainly suggests that more stimulus is coming, but we would argue that any such move perpetuates a long series of monetary mistakes. If four years of zero interest rates, five trillion dollars of deficit spending, QEI, QEII, and Operation Twist have not worked, why would further quantitative easing work?
Value investing refers to picking stocks that appear cheap relative to their own fundamentals (earnings, cash flow, book value, etc.). By comparison, growth investing involves looking for companies with growing profits. When earnings growth is scarce, traders pay a premium for that growth – think Apple or Starbucks (neither company is a holding in the Fund) during the first quarter of 2012. When value underperforms growth, cheap stocks continue to become cheaper, relative to the rest of the market. However, over time, studies repeatedly show that value outperforms. Why? Investors systematically over pay for growth, and it turns out that growth is extremely difficult to forecast. When investors are confident, they pay up for future earnings. But markets are extremely complex systems and total certainty is never completely possible. Along with uncertainty, timing is always a difficult issue. As value investors, our job is to determine the fair value of a business — not to figure out where the business’ public stock will trade in one year’s time.
As value investors, we have noticed the growing degree of synchronization between the economic cycle and the stock market. The reason for this increased synchronization is the role of the drivers of return. An equity portfolio derives its return from three primary sources: the purchase price in terms of valuation, the growth of the underlying business, and any change in valuation multiples. Over the long term, very little of an investor’s total return is driven by changes in valuation multiples, but rather comes from dividends and the growth of these dividends. Given the persistently low starting dividend yields in today’s market, investors are now more dependent on growth to generate their investment returns. Therefore, the market tends to sync up with economic growth – it needs that growth to deliver a meaningful level of return. Of course, when that growth disappears, investors force valuation multiples downward to restore the valuation support.
What does this mean for value investing? In the words of Benjamin Graham:
Since common stocks are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing, we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upwards, to sell or refrain from buying when the course is downwards. By pricing, we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.
Consider the recent initial public offering (IPO) of Facebook (This company is not a holding of the Fund). On the day of the IPO, the company’s stock was priced at $38 per share which valued the company’s estimated 2012 revenue of $4 billion at $100 billion. However, Facebook’s initial investors are not buying Facebook on the IPO because they believe it is fairly valued, they are buying the stock because of the growth they anticipate. If we assume that Facebook investors desire a return of 15% per year over the next five years, then Facebook’s market capitalization must double in five years, to $200 billion. Coincidentally, Google’s (This company is not a holding of the Fund) market capitalization today is almost $200 billion but Google’s trailing twelve month revenue is $40 billion. Since both companies are in the advertising business and have very similar low cost structures, perhaps the market will value Facebook in similar fashion to Google. Therefore, for an investor to double their money over the next five years, Facebook must increase its revenues tenfold.
Perhaps a tenfold increase in revenue over the next five years is achievable. The company’s name is synonymous with the very concept of social networking and Facebook currently has 900 million users. Regardless, increasing revenues tenfold is still a difficult undertaking. Several recent studies by web research companies already point to user fatigue. Facebook is undeniably a productivity drain, and employers may start blocking employee access to Facebook during business hours, which will further decrease the time spent on it. Another risk cited in several studies includes “zero presence” in China, the largest Internet market in the world. Facebook has been largely shut out of China due to both local competition and official and unofficial policies by the Chinese government to leave control of key media assets in local hands. Given that China has become the largest country in terms of Internet users; such a scenario poses a significant challenge to Facebook’s global user growth and future revenue potential.
“Prepare for the worst and hope for the best” has always been sensible advice. An investor never knows what will happen with a young company like Facebook; therefore, one should seek investments that are already so cheap that unexpected setbacks do not destroy the investment. If an investor buys a share in a company because they think the price will go up, they are betting that they can see into the future. The “unknown unknowns” are likely to work against the investor. Better to buy a share of a company that you want to own over the long term — not whether the price goes up in the short term. Risk, in terms of an investment, is when one is forced to sell an investment at a loss. Overpaying for an investment is the quickest way to add risk to an investment portfolio. While an undervalued investment may grow more undervalued over some period of time, the inherent value in the asset ensures that it will be return to fair value at some point in time. By contrast, the best an overvalued asset can do is to fall to its fair market value. More likely, given the nature of markets, the asset will almost certainly fall even further than that. Paying too much for any asset is essentially buying investment risk.
Nevertheless, ask enough people for advice and an investor will eventually find someone who will tell them what they want to hear. The need for advice burns so strongly within some humans that people are often blind to the quality of the advice. There is a tendency to trust “experts” even when there is little evidence of their forecasting ability. The more quoted the “expert” by the news media, the more suspect we personally grow of their forecasting abilities. The tendency for individuals to rely on expert advice, even when the advice clearly has no use, was recently illustrated in a recent academic paper, Why Do People Pay for Useless Advice?.
Undergraduates in Thailand and Singapore were asked to place bets on five rounds of coin flips. The participants were told that the coins came from fellow students; that these coins would be changed during the experiment; that the coin-flipper would be changed every round; and that the flippers would be participants, not experimenters. Meaning, there was a high probability that the results would be random. Taped to the desk of each participant were five envelopes, each predicting the outcome of the five successive coin flips. Participants could pay to see the predictions in advance, but they saw them free after the coin toss had occurred. When the initial prediction turned out to be correct, students were more willing to pay to see the next forecast. This tendency increased after two, three and four successful predictions. Furthermore, those students who paid in advance for predictions placed bigger bets on subsequent coin tosses than those students who did not pay in advance for predictions.
While heeding economic forecasts might not seem quite as inexplicable as paying for coin toss predictions, there are some similarities. Nobody can reliably predict the short-term outlook for economies, interest rates or stock markets, yet plenty of economists and strategists earn a decent living doing just that. The sheer complexity of modern financial markets and the flood of information published each day are a godsend to Wall-Street strategists. Investors may feel that they simply do not have the time to analyze all the data and therefore need to rely on the advice of “experts”. Then again, investors may have a psychological need to listen to the many experts on CNBC – the avoidance of regret. If an investor chooses to put all of their money in social networking stocks based on their own research, and that market sector implodes, the investor only has himself to blame. But if the investor had listened to an expert’s advice, then the expert was at fault. Maybe some forecast, any forecast, is somehow more comforting to investors.
Investment Philosophy
Most investment professionals recognize that a discounted cash flow is the appropriate model for valuing financial assets in well-functioning capital markets, including stocks. However, estimating distant cash flows is both difficult and time consuming. As a less-intensive alternative, investors attach substantial weight to short-term performance, particularly earnings, in order to select stocks. Analysts fixate on quarterly earnings while often neglecting the longer-term drivers of shareholder value. The fascination with earnings is not surprising. Investment managers fear that failure to outperform relative to a target benchmark might lead to large fund withdrawals and ultimately their dismissal, otherwise known as business risk and career risk. Consequently, many investment managers focus on short-term stock price performance which they believe is strongly influenced by quarterly earnings. It is not unusual for investors to observe sizeable price swings in response to earnings surprises, which simply reinforces the rationale to employ earnings analysis rather than discounted cash-flow models. All we can surmise is that there is greater career risk in going against the market’s apparent pricing model than there is reward.
Then again, Wall Street’s favor of short-term earnings over long-term cash flows matches the relatively short holding period for stocks. The annual portfolio turnover in professionally-managed funds is greater than 100 percent for an average holding period of less than one year. In contrast, the average holding period was about seven years until the mid-1960s. The shorter the holding period, the more the beliefs of others, rather than long-term fundamentals, become central to investment decisions. High turnover sets the stage for short-term earnings-based decision making… Welcome to Keynes’ beauty contest.
Short-term investors obviously expect to derive substantially all of their gains from selling their shares at the end of their investment horizon and very little from cash dividends. With dividend yields averaging around 2% and assuming a one-year investment horizon based on current portfolio turnover trends, about 98% of investment gains must be expected to come from the selling of shares at higher prices. Without a dividend or cash-flow underpinning the investment, investors increasingly focus on forming an expectation about the selling price in order to generate their return. Unfortunately, this expectation depends on the impossible task of assessing the expectations of countless other market participants with varying investment horizons. Faced with this impossible task, and under pressure to show acceptable short-term performance, investment managers turn to past and expected short-term metrics, particularly earnings, to project short-term prices.
Over the past ninety days, the “experts” have reduced their 2012 earnings estimates on Procter & Gamble (4.81% of Fund Assets as of 6/30/12) from $3.96/share to $3.81/share – a 3.8% reduction. The stock has dropped by 12% over that same period of time. Bear in mind that Procter & Gamble is the leading consumer product manufacturer in the world with more than $80 billion in annual sales. The company’s scale, research and marketing are competitive advantages that sustain a portfolio of leading brands, 26 of which generate more than $1 billion per year, and another 20 brands of which generate more than $500 million in sales annually. In contrast to Facebook, we feel secure in assuming that P&G will continue generating ample free cash flow from its brands (baby care, blades and razors, laundry detergent, batteries, etc.) 20, 30, 40 years from now. Contrary to those who believe that stocks are priced on a company’s short-term outlook, most stocks require at least ten years of value-creating cash flows to justify their price.
John Burr Williams was one of the first economists to understand that stock prices are determined by “intrinsic value”. Similar to Benjamin Graham, Williams argued that financial markets are a reflection of an asset’s intrinsic value and that investors should not focus on the timing of asset prices but rather the underlying components of asset value. His 1938 classic text “The Theory of Investment Value” was among the earliest to articulate the theory of discounted cash flow based valuation, and in particular, dividend based valuation. Williams proposed that the value of an asset should be calculated using “evaluation by the rule of present worth”, a more colorful way of saying discounted cash flow. According to Williams, the intrinsic worth of a common stock is the present value of its future cash flows—or the discounted value of all future dividends.
Although our company’s investment valuation models of “evaluation by the rule of present worth” emphasize free cash flow and economic profit, William’s dividend discount model is still a worthwhile tool for equity valuation. The stable dividend discount model is best suited for companies experiencing long-term stable growth—a rate equal to the long-term nominal growth rate of the economy. Proctor & Gamble has steadily paid out dividends to shareholders since 1891 and has increased its dividend payout each year for the last 55 years. Over the past forty years, the dividend has increased at an annual rate of 10%. Assume the dividend continues to grow at 7% and we discount those future dividend cash flows at 10%. Based on next year’s dividend of $2.25, the stable dividend discount model values P&G at $75 per share. Because stock valuations measure very long-term streams of future cash flows, the next five years of dividend cash flows only represent 13% of P&G’s $75 intrinsic value. In other words, 87% of P&G’s value is based on cash flows that will materialize after the year 2017.
Imagine an individual who purchased P&G exactly twenty years ago in July 1992. The individual paid $11.50 per share and received $0.24 in dividends. Adjusted for stock splits, that individual now owns four shares for every share he originally purchased and receives $9.00 in dividends today for each share he purchased. P&G’s annual dividend, twenty years later, now equals 78% of his original investment. This individual does not care if the “experts” are currently reducing their earnings estimates for the next quarter. This individual has no interest in swapping their position in Proctor & Gamble for Facebook, nor does this individual have any interest in selling their P&G stock next year. This individual realizes that his stock is partial ownership in a boring but steady business that consistently returns its excess cash to its owners. This individual is an investor.
Kind regards,
Robert J. Mark
Portfolio Manager
Larry J. Redell
The Castle Focus Fund’s prospectus contains important information about the Fund’s investment objectives, potential risks, management fees, charges and expenses, and other information and should be read and considered carefully before investing. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. You may obtain a current copy of the Fund’s prospectus by calling 1-877-743-7820. Distributed by Rafferty Capital Markets, LLC-Garden City, NY 11530, Member FINRA.
The risks associated with the Fund, detailed in the Prospectus, include the risks of investing in small and medium sized companies and foreign securities which may result in additional risks such as the possibility of greater price volatility and reduced liquidity, fluctuations in currency exchange rates, and political, diplomatic and economic conditions as well as regulatory requirements in foreign countries. There also may be risks associated with the Fund’s investments in exchange traded funds, real estate investment trusts (“REITs”), significant investment in a specific sector, and non-diversification.
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