Oct 09

“Abiding by the First Rule”, Quarterly Letter, Q3 2012

Third Quarter Letter

Market Comments

There is an old saying that the definition of insanity is doing the same thing over and over again and expecting different results.  Evidently, the Federal Reserve wants to confirm that theory once again, for now it has embarked on QE3.  QE stands for “quantitative easing” and refers to a central bank buying bonds to push down yields.  Despite the protests of some academics, QE is also defined as debt monetization, or money printing.  By employing QE3, the Federal Reserve refuses to let real-world evidence get in the way of academic theories, as QE operations provide no permanent fix to the economy.  In fact, we think that the actions of the Federal Reserve mutate the very economy it is trying to improve.

To download a PDF of this report, click here.

Yet, like Pavlov’s dogs, stock markets responded to the latest announcement of money printing by pushing stock prices higher.  With the European Central Bank and the Bank of Japan joining the Federal Reserve in their own versions of quantitative easing, one wonders if value-oriented analysts should simply stop analyzing company fundamentals and just focus on the relentless stream of headlines generated by central banks.

We question just how firm the footing of this central bank-inspired market rally really is.  Previous efforts by the Federal Reserve have merely provided the markets with a temporary sugar rush–stock prices momentarily pushed higher but without an increase in the underlying earnings.  Meaning, once the euphoria of the Federal Reserve’s actions wear off, reality will reappear when investors focus once again on the market’s weakening fundamentals.

With the benefit of hindsight, we understand why the banking system built up its reckless lending practices in the years leading up to the 2008 credit crisis–reckless behavior paid well.  Today, instead of enabling reckless bank lending, the Federal Reserve and other central banks around the world are allowing governments to borrow on unrealistic terms.  By suppressing interest rates near zero percent for years, central banks are transferring wealth from savers to governments.  With budget deficits measured in the trillions, central bankers will ultimately do the bidding of governments and print money.  We consider this practice a strong case for future inflation.

We find it impossible to imagine how the Federal Reserve will reduce its balance sheet back to its pre-quantitative easing state.  Like a roach motel, QE operations are easy to enter but impossible to exit in a practical manner.  The Federal Reserve has gone “all in” with QE3 on the bet that its money printing will not lead to a rise in consumer prices.  Eventually our central bank will face a dilemma: sacrifice the stock and bond markets or risk a complete loss of confidence in our paper-based monetary system.

QE3 differs from previous actions by the Federal Reserve in that prior cases the central bank would wait for a deflation scare before launching another round of monetary easing.  This latest program of debt monetization marks a change in strategy.  As opposed to the dollar value of the new inflation program at a mere $40 billion per month, we note that the Federal Reserve introduced a new QE program at a time when the rate of monetary inflation is already high.  To illustrate the difference between the latest QE and earlier programs, we present the chart below which shows the spread between the yields on standard 10-year U.S. Treasury Notes and “inflation-protected” U.S. 10-year Treasury Notes (TIPS).  Think of this difference in yields as the market’s view of how inflation will change over the years ahead.  In other words, this chart is an indicator of inflation expectations.

When earlier Federal Reserve quantitative easing programs were initiated, inflation expectations had either just fallen to a 12-month low, as in the case of QE2, or just fallen to a multi-year low just before QE1.1 and QE1.2.

The latest debt monetization program was initiated with the market’s expectations of inflation reaching multi-year highs.

The second chart shows that when earlier central bank money printing programs were initiated, the equity markets, as measured by the S&P 500 Index, were ‘oversold’ and either near a 12-month low or long-term low.  In contrast, the Federal Reserve’s latest efforts begin with the equity markets near long-term highs.

In the interim, one of the longest-running myths in financial markets continues to perpetuate itself: the myth that central bank money printing — in the context of a modern banking system — increases the value of stocks.  There is a ridiculous school of thought that creating credit will permanently increase stock prices which in turn will lead to a sort of trickle-down economy phenomenon.  Federal Reserve Chairman Ben Bernanke said as much in his rather well-known November 2010 opinion editorial in The Washington Post (http://www.federalreserve.gov/newsevents/other/o_bernanke20101105a.htm ): “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Since Bernanke’s editorial, the S&P 500 has rallied from 1200 to 1450, mostly on the growing belief that stocks are a substitute for bonds.  And yet we cannot help but believe that the Federal Reserve’s loose monetary policy has simply front-loaded investment returns.  In essence, the Federal Reserve’s actions bring forward future potential market gains as stock prices push further above intrinsic value.  At some point, when the Federal Reserve attempts to withdraw its liquidity from the market, stock prices could quickly fall back to intrinsic value.

Yale professor Robert Shiller created the “Shiller P/E ratio,” which we argue is one of the more legitimate measures of the intrinsic value of the broad stock market.  The Shiller P/E ratio is calculated as follows: Divide today’s S&P 500 index by the average inflation-adjusted earnings from the previous ten years.  (As analysts, we also look at ten years of earnings and cash flow data when researching companies in order to help gauge how future earnings might look.  Unfortunately, many investors remain too focused on the quarter-to-quarter noise, which often leads to surprises at turning points in the earnings cycle.)

The Shiller P/E of the S&P 500 is currently 22.2 — 38% higher than its long-term average.  The average Shiller P/E ratio since 1880 is about 16.4.   Regression to the historical mean average would take the S&P 500 back to 1000.

The chart above also shows that the bull market in stocks that began in 1982 was largely driven by the decline in long-term interest rates from near 16% down to below 2%.  Lower interest rates reduce the required rate of return that company management demands when allocating capital to new investments; therefore, a greater number of investments appear profitable as interest rates drop.

Every company, whether private or publicly-traded, continuously allocates capital.  If capital is allocated to a new project, then the initial cash outlay is weighed against the present value of those anticipated future cash flows.  When long-term U.S. Treasury interest rates approached 16%, companies faced an extremely high hurdle rate to justify their capital project outlay.  With the 10-year U.S. Treasury rate at 1.75%, companies can almost justify any capital outlay as attractive on a relative basis.  That is because today’s low interest rates make future cash flows look deceivingly more attractive.

Long-term investors must understand that monetary actions by the Federal Reserve do not increase the intrinsic value of stocks.  Only companies that generate returns above their cost of capital can increase intrinsic value.  By forcing interest rates lower, the Federal Reserve has artificially increased stock prices.  Try as they might, a central bank cannot lower the real cost of capital for companies—the effect is only temporary.  By artificially pushing interest rates down to zero and suppressing them from rising, the Federal Reserve fools investors into believing that the cost of capital is low.  And therein lays the danger of allocating capital on a relative basis as opposed to an absolute basis.  This misallocation of capital will quietly continue to rot the foundation of our market economy.

Consider the case of Fortescue Metals Group (not a holding in the Fund), whose only business is digging up iron ore in Western Australia and shipping it to China.  This business model is very profitable as long as China’s economy grows and extraction costs in Western Australia remain low.  Any slowdown in Chinese construction and demand for steel negatively impacts Fortescue.  With iron ore inventories piling up at ports across China, spot prices of iron ore have dropped by more than 30% since April.  Unfortunately, the company financed its recent growth with debt.  Fortescue has accumulated so much debt that with spot iron ore prices below $100 per ton, the company may not even cover the interest on its debt with its free cash flow.  So, with the company’s balance sheet in trouble, what did the company do?  It borrowed even more money.  The company recently announced a new $4.5 billion financing package from JP Morgan and Credit Suisse.  As of June 30th, Fortescue already had total long-term debts of $9.2 billion.  In August it added $1.5 billion, lifting its total borrowing to $10.7 billion.  With their new debt capacity, the company will add nearly a billion dollars of net debt, taking the total to $11.7 billion.

While it seems obvious to most rational people that you cannot borrow your way out of debt, companies such as Fortescue, and nearly every Western government, believe otherwise.  The accepted wisdom is to borrow more, extend the debt payback period, and ignore the problem in paying that debt back.  What completely puzzles us is that the market is comfortable with this arrangement.  In fact, Fortescue’s share price jumped by 20% after their latest debt financing was announced.  The problem with quantitative easing is that central banks allow markets and governments to treat the symptoms of too much debt rather than actually fix the problem of too much debt.  The misallocation of capital continues.

But markets are peculiar animals.  They cause normally rational people to behave completely irrational.  Consider how people become less risk-averse after ‘risk’ has materially increased and more risk-averse after ‘risk’ has decreased.  The stock market is thought to be ‘safe’ after it has risen for many weeks or months, while it is considered ‘risky’ after it has declined substantially.  The bigger the rally, the safer the market appears to be, and the opposite holds true for market declines.

Today, with the market approaching pre-credit crisis highs, only 5% of traders are bearish.  With equity mutual funds showing continuous outflows over the past three years, retail investors have just now returned to the stock market with weekly inflows hitting a four year high as central banks have restored the animal spirits.  Investors mentally associate ‘certainty’ with rising stock prices.  Inexplicably, rising prices increase confidence and cause investors to anticipate a more certain future.  By contrast, ‘uncertainty’ is associated with downside movements in stock prices.  In reality, the future is always uncertain.

As an investor, future uncertainty should be reflected in the price one pays for an investment.  The higher the price an investor pays for a given set of expected future cash flows, the lower the prospective future rate of return, as higher prices pull forward future potential returns.  Conversely, a lower price paid by an investor adds to future prospective returns.  Unless an investment materially improves its future cash flows, we find it confusing how investors grow increasingly confident by paying a higher acquisition price for an investment.

Obviously, price change itself does not create wealth.  From a macroeconomic standpoint, central bank actions that elevate current asset prices do not make a nation any wealthier.  Economic wealth is only created by savings and investments rather than debt and consumption.

Investment Philosophy

Conventional wisdom justifies buying stocks today because the Federal Reserve wants the stock market to go higher and, naturally, you cannot fight the Federal Reserve.  Or, institutional money managers are underperforming and will therefore be forced to put their cash to work in an effort to play “catch-up” by yearend.  Another line of thought focuses on the election cycle, where the sitting administration is always motivated to do whatever it can to promote a higher stock market.  Maybe these are indeed valid reasons to be bullish on higher stock prices, but they are manufactured reasons which have likely already been discounted by the stock market.  Barclays Capital Chief European Economist, Julian Callow, captured the market’s mentality best when he was quoted last week in the Financial Times, “The recent wave of global central bank easing ought to give markets greater confidence that there is a determined monetary policy reaction to the recent signs of weaker business activity.”  In other words, swing away because fundamentals matter little and the central banks have you covered.

Market participants can be divided into traders and investors.  As investors, we focus on purchasing stocks because they are cheap and represent good value.  We buy a stock because we believe in the long-term prospects of the company.  Traders, by contrast, emphasize criteria like price trends and momentum rather than fundamentals.  From a trader’s perspective, it is less about earning a piece of corporate profits but rather about front-running the actions and comments of Federal Reserve Chairman Ben Bernanke.

In recent years, traders appear to have gained the upper hand and short-term price movements now dominate the performance measurement derby.  The saddest part of this is that many long-term investors have now been drawn into the momentum game.  The growing emphasis on relative performance leads to a growing herd in the companies and sectors that are currently outperforming on a price basis.   Goldman Sachs noted in a recent report that 30% of fundamentally-driven hedge funds hold at least one share of Apple, Inc. (AAPL, not a holding in the Fund) while one out of five hedge funds now has AAPL among its ten largest long positions with an average portfolio weighting of 8%.

When investors who should be patient join the momentum traders, stock prices can be pushed further away from fundamental values that are based on future cash flows.  If the majority of investors neglect the underlying value of the stocks being traded, capital gets misallocated, markets are volatile, and returns are minimal.  Is there any wonder that trading volume in equity markets is dismal?

As patient investors, we believe that investing based on attractively purchasing future cash flows generated from returns on invested capital is the most effective means to the long term accumulation and preservation of wealth.  The current market environment, which is dominated by the actions of the Federal Reserve and other central banks around the world, remains hostile to our longer term investment philosophy.  As a result, we abide by the first rule of investing—do not lose money.

Kind regards,

Robert J. Mark

Portfolio Manager

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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