Tuesday, February 14, 2017

Six Sigma Buffett, Taxes, Fund Returns etc.

Whenever I read about Buffett and other great managers, what I tend to see all the time are things like, "xx has beaten the market y out of z years; the odds of that happening are 1 in 5,000!" or some such thing. Not too long ago, there was an article about managers with outstanding performance and the screen was based on who beat the market five years in a row, ten years in a row or something like that.

But for me, I tend not to care about that at all. In fact, I would rather invest with someone who only beat the market seven out of the last ten years but with a wider and more consistent margin than someone that beat the market ten years in a row, and only with a small margin.

So that got me thinking about what I should look at. Well, when I say that, I don't mean that I would use this stuff to choose investment managers since I don't really invest in funds at all. What I mean, I guess, is that if I don't like the above 'beat the market x out of y years', what is a better indicator?

Tax Digression
But before that, I just happened to be reading the 1986 Berkshire Hathaway letter to shareholders and came across this comment about taxes.  Trump is expected to do something about taxes and I heard Buffett or Dimon mention somewhere recently that any tax cut will be competed away by the market implying that it won't make a difference to investors.  Anyway, this is what he wrote about it back in 1986 after the last big tax change:

Taxation

     The Tax Reform Act of 1986 affects our various businesses in 
important and divergent ways.  Although we find much to praise in 
the Act, the net financial effect for Berkshire is negative: our 
rate of increase in business value is likely to be at least 
moderately slower under the new law than under the old.  The net 
effect for our shareholders is even more negative: every dollar 
of increase in per-share business value, assuming the increase is 
accompanied by an equivalent dollar gain in the market value of 
Berkshire stock, will produce 72 cents of after-tax gain for our 
shareholders rather than the 80 cents produced under the old law.  
This result, of course, reflects the rise in the maximum tax rate 
on personal capital gains from 20% to 28%.

     Here are the main tax changes that affect Berkshire:

   o The tax rate on corporate ordinary income is scheduled to 
decrease from 46% in 1986 to 34% in 1988.  This change obviously 
affects us positively - and it also has a significant positive 
effect on two of our three major investees, Capital Cities/ABC 
and The Washington Post Company.

     I say this knowing that over the years there has been a lot 
of fuzzy and often partisan commentary about who really pays 
corporate taxes - businesses or their customers.  The argument, 
of course, has usually turned around tax increases, not 
decreases.  Those people resisting increases in corporate rates 
frequently argue that corporations in reality pay none of the 
taxes levied on them but, instead, act as a sort of economic 
pipeline, passing all taxes through to consumers.  According to 
these advocates, any corporate-tax increase will simply lead to 
higher prices that, for the corporation, offset the increase.  
Having taken this position, proponents of the "pipeline" theory 
must also conclude that a tax decrease for corporations will not 
help profits but will instead flow through, leading to 
correspondingly lower prices for consumers.

     Conversely, others argue that corporations not only pay the 
taxes levied upon them, but absorb them also.  Consumers, this 
school says, will be unaffected by changes in corporate rates.

     What really happens?  When the corporate rate is cut, do 
Berkshire, The Washington Post, Cap Cities, etc., themselves soak 
up the benefits, or do these companies pass the benefits along to 
their customers in the form of lower prices?  This is an 
important question for investors and managers, as well as for 
policymakers.

     Our conclusion is that in some cases the benefits of lower 
corporate taxes fall exclusively, or almost exclusively, upon the 
corporation and its shareholders, and that in other cases the 
benefits are entirely, or almost entirely, passed through to the 
customer.  What determines the outcome is the strength of the 
corporation’s business franchise and whether the profitability of 
that franchise is regulated.

     For example, when the franchise is strong and after-tax 
profits are regulated in a relatively precise manner, as is the 
case with electric utilities, changes in corporate tax rates are 
largely reflected in prices, not in profits.  When taxes are cut, 
prices will usually be reduced in short order.  When taxes are 
increased, prices will rise, though often not as promptly.

     A similar result occurs in a second arena - in the price-
competitive industry, whose companies typically operate with very 
weak business franchises.  In such industries, the free market 
"regulates" after-tax profits in a delayed and irregular, but 
generally effective, manner.  The marketplace, in effect, 
performs much the same function in dealing with the price-
competitive industry as the Public Utilities Commission does in 
dealing with electric utilities.  In these industries, therefore, 
tax changes eventually affect prices more than profits.

     In the case of unregulated businesses blessed with strong 
franchises, however, it’s a different story:  the corporation 
and its shareholders are then the major beneficiaries of tax 
cuts.  These companies benefit from a tax cut much as the 
electric company would if it lacked a regulator to force down 
prices.

     Many of our businesses, both those we own in whole and in 
part, possess such franchises.  Consequently, reductions in their 
taxes largely end up in our pockets rather than the pockets of 
our customers.  While this may be impolitic to state, it is 
impossible to deny.  If you are tempted to believe otherwise, 
think for a moment of the most able brain surgeon or lawyer in 
your area.  Do you really expect the fees of this expert (the 
local "franchise-holder" in his or her specialty) to be reduced 
now that the top personal tax rate is being cut from 50% to 28%?

     Your joy at our conclusion that lower rates benefit a number 
of our operating businesses and investees should be severely 
tempered, however, by another of our convictions: scheduled 1988 
tax rates, both individual and corporate, seem totally 
unrealistic to us.  These rates will very likely bestow a fiscal 
problem on Washington that will prove incompatible with price 
stability.  We believe, therefore, that ultimately - within, say, 
five years - either higher tax rates or higher inflation rates 
are almost certain to materialize.  And it would not surprise us 
to see both.

OK, the last paragraph is kind of interesting too. Buffett said he bought $12 billion in stocks after the election so I guess he is not so worried about the fiscal position of the U.S.

Back to fund performance stuff...

Comparing Two Distributions
I said that I don't care for the 'beat the market x out of  y years' idea. So that got me thinking about the simple high school statistics problem of comparing two normal distributions. I am aware of the argument against using normal distributions in finance, but I don't really care about that here. I am just looking for some simple descriptive statistics. I'm not creating a derivatives pricing model to price an exotic option for a multi-billion dollar book where modeling errors can cause huge losses. So in that sense, who cares. Normal distribution is fine for this purpose.

Plus, I am not so interested in factor models that try to assess fund manager skill. Some people use factor models and whatever is left over is what they define as 'skill'.  Well, say the model cancels out 'quality' as a factor and doesn't give the manager credit for it; what if the manager intentionally focused on quality investments? Should he not get credit for it? Having said that, I don't know much about these models so whatever...  I don't get into that here. Whatever factor exposures these managers have, I assume the manager intentionally assumed those risk factors to gain those returns.

Basically I just want to compare two distributions and see how far apart they are. It's basically the question, is distribution A, with 99% confidence, the same as distribution B? In other words, are the two distributions different with any degree of statistical significance? Or are we just looking at a bunch of noise resulting from totally random chance?

The simple comparison of two distributions is:

standard deviation of the difference between two means (Std_spd) =

   Sqrt[(Vol_A^2/n) + (Vol_B^2/n)]

   where: Vol_A = standard deviation of distribution A and
               n = number of samples

So the z-score would be:
  (mean_A - mean_B) / Std_spd

And then you can just calculate or look up the probability from this z-score.

Looks good.  This would tell me how significantly different a manager's return is versus the market.

But the problem is that these two distributions are not independent. In your old high school statistics text book, the example is probably something like number of defective parts in factory A versus factory B.  Obviously, those distributions would be independent.

This is not so in the stock market. A fund manager's returns and the stock market's return are not independent. Hmm... Must account for that.

The answer to that goes back to my derivative days; calculating tracking error. Sometimes fund managers or futures traders wanted to use one index to hedge against another. An example might be (in the old days!) an S&P 100 index option trader wanting to hedge their delta using the S&P 500 index futures.  Does this make sense? What is the tracking error between the two indices? Does it matter? Is the tracking error too big for it to be an effective delta hedge? How about using the S&P 500 futures to hedge a Dow 30 total return swap? TOPIX index swap with the Nikkei 225 futures?

Anyway, the calculation for tracking error simply makes an adjustment by making a deduction for correlation (getting square root of the covariance).

So, the above formula becomes:

    Sqrt[(Vol_A^2/n) + (Vol_B^2/n) - ((2 * Vol_A * Vol_B * correlation(A,B)) / n)]

Using this formula, I calculated all this stuff for the superinvestors, just for fun.

I just wanted to know simple things like, is it harder to outperform an index by 10% per year over 10 years, or by 3% per year over 20?  Or something like that.  The Buffett partnership was only 13 years, and Greenblatt's Gotham returns in the Genius book is only 10 years. But the spread is so wide that it is yugely anomalous to achieve, or is it? This is sort of what I wanted to know. It normalizes the outperformance spread versus the length of time the outperformance lasted.

Few Standouts
A few of the standouts looking at it this way, not surprisingly:

  • Buffett Partnership 1957-1969:  a 6.0 sigma event, 1 in 1 billion chance of occurring (yes, that b is not a typo!) 
  • Walter J. Schloss 1956-1984:  5.2 std, 1 in 9.4 million 
  • BRK 1965-2015:  4.8 std, 1 in 1.3 million
  • Greenblatt (Gotham 1984-1994): 3.8 std, 1 in 14,000
  • Tweedy Brown 1968-1983: 3.7 std, 1 in 9,300

For the Graham and Doddsville superinvestors, I looked first at the "beat the market x out of y years" to see the probability of that happening assuming a 50% chance of beating the market in any given year. And then I'll compare the two distributions as described above. At the end, I also added Lou Simpson's returns from the 2004 Berkshire letter.

Keep in mind that just because a manager is not in the 4-5 sigma range, that doesn't make them bad managers. Some of these numbers are just insanely off-the-charts and can't be expected to happen often.

Anyway, take a look!

Buffett Partnership (1957-1969)
Beat the market 13 out of 13 times: Chance of occuring: 0.012% or 1 in 8,192.

Given that Buffett partnership gained 29.5%/year with a 15.7% standard deviation while the DJIA returned 7.4%/year with a 16.7% standard deviation and the Partnership had a 0.67 correlation, the partnership returns is 6.0 standard deviations away from the DJIA.  6 standard deviations make the partnership returns a 1 in 1 billion event.

What's astounding is that the standard deviation of Buffett's returns is actually lower than the DJIA.


BRK 1965-2015
Beat market 40 out of 51 years:  0.003% chance or 1 in 35,000

                     BRK        S&P500
Return          19.3%        9.7%
std                14.3%      17.2%
correl             0.61

4.8 std, 1 in 1.3 million

This uses book value, which may not be fair as not everything in BPS is marked to market (over 51 years). Using BRK stock price, it would be a 3.2 std event, or 1 in 1,455. But this too may not be fair as the volatility of the price of BRK is more a function of Mr. Market than Mr. Buffett.  This may be true of all superinvestor portfolios, but in the case of BRK, there is a penalty in that we are looking at the volatility of a single stock (BRK), and not the underlying portfolio.  Single stock volatility is usually going to be much higher than that of a portfolio.

Munger 1962-1975
Beat the market 9 out of 14 years: 21% chance or 1 in 5

                    Munger     DJIA
return           19.8%       5.0%
std                33.0%      18.5%
correl:            0.73
#years: 14

2.4 std, 1 in 122.

Sequoia 1970-1983
Beat the market 8 out of 14 years: 40% chance or 1 in 2.5

                Sequoia        S&P 500
return       17.2%        10.0%
std            25.0%        18.1%
correl         0.65

1.4 std or 1 in 12.

This is the in-sample period; the period included in the Superinvestors essay.

Sequoia 1970-2016
Beat the market 26 out of 47 years, 28% chance or 1 in 3.6


                  Sequoia       S&P500
return        +13.7%        +10.9%
std               19.3%          17.1%
corr 0.67

1.3 std or 1 in 10

Sequoia 1984-2016
This is the out of sample period; the period after the essay.

Beat the market 18 out of 33 years, 36% chance or 1 in 3

                  Sequoia      S&P500
return          11.9%         10.9%
std               16.0%         16.6%
corr               0.73

0.5 std or 1 in 3

Sequoia 2000-2016
And just for fun, a recent through-cycle period starting in 2000. They have been underperforming the market since 2007, though.

Beat 9 out of 17 years, 50% chance or 1 in 2.

                   Sequoia     S&P500
return           7.3%          4.5%
std              13.7%        18.1%
correl           0.69

0.9 std or 1 in 5

Walter J. Schloss 1956-1983
Beat the market 22 out of 28 years, 0.2% chance, or 1 in 540

                   WJS      S&P500
return         21.3%     8.4%
std              19.6%   17.2%
corr:             0.75

5.2 std or 1 in 9.4 million


Tweedy, Browne Inc. 1968-1983
Beat the market 13 of 16, 1.1% chance or 1 in 94

                   Tweedy   S&P500
return           20.0%       7.0%
std                12.6%     19.8%
corr:               0.71

3.7 std or 1 in 9,300


Pacific Partners Ltd. 1965-1983
Beat the market 13 of 19 years, 8% chance or 1 in 12

              Pacific       S&P500
returns    32.9%         7.8%
std          60.2%       17.2%
corr:         0.37

1.9 std or 1 in 35


Gotham 1985-1994
Beat the market 9 out of 10 times: 1.1% or 1 in 93 chance

3.8 std, 1 in 14,000

Lou Simpson (GEICO: 1980-2004)
18 out of 25 years. 2.2% chance or 1 in 46.

               GEICO   S&P
return      20.3%    13.5%
std           18.2%   16.3%
corr:         0.74

2.7 std, 0.4%, 1 in 288


Conclusion
So that was kind of interesting. It just reaffirms how much of an outlier Buffett really is. There is a lot to nitpick here too, so don't take these numbers too seriously. I used standard deviation of annual returns, for example. I suspect some of these correlations may be higher if monthly or quarterly returns were used.

This sort of thing may be useful in picking/tracking fund managers. At least it can be one input.  For example, it gives you more information than the Sharpe ratio; whereas the Sharpe ratio doesn't care how long the fund has been performing, the above analysis takes into account how long someone has been performing as well as by how much. But yeah, Sharpe ratio is trying to measure something else (return per unit of risk taken).

Anyway, as meaningless as it may be, it's one way of seeing if it's harder to create a long term record like Buffett (1965-2015) or a shorter super-outperformance like Greenblatt (1984-1994). This analysis says that Buffett's 1965-2015 performance is a lot more unlikely to be repeated (well, at least on a BPS basis; using BRK stock price, Greenblatt's performance is more unlikely!).

I sliced up Sequoia Fund's return into various periods for fun as it is the only continuous data (other than BRK) out of the Graham and Doddsville Superinvestors. I was going to look into their performance since 1984 a little more deeply, but this took a little more time than planned (despite the automation of a lot of it; well, debugging and fixing takes time, lol...).

So maybe I will revisit the Sequoia Fund issue in a later post. My hunch is that the Superinvestor returns were achieved on a much lower capital base so the universe of potential investments were much larger than what Sequoia (and others) are looking at now despite their efforts to keep AUM manageable.

Also, you will notice that comparing the two distributions gives a more nuanced or accurate picture of the performance than just looking at how many years someone has outperformed; it incorporates the spread, correlation, volatility etc...

Anyway, I guess that's enough for now...






Wednesday, February 1, 2017

Bogle Book, Indexing etc.

I have watched and listened to John Bogle for years and always thought he was great, but I never read any of his books. I understand his message and agree with him for the most part. But the other day while I was browsing the library, I came across this book and just grabbed it and decided to read it even though I have a big stack of books that I started and have yet to finish.




There is nothing new in here in terms of message (active managers don't outperform, costs is primary determinant of performance over time; low cost beats high cost in every category, every time period etc...), but it is still amazing to read with all the tables and facts laid out.

Every time non-industry people ask me about stocks and how to learn about them, I go through the usual books that we've all read. I noticed, though, that if they are not in the industry, or not a true market fanatic, people don't ever read the books you recommend.

I understand telling someone to read all of the Berkshire Hathaway letter to shareholders going back to 1977 (available for free, I tell them, at the BRK website) seems like such a tedious thing that no normal, non-financial person would actually do it.

From now on, I think, I will just direct them to this book. It's that good, and it would answer most questions I typically get in the usual 'cocktail party' conversation about markets.

As for stock picking, from now on, I will tell them to just pick stocks based on what you like and believe to be truly good businesses at reasonable valuations.  Even overpriced is OK as long as it is kept small and it's not bubble-like; compensate for the assumption of price risk by keeping dollar exposure low. But keep most of the equity exposure indexed (OK, BRK is fine too, but most people won't know what to do when something happens to Buffett, and may not want to deal with the volatility/uncertainty related to the headlines).

Expensive Stocks
Every once in a while, you just come across businesses that you think are just really, really great, as a customer and as a business analyst. For me, that was Chipotle Mexican Grill (CMG). I bought some a while ago and did very well with it, even selling out at the top once and buying back in at a low and then selling out again (most recently in late 2014).  I know others who have owned Starbucks (SBUX) forever, and I kick myself for not owning that one too. I go there way more often than I'd like to admit, and when you travel, there is never a SBUX anywhere that doesn't have a long line in the morning. And often, it's the only place to get a bagel and coffee.

(By the way, this section has nothing to do with the Bogle book!)

So, on those occasions where you actually see and verify for yourself a great business in action, and the price is reasonable, or even a little on the high side, I say go for it. Own it and hold it for as long as it's good. We value investors are usually afraid of high P/E stocks because we remember 1999/2000 and many high P/E disasters.

Value investors who run value funds might get into trouble owning such growth stocks, but for individuals managing their own money, why not?

I know this goes against the idea of having discipline, but if most of someone's equity exposure is indexed and they 'play' with a small portion of their portfolio on their own picks, it's probably not a bad idea.  Plus, those opportunities don't come up all that often. That's all the more reason to go for it.

Worse is actually going out and trying to find stocks that will go up; buying stuff that you have no idea about etc.  At least with some businesses, you have a strong idea about their competitive position etc. What you absolutely don't want to do is to bend that rule and overpay for things just because everyone says it's the next Chipotle,  Starbucks, Facebook or whatever.  Forget about those "this is the next..." stocks.  Only go for the ones that you really understand.  The "this is the next..." argument is a shortcut; it allows people to pump stocks with minimal bandwidth.  Who's adrenaline doesn't start to flow when you hear about the next CMG, or next Buffett?  (Well, I do some of that here...).

Market Timing
Bogle is also anti-market timing, and that's been a constant theme on this blog too. Market timing is a waste of time unless you are a Druckenmiller-type active trader. But market timing when you are supposed to be allocating assets / investing doesn't make much sense.

I was thinking of this the other day, seeing a lot of market-timers doing horribly in recent years. A lot of people have horrible performance because they were short the market for the past few years.

Gambler's Fallacy
And I realized that this "the market is expensive so it must go down. Therefore, I am short"-type manager is falling for the gambler's fallacy.  OK, well, not exactly.  With the gambler's fallacy, for example, if a coin toss results in heads ten times in a row, people tend to believe the next one must be tails. But the fact that the coin landed on heads ten times in a row doesn't affect the probability of the next coin toss.  Each coin toss is independent. Regardless of how many times you had heads in a row, the odds on the next flip is still 50/50.

In the stock market, this is not true. The higher the market goes, the more expensive it gets, and the lower the prospective returns will be.  So the probability distribution of going forward returns actually shifts lower; the probability of a loss increases as the market gets more expensive.

So this is not an accurate analogy. But for me, it still is interesting because when the stock market is expensive, my temptation is to ask, when the market is this expensive, what tends to happen in the following year?  Greenblatt does this and mentions it just about every time he is interviewed. And even in the past few years, using 30 years of data, I think, his prospective returns one year out from the then current valuation has always been positive.

Even many of the bears have long term expected returns that are positive, but just low. Yet they are short. Even more recently with negative long term expected returns, it is usually low negative. So maybe -2%/year or some such.  In that case, it's still better to invest in corporate bonds or other fixed income at something higher than that to earn a positive return than shorting the market.  What if the market went into a bubble like in 1999/2000? The stock market valuation is nowhere near that silliness. If the market did rally like that, it would put a lot of those bearish funds out of business.

Now, what are the odds of some sort of blow-off like that? Versus what are the chances of an imminent collapse/bear market? These are things that you usually don't hear about, and to me, are the more relevant statistics to look at if you insist on timing the market.  And I suspect those are some things that the more successful quant funds are good at evaluating (and therefore don't lose money being net short for multiple consecutive years!).

Hasty Generalization?
The other related and more precise fallacy is the fallacy of hasty generalization or maybe faulty causality. Actually, I'm not sure this is the right one, but let's use it. Initially I was thinking it was fallacy of composition, but my understanding is a little bit different there. I'm referring to the fallacy of assuming that since all bank-robbers had guns, that all gun-owners must be bank robbers.

We all look at these long term valuation charts and go, hey look!,  the market P/E was over 20x before 1929, 1987 and 1999! So, the thinking goes, the market is now over 20x P/E so a crash must be imminent! But then we tend not to look at all the people who own guns that are not bank robbers.

Also, when someone says that the stock market is 90% percentile to the expensive side, there is a tendency to want to believe that there is a 90% chance that the market will go down in the future. Well, if the market is 90% percentile to the expensive side over the past 100 years, then it means that the market will be valued at a lower level 90% of the time in the next 100 years if the same conditions occur.

Anyway, since I was so curious about the year-forward returns and was worried about the declining interest rate bias of Greenblatt's sample (as he uses the past 30 years), I decided to look at this data for myself.

First let's look at Greenblatt's time span. That would be starting around 1985 or 1986.

Just so we can actually see the data, I will use annual figures.  I will look at the P/E ratio (as reported) of the stock market at the beginning of the year and compare it to how the market did during that year (actually, the P/E ratio of the end of the previous year is used).

Using Greenblatt's time period and looking at years when the stock market started with a P/E ratio of over 20x, here are the results:

P/E level of over: 20
Number of up years: 11
Total # years: 15
Percent up years: 73.33%
Average change: 5.5%

DateP/Ereturn
1991.1224.3315.32%
1992.1222.829.85%
1993.1221.290.52%
1997.1224.2325.34%
1998.1231.5621.45%
1999.1229.66-5.70%
2000.1226.62-12.79%
2001.1246.37-20.06%
2002.1232.5922.11%
2003.1222.1712.77%
2004.1220.487.09%
2007.1222.35-38.75%
2008.1258.9829.08%
2009.1221.7813.86%
2014.1220.082.10%
2015.1223.74


The data excludes total return for 2016, but we know it was more than 11%, so the results would be even stronger.  From the above, when the market started the year with a P/E ratio of over 20x, the market was still up more than 70% of the time, for an average gain of 5.5%.  Sure, 5.5% is lower than the 10% or so long term average.

But if you own a fund that is short and is losing money with the market going up, it makes no sense. Actuarially speaking, it makes no sense to short the market just because the P/E ratio is over 20x.  Any middle schooler would know this is a bad bet to make.

Oh, and this only looks at the period since 1985. Interest rates have been declining so there has been a huge tailwind.  So let's look at the same table over a longer time period.

Here is the analysis using data since 1871:

P/E level of over: 20
Number of up years: 14
Total # years: 20
Percent up years: 70.0%
Average change: 5.9%

DateP/Ereturn
1894.1226.884.88%
1896.1220.1016.82%
1921.1225.2127.09%
1933.1222.66-2.61%
1961.1222.49-9.72%
1991.1224.3315.32%
1992.1222.829.85%
1993.1221.290.52%
1997.1224.2325.34%
1998.1231.5621.45%
1999.1229.66-5.70%
2000.1226.62-12.79%
2001.1246.37-20.06%
2002.1232.5922.11%
2003.1222.1712.77%
2004.1220.487.09%
2007.1222.35-38.75%
2008.1258.9829.08%
2009.1221.7813.86%
2014.1220.082.10%
2015.1223.74

And I was sort of surprised that using data that goes all the way back, the results aren't all that different. This includes periods of increasing and decreasing interest rates, so you can't say the data is biased due to a bond bull market tailwind. You can still argue that it is biased by a U.S. bull market tailwind, though.

So yes, my gambler's fallacy analogy is not accurate, but check it out. If someone says that the coin landed heads ten times in a row so the next flip must be tails, you'd think he is an idiot. But if you are short the market because the market is overvalued at 20+x P/E ratio, you are even more of an idiot because at least the coin flipper and real fallacious gambler has a 50% chance of being right whereas if you are short a 20x P/E market, you only have a 30% chance of being right!

That's kind of surprising.

What happens if we do the above with a 25x P/E threshold?

Since 1871:

P/E level of over: 25
Number of up years: 5
Total # years: 8
Percent up years: 62.5%
Average change: 8.3%

Since 1985:

P/E level of over: 25
Number of up years: 3
Total # years: 6
Percent up years: 50.0%
Average change: 5.7%

The average change is still up. Since 1985, the market was up only 50% of the time in years the market started at a 25x or higher P/E ratio. But these figures are questionable as there isn't enough data points to be significant.

Even the earlier figures are questionable with only 15 or 20 years in the sample size.

All Months, not just year-end
Just to be thorough, I reran all of the above using all months, not just year-end.  I looked at all months where the P/E ratio was over 20x or 25x and what the total return was 12 months later.

PE >= 20

Since 1871:
P/E level of over: 20
Number of up years: 139
Total # years: 223
Percent up years: 62.3%
Average change: 3.5%


Since 1985:
P/E level of over: 20
Number of up years: 111
Total # years: 162
Percent up years: 68.5%
Average change: 4.8%


PE >= 25

Since 1871:
P/E level of over: 25
Number of up years: 58
Total # years: 96
Percent up years: 60.4%
Average change: 5.1%

Since 1985:
P/E level of over: 25
Number of up years: 54
Total # years: 90
Percent up years: 60.0%
Average change: 5.2%

Using all months, you still get positive expected return with P/E's over 20x and 25x over the next 12 months, with the market rising 60%-70% of the time. I think markets are usually up 70% of the time, 12 months after any given month.

This sort of shows you why it doesn't make too much sense to point to an 'overvalued' stock market, go short and stay short. There are people who have been net short for years and it's amazing to think anyone would do so given the above statistics.

It also explains why Buffett and others can keep buying stocks even as many 'experts' claim the market is way overvalued and due for a correction. Buffett is a numbers and odds guy so I'm sure all of the above figures, at least intuitively, are in his head.

Anyway, the next time someone tells you that they are short because the market is expensive, run away! If they have your money, get it back.

But as usual, this is not to say that the market won't correct at some point. It will correct, as it always does.

Indexing
So, why am I advocating indexing here on a value investing, stock-pickers blog? I don't know. That's a good question. I do believe that most funds over time will not outperform the market so I do believe that indexing is probably right for most people. But do I believe that the market is totally efficient? Well, no. I am a big fan of Buffett, Greenblatt and many others who have outperformed over time.

The stats in Bogle's book are amazing. He shows how top performing funds almost always revert to the mean, even in the long term.

I was going to post more about this here, but this is already getting long and I would like to get this out, so my next post will be about funds, indexing and things like that. Just my random thoughts on the subject.

I was thinking about the above analysis and was playing around with Python and ended up writing a script to calculate all of that. I loved how Greenblatt always said the market is valued at so-and-so percentile and the going forward expected return from these levels is x%.  And he uses 30 years as his history and it always sort of nagged at me that the entire sample period was during a huge decline in interest rates. The above work sort of comforts me.

Trump
Oh yeah, and on Trump. Hmm.  What can I say. We live in interesting times. I binged House of Cards last year and loved it, but nowadays, it seems like truth is stranger than fiction (fiction has to make sense!).

Am I worried? Well, I am worried about all sorts of things, but although I may be wrong, I am not that worried about economic issues. I am not expecting some huge infrastructure binge or anything like that. All that was needed is just a leaning in the other direction from over-regulation. Just the lifting of some of that pressure, and not even a lot of deregulation, I think, is enough to lift business sentiment.

I am comforted by the fact that Trump is surrounding himself with people I respect (business world people, not the alt-right), and I hope they will be listened to.

As for the tweeting and big pronouncements, I do think a lot of that is posturing. He is a negotiator so it's to his advantage to start at the extreme and then work his way down.

At least that's my hope. That' what I hope he's doing. But we can't be sure.

We shall see.

Thursday, December 8, 2016

Overbought!!?

So, the market has been going crazy after the election and people keep talking about how 'overbought' the market is. Well, the market certainly has gone up a lot in a short time. But is this important or relevant?

Back in my technical days when I was doing a lot of research on technical indicators, the irony was that when a short term oscillator like the RSI or MACD was in 'overbought' region where most books tell you that the market is overbought and therefore must be sold, the markets tended to do even better.  Of course, over time, all of this nets out to a random result as buying overbought markets made you tons of money in trending markets and vice versa. The key was trying to figure out whether the market will be range-bound or trending in the future. Without knowing that, the indicators were basically useless.

But anyway, the overvaluation, rising interest rates and short-term overbought-ness of the market got me thinking about what really matters in calling major turns. People have been calling for a bear market since the crisis and they've been wrong. The stock market has been called a bubble too.  Maybe it's a bubble. In any case, people have been saying the market is overbought for a long time, even when the market just rallied back to where it was pre-crisis. Is something that goes from $100 to $50, and then back to $100 really overbought? Or is it just flat?

Predictions
And by the way, I just want to reiterate how useless predictions are. I remember on a Markel conference call Thomas Gaynor pointed out how oil prices went from $100 to $50 in just a few months, proving that "nobody knows anything" or some such.

This year has again really reinforced this idea. First it was Brexit, and then it was the U.S. election. People were wrong about Brexit (UK voted 'out') and then the markets rallied hard after an initial dip. The same thing happened with the U.S. election.

People say that the market is getting overly optimistic and is likely discounting more than Trump can actually deliver. This is probably true to some extent.

But my feeling is not so much that Trump is going to get the economy going strong; it's that the heavy cloud hanging over the economy and banks has sort of been lifted. Elizabeth Warren will probably have less influence, and the cabinet seems to be filling up with billionaires including Goldman Sachs people and Jamie Dimon too, to head the Business Roundtable.


Long-Term Overbought
Anyway, for long term investors, we don't care if the market is short-term overbought or oversold. We'll leave that to the daytraders. Short-term overbought means nothing, usually. It either means the market will take a break, correct, or will keep going up. Useful, right?

But seriously, if you want to look at overbought oscillators, there is one that is sort of interesting. There was a chart in Barron's last year that was interesting to me. It was in an interview with Joe Rosenberg, the chief investment strategist at Loews. He was calling for higher returns in U.S. stocks over the next 15 years. This was in contrast to most long term bearish views at the time (and even now).

Check it out.


I admit that when I saw this, I scratched my head a little. The chart looks like it should revert back to 10-12%, implying 10-12% trailing total returns over 15 years at some point in the future. That is not the sort of equity market return that I would expect over time. Of course, this may happen 15 years after the 2008/2009 low; this would give that 15-year return a little bump due to the low starting point.

But never mind that, the more important point for me was that despite what people were saying, that the market is overvalued, that the market is overbought (looking at the S&P return since the crisis low) and all that, I just wasn't feeling like the market was in a bubble ready to collapse.

I've seen some bubbles, and one of the key indicators in my mind of a real bubble is not only valuations, but trailing returns. When you see the Nikkei 225 in 1989, U.S. market in 1929 and 1999 and the recent gold bull market, they all had spectacular 1,3, 5 and 10 year (and maybe more time period) returns. This sort of high return pattern over many time spans reinforces the bull story and gets everybody participating.

To me, that sort of thing sets up the bubble; people chase returns, everybody jumps on board, that makes the market go up more, improving trailing returns in a self-reinforcing, virtuous circle of ever-rising stock prices.

This is not something that we see now. I haven't seen it at all in the rally since the crisis low either. It's been more of a grudging rally with doubts and deniers all along.

Updated Chart
So naturally, I updated the above chart to include the S&P 500 rally after the election through now (the Novemeber S&P figure is 2240).

If you notice the previous peaks, we are far away from that. We are in no way set up for a 1929 or 1999-type top in the stock market.

S&P 500 Index 15-year Annualized Change
(this is not total return like the above chart)

Of course, as usual, this doesn't mean that we can't go into a bear market. We can enter a bear market at any time for any reason. And the only people who are going to call it correctly are going to be the people who have been calling for one for years or decades (and those broken clocks will be right then).

Putting this together with my other post about interest rates, there doesn't seem to be a threat of an imminent, 1929/1999/Nikkei 1989-like top in the stock market. Sure, it can happen, but to me, the setup just isn't there.

Brooklyn Investor Website
Anyway, you can see this chart on an interactive basis (you can click to see values, even though I don't know why I can't see the latest datapoints; I am still experimenting with various charting libraries; this one uses Google Charts) at the new and still under-construction-so-not-so-interesting Brooklyn Investor website.

The chart is here: S&P 500 15-year Change

The website is here: http://brklninvestor.com/

Obviously, the more obvious, preferable domain names were already taken so I just took out the 'oo's from Brooklyn.

Anyway, I will be adding stuff there over time. Maybe charts and tables that I like to keep up to date and track and some 'notes' about certain topics that I might want over there instead of here where it can get buried under hundreds of other blog posts.

Keep in mind that it is sort of a coding experiment on my part too, so there will be problems that I will try to resolve over time. For example, the 13F tool stinks... I have to work on that. Probably not too hard, but just a matter of spending time to fix it.


Tuesday, November 22, 2016

Bonds Down, Stocks Up!

So bonds are 'crashing' and stocks are going up. Some say that this can't continue; you can't have stocks and bonds go in opposite directions for long before something snaps. Well, this is true to some extent.

But it sort of depends on which way the 'snap' is happening.  What if bonds were way overvalued versus stocks? In that case, bonds can tank a lot before stocks have to correct. Bears have been saying forever that once the bond market turns and interest rates start to go up, the stock market will crash.

Maybe so.

Let's take a step back and look at what's going on. How can bonds go down and stocks go up?

Here is a look at the earnings yield versus 10-year bond yields since 1871.  The data is from Shiller's website:

S&P 500 Earnings Yield versus 10-year Bond Yield
(1871-November 2016)


Earnings yield and bond yields have sort of tracked each other closely since the 1960's or so. Recently, bond yields went down a lot while earnings yield refused to follow it down. This spread is sort of a cushion for the stock market. Since the spread is so wide, it's not unnatural for both of them to go in opposite directions.

Here is a close-up of this chart from 1950. You can see that that bond yield and earnings yield do sort of track each other, and there is a cushion between them so rising bond yields at the moment do not pose an imminent threat to stock valuations.


S&P 500 Earnings Yield versus 10-year Bond Yield
(1950-November 2016)


Back in 1987 and 2000, for example, bond yields were higher than earnings yield. Back in 1987 before the crash, this spread blew out from 1.3% in December 1986 to 4.4% in September 1987.  That was the rubber-band stretch that caused the market to 'snap' (Black Monday) back into normalcy.

In January 2000, the gap also blew out to 3.3% from less than 1% after the Asian Contagion of 1997.

Here is the spread between bond yields and earnings yields since 1950:


Bond Yield - Earnings Yield
(1950-November 2016)


...and here's a close-up since 1980:

Bond Yield - Earnings Yield
(1980-November 2016)

You can see that pre-Black-Monday-spike in the spread in 1987. Just because the spread is wide doesn't mean a correction is coming, of course. The spread widened many times since 1980.

Nor does it mean that the market can't correct or crash when this is negative. In fact, the spread was negative before the financial crisis in 2007.  That spike you see in the spread chart above actually happened in 2009 when earnings plummeted.

But it is sort of a big-picture-rubber-band indicator. A correction in bonds doesn't automatically mean we must correct in stocks.  One way to look at it may be that if the spread widens too much above zero, it's a warning sign.  We are far from that at this point. 

P/E's Too High
And since I keep hearing, and have kept hearing for years and years that the stock market P/E is too high so therefore must crash or correct, I created this chart to show how meaningless the comment about P/E ratios are when looked at alone.

From the above, we can sort of see that earnings yields and bond yields track each other.  I know many people argue that this Fed model is no good. OK, so maybe it's no good, whatever that means. But you can't really separate the risk free interest rate from asset valuations. Whether you want to use 2.3% to discount long term assets or not is another issue. But over time, of course the treasury rate is going to be a huge factor in determining asset prices.

So, instead of looking at yields, I just drew the same charts as above but using a P/E ratio.  Instead of a bond yield, I created the bond P/E ratio (inverse of yield).

Check it out:

S&P 500 P/E versus 10-year Bond P/E
(1871-November 2016)


...and here's a close up:

S&P 500 P/E versus 10-year Bond P/E
(1950-November 2016)

So you see how bonds are way more overvalued than stocks.  Well, actually, I really don't know if bonds are overvalued or not. In order to know that, I would have to know what future inflation and economic growth is going to be, and I don't know that.

I am always baffled at comments like, "The market has averaged a P/E ratio of 14x for the last 100 years so the stock market is 40% overvalued at 20x...".

How can you compare 14x P/E to the current level without discussing interest rates?  And if you think stocks should trade at 14x P/E today, then you should also think that interest rates should be much higher than they are now. For example, the 10-year bond rate averaged 4.6% since 1871 and 5.8% since 1950. But these periods include a time when interest rates were not set by the market.

OK. So far, we have determined that the bond market rout up to now is no cause for concern for the stock market. Yields of 2.3% is still way below earnings yield.

So What Should 10-year Treasuries Yield?
Obviously, this is the next question. I am no economist so I actually have no idea, but one idea I have always liked is that someone said that long term interest rates should be equal to real GDP growth rate plus the inflation rate, or more simply, nominal GDP growth. This sort of makes sense.

So below is a chart of nominal GDP growth versus the 10-year bond yield. The data is from the FRED (St. Louis Fed) website.

Nominal GDP Growth versus 10-year Treasury Rate
(1930-2015)

Not so bad tracking. Here's a close-up from 1950:

Nominal GDP Growth versus 10-year Treasury Rate
(1950-2015)

So not bad.

From this chart, you can see that the bond market is in fact overvalued, even with a yield of more than 2%. Either that, or the market is expecting nominal GDP growth of only 2.3% or so as of now. As usual, we don't know who is right.

I read a quote of Jeffrey Gundlach of Doubleline saying that he thinks long term rates can get up to 6% in a few years. I don't know if he was referring to the 10-year or 30-year. But who looks at the 30-year anyway, right?

But for yields to get to 6%, Gundlach must be expecting much higher inflation. Real GDP is probably not going to grow that much more than 2%.  Maybe 3%.  But if it does grow 3%, we only need 3% inflation to get to a 6% bond yield.  OK. Maybe that's possible.

So should we be worried about 6% long term rates?

Here is a snip from my Scary Chart post from this summer. 

1955-2014:
            Interest rate range           average P/E
                   4 - 6%                             23.3x
                   6 - 8%                             19.6x 

I looked at the data from 1955-2014 (adding one more year to update this isn't going to change much) to see what the average P/E ratios were when interest rates were in certain ranges.

From the above, we see that the market traded at an average P/E of 23.3x when interest rates were between 4% and 6%.  The 10-year now is at 2.3%.  So we have a long, long way to go for interest rates to threaten the stock market, at least in terms of the bond-yield/earnings-yield model.

Even if rates got up to the 6-8% range, the average P/E has been 20x P/E, or where the stock market is now on a current year basis.

So even if interest rates popped up to 6-8%, the stock market has no need for a valuation adjustment.

Of course, the market can still react negatively to big moves in the bond market, and of course, higher interest rates will impact earnings of companies with debt. This may be offset by a stronger economy if that's what leads to higher rates, not to mention higher earnings at banks and other financials that have been suffering under this low rate environment. It's always tough to model this stuff out.

As we have seen recently with the election, nobody really knows what's going to happen. And even when things are predicted correctly, the market reaction tends to surprise.

From the above blog post, here is a regression analysis of bond yields versus earnings yields. The 1980-2007 period seems overfit for sure; it's a period when stock yields and bond yields tracked each other very closely. I think I used the excuse that post-2007, we have been living in a post-crisis environment of unnaturally low interest rates.

So you can reject that regression as not valid.


Here is the original post when I looked at the relationship between bond yields and earnings yields:
scatterplot.

Again, keep in mind that long term rates after the post-election 'plunge' is 2.3%. The above regression shows that even at 4%  bond yields, almost double the current level, the market tends to trade at anywhere from 19x to 31x P/E.

Conclusion
So bond prices have tanked and the stock market doesn't care at this point. Bears say this can't go on and that overvalued stocks will follow bonds down soon.

The above shows that

  • The recent plunge in bonds is a rubber band snapping back (bonds way overvalued versus stocks) and not a rubber band stretching that will eventually snap (like the bond crash before Black Monday).
  • Bond yields are still below earnings yields so current bond market correction shouldn't be a threat to stock prices at current or much higher levels. 
  • Bond yields will probably have to get much higher than earnings yield before it becomes a serious threat to stock prices. 
  • Even with bond yields at 6-8%, stocks prices can be reasonably valued at current levels. 
  • Saying the stock market is overvalued with respect to historical averages is nonsense without reference to historic relationship to bond yields.
  • etc...
Having said all that, of course the market can still tank for any number of reasons; geopolitical issues, economy tanking, some sort of crisis etc. 

This only isolates and looks at two factors. And according to those two factors, there is no tension that needs to be resolved. 

Since I tend to post these and other charts on occasion, and it's a hassle for me to update every time, I am going to set up a companion website to this blog that will have this data and charts that I can update and reference so I don't need to update and cut/paste into a blog post. Also, anyone can go there and look at it at any time to see what these indicators are saying. 

There will be other information/data posted there too as sort of my public, personal investment notebook.  

I will provide a link to it when it's ready. 

Tuesday, November 15, 2016

Active Play: Pzena Investment Management Inc. (PZN)

So, continuing with the theme of active investing, I decided to take a look at Pzena Investment Management again. I've been watching it for a while and have posted about it in the past, but the stars are lining up more now than before. I think the sentiment against active investing is at sort of a peak.

I don't usually like investing in themes, though. Those things never seem to work out. Health care stocks because of the aging population, investing in the baby-boom consumption boom, investing in green/environmental, investing in hard assets because they don't make land anymore (versus paper assets) etc. From what I've seen over the years, it just never seems to work out the way people think. Just sticking to great businesses at decent prices seems the way to go.

But sometimes, there are themes that look sort of interesting only because sentiment seems to be leaning too hard one way or the other, and there seems to be interesting investment ideas.

I don't like when things line up too much in terms of investment themes because that often means a lot of people also agree and it may not work out. But things got more in line this week with the surprise election of Trump.  Of course, everyone thought Clinton would win (but she didn't), and many thought that the market would crash if Trump was elected (but it rallied, even though the crash callers were sort of right for a few hours).

This has lead to a huge rally in the stock market with financials finally showing some real strength. Even the Berkshire Hathaway chart looks funny, like it was about to be LBO'ed or something.

Even Stanley Druckenmiller sold his gold and got into stocks on Trump's win. It's true that in terms of trend, DC will probably move away from over-regulation.  And banks probably won't have to worry about Sanders/Warren bank-destruction.

Many may not like Trump, but in the end, he has his ego on the line and he is a negotiator so I would not be surprised if he got a lot of things done. Many things people will not agree with, like rolling back environmental/green initiatives. But these can be very pro-business, pro-investment.

So when you see it that way, and see how the industrial cyclicals and banks rallied and the FANGs got killed, if this trend continues, it can really put a dent in the below value cycles charts because the value stocks were the ones that have been suffering in recent years due to this tendency to over-regulate.

Anyway, I usually wouldn't expect a lot of change from an election, but this time the Republicans control congress (Republicans don't really control Trump, though) so there can be a lot more change than usual.

Before we start on PZN, they updated their report on the value cycle so let's look at that. It's really interesting.

Pzena Update on the Value Cycle
Here's the link to their 3Q commentary. Go there and read it:

     Pzena 3Q commentary

What really interested me about this idea and why I am so intrigued by it is that for most of the time I've been writing this blog (starting in 2011), people have been saying that the market is way overvalued, that the market will crash, that it's a bubble etc.  Even in 2008/2009, people were saying that the sky-high P/E ratios were insane and the market will not recover (even though the high P/E's were due to great recession-depressed earnings).

And each time I read that stuff, I looked at the stocks I own, watch or whatever, and what I saw on my spreadsheets just didn't correspond to what people were saying about the market. I've posted about that over the years. I was always scratching my head.

And then I found these reports and I was like, of course!  The market is bifurcated. FANG stocks and many others were going through the roof and had super-high valuations, but many others were just priced normally.  Maybe not cheap, but not expensive either. And actually, many were cheap (especially financials).

Anyway, let's take a look at some of the updated charts.





Now that's an amazing chart. Do you want to be long that chart or short it? Some will argue that this looks just like the P/E chart. If you want to short this chart, why wouldn't you want to short the P/E chart too (short stocks). The big difference here is that this chart is a spread between stocks, so it is much more likely for this chart to mean revert than the other P/E chart (which may stay high for years due to lower interest rates; yes, rates are moving up now, but they would have to move up a lot to get P/E's to revert to 100-year average levels).

If you look carefully at this chart, you will see that the chart mean-reverted as recently as the mid-2000's (actually hitting the lower bound of it, unlike the P/E or CAPE charts).

So this chart is way more likely to mean-revert than raw P/E or CAPE charts. I would much rather short this chart than a raw P/E or CAPE chart.

And to play this, you obviously want to go long value stocks, or get into a long/short strategies based on valuation (see my previous post about the Gotham Funds or OZM).

Pzena shows the same charts/tables for European and Japanese stocks too and it is very interesting.  I won't paste those here, though, so go see for yourself.

Check out this table:



This sort of shows the various deep value cycles we've been through over the years. The current cycle hasn't been that great for value, but I see it as sort of an elongated cycle; elongated partly due to the great recession and it's after-effects.

Value Didn't Suddenly Become Useless
I don't think anything happened that suddenly makes value not work anymore. There is a lot of factors at work here, and interestingly, a lot of it may also have to do with the boom in passive investing and the bear market in active investing. People often argue that fundamental stock-picking doesn't work anymore due to indexing and the ETF-ing of the world. But as Buffett said in his 1985 letter, that should really be great for us value people.

But regulation and subdued economic cycle after the great recession made value stocks perform poorly making active funds not perform well, thus pushing investor capital out of active funds into passive funds thus exacerbating the prolonging of the value cycle etc. This is sort of the self-reinforcing cycle that lead to the extreme valuation dispersion you see in the chart above.

This is not a permanent state, though. We've seen this before.

Anyway, let's take a closer look at Pzena, their funds' performance and how this all ties into the above charts/tables and how it tells an interesting story about the possible future of PZN.

PZN Fund Performance
What's really great about PZN's disclosure is that they have performance figures in their 10-Ks and 10-Qs, with a benchmark. Alternative asset managers usually have this stuff too, making it easier to evaluate as potential investments.  Many conventional managers, though, don't show this stuff, so you really have no idea if their funds outperform or not.

I have always been interested in the Affiliated Managers Group (AMG), for example, but that's sort of been my problem. They own fund managers that I really respect, from Tweedy Browne to Yacktman, ValueAct etc., but you really can't tell how they are performing overall. Also, the managers I am familiar with are only a small part of their business. Plus they own a bunch of alternative managers; I would be even more curious about those and how they perform. On a cash earnings basis, AMG is cheap so it is interesting, but that's always been the hurdle for me that I couldn't get over.  I don't think they will have a Legg-Mason-(LM)-during-the-crisis type of problem, but that's the thing with alternative managers; if you don't really understand what they are doing, you don't know if there are any time bombs anywhere.

Anyway, let's look at PZN.  From the above value cycle charts, we sort of already know that value funds haven't done well in the recent past. You can see that the value spread since the mid-2000's has just continued to widen, meaning expensive stocks got more expensive versus cheap stocks. If you are a value investor, you would be rowing upstream.

The following table is from their 3Q2016 10-Q:
Period Ended September 30, 20161
Investment Strategy (Inception Date)
Since Inception
5 Years
3 Years
1 Year
Large Cap Expanded Value (July 2012)








Annualized Gross Returns
14.5
 %
N/A

9.1
 %
14.6
%
Annualized Net Returns
14.3
 %
N/A

8.9
 %
14.4
%
Russell 1000® Value Index
13.6
 %
N/A

9.7
 %
16.2
%
Large Cap Focused Value (October 2000)
Annualized Gross Returns
6.7
 %
16.2
%
8.7
 %
15.3
%
Annualized Net Returns
6.3
 %
15.7
%
8.2
 %
14.9
%
Russell 1000® Value Index
6.3
 %
16.2
%
9.7
 %
16.2
%
Global Focused Value (January 2004)








Annualized Gross Returns
4.8
 %
12.8
%
3.5
 %
8.9
%

Annualized Net Returns
4.0
 %
12.1
%
2.9
 %
8.2
%
MSCI® All Country World Index—Net/U.S.$2
6.2
 %
10.6
%
5.2
 %
12.0
%
International (ex-U.S) Expanded Value (November 2008)








Annualized Gross Returns
10.3
 %
9.7
%
0.5
 %
5.9
%
Annualized Net Returns
10.0
 %
9.4
%
0.2
 %
5.5
%
MSCI® EAFE Index—Net/U.S.$2
7.2
 %
7.4
%
0.5
 %
6.5
%
Focused Value (January 1996)








Annualized Gross Returns
10.6
 %
17.2
%
9.1
 %
16.1
%
Annualized Net Returns
9.8
 %
16.5
%
8.5
 %
15.5
%
Russell 1000® Value Index
8.7
 %
16.2
%
9.7
 %
16.2
%
Emerging Markets Focused Value (January 2008)




Annualized Gross Returns
1.2
 %
5.3
%
(1.7
)%
19.8
%
Annualized Net Returns
0.3
 %
4.6
%
(2.4
)%
18.9
%
MSCI® Emerging Markets Index—Net/U.S.$2
(1.2
)%
3.0
%
(0.6
)%
16.8
%
Global Expanded Value (January 2010)








Annualized Gross Returns
7.8
 %
12.4
%
4.4
 %
9.6
%
Annualized Net Returns
7.5
 %
12.1
%
4.0
 %
9.2
%
MSCI® World Index—Net/U.S.$2
8.2
 %
11.6
%
5.8
 %
11.4
%
Mid Cap Expanded Value (April 2014)




Annualized Gross Returns
6.3
 %
N/A

N/A

18.1
%
Annualized Net Returns
6.1
 %
N/A

N/A

17.8
%
Russell Mid Cap® Value Index
6.9
 %
N/A

N/A

17.3
%
Small Cap Focused Value (January 1996)








Annualized Gross Returns
13.9
 %
20.1
%
10.7
 %
18.5
%
Annualized Net Returns
12.6
 %
18.9
%
9.6
 %
17.3
%
Russell 2000® Value Index
9.7
 %
15.5
%
6.8
 %
18.8
%
European Focused Value (August 2008)




Annualized Gross Returns
4.0
 %
10.2
%
(1.6
)%
1.9
%
Annualized Net Returns
3.6
 %
9.8
%
(2.0
)%
1.5
%
MSCI® Europe Index—Net/U.S.$2
0.9
 %
7.5
%
(0.6
)%
2.5
%
International (ex-U.S) Focused Value (January 2004)




Annualized Gross Returns
5.7
 %
10.2
%
0.3
 %
6.7
%
Annualized Net Returns
4.9
 %
9.5
%
(0.3
)%
6.1
%
MSCI® All Country World ex-U.S. Index—Net/U.S.$2
5.5
 %
6.0
%
0.2
 %
9.3
%
Mid Cap Focused Value (September 1998)




Annualized Gross Returns
12.8
 %
20.0
%
9.4
 %
18.3
%
Annualized Net Returns
12.0
 %
19.2
%
8.7
 %
17.6
%
Russell Mid Cap® Value Index
10.4
 %
17.4
%
10.5
 %
17.3
%


Some of the long term performance is pretty good, but otherwise a mixed bag, but then again, against the backdrop of a 'bad for value' environment for most of the recent past, it may not be so bad. OK, maybe I am being too forgiving. But that's just my view. It has just been a terrible time to be a value investor.  The value opportunity chart went from -1 standard deviation to +3 standard deviations. That's a really strong headwind.

Older Record of PZN
OK, so I decided to look further back.  How did PZN do when there wasn't such a headwind? From their prospectus in 2007, I found this chart. It's the performance of their value strategy from 1995 to 2007.

Look:


That's really impressive.  Great outperformance.

And then go back to the value opportunity chart above. There really was no massive wind at their back in terms of value opportunity. It wasn't like the period 1995-2007 was one where it went from "significant value opportunity" to "limited value opportunity". It looks like, just eyeballing, it went from a period of "limited value opportunity" to "limited value opportunity", but maybe slightly less so.  So there wasn't that sort of wind at their back.

But look closer at the above chart.  From 1995 to around 2000 or so, PZN was underperforming. And again, go back to the above value opportunity chart, and sure enough, that period of underperformance corresponds to a period when the market went from "limited value opportunity" to "significant value opportunity" in 2000. Bingo!

So this current cycle of underperformance may be a little elongated, but if 1995-2000 is any guide, PZN may have some serious outperformance in store when things mean revert.

And if the period of underperformance is elongated, the period of outperformance may be elongated too.  Who knows?

Here's a marked version of the above charts close to each other so you can see it better:





The red arrows show periods bad for value investing and blue arrows show good times for value. We may get a nice extended blue arrow in the next few years. If that happens, that would be great for value funds.

PZN Fundamentals
So what is PZN worth? I don't know. I have no idea. In order to figure that out, you have to know what AUM will be in the future, and I have no idea about that.

But I think if you can make the case that PZN is reasonably valued at current levels of AUM and profitability, then it's a good deal because you are expecting the mean reversion of the above value spread chart and therefore outperformance, maybe even significant and long term outperformance over the next few years. Operating leverage of asset managers here might kick in too as PZN seems to run their funds as a small team (alternative asset managers seem to add AUM by adding teams which doesn't give it the same operating leverage as the cost base goes up).

So that's all I hope to achieve. Let's just see if it's reasonably priced with conservative, reasonable, close-to-status-quo assumptions.

Here are some key data of PZN:

Year-
OperOperDVD/end
RevenuesincomemgnshareAUM
($mn)($mn)($bn)
200232,81715,82848.23%3.1
200333,58414,41342.92%5.8
200451,89618,05034.78%10.7
200578,59631,57740.18%16.8
2006115,08733,60929.20%27.3
2007147,14969,37847.15%$0.1123.6
2008101,40464,39363.50%$0.2710.7
200963,03929,78747.25%$0.0014.3
201077,52539,97051.56%$0.2415.6
201183,04537,85445.58%$0.1213.5
201276,28037,17948.74%$0.2817.1
201395,76950,84853.09%$0.2525.0
2014112,51160,95354.18%$0.3527.7
2015116,60755,41747.52%$0.4126.0

You can see that PZN has had a rough history, but mostly due to the financial crisis. If you think something like that is coming soon, then of course, don't bother with this stock.  Just wait for the crisis to happen and buy it then.

Otherwise, here are some simple assumptions I made to model their earnings.

First, their AUM at the end of October 2016 was $27.2 billion. But since the post-Trump rally was good for financials and value stocks in general, and maybe some people will buy PZN funds after reading this post, let's use $30 billion in AUM.  It's not stretch at all from the pre-Trump AUM of $27 billion.

Their average management fee rate was around 0.43% in 2014 and 2015, 0.48% in the past five years, and 0.51% since 2007 (actually this is just revenues divided by average AUM).  These figures include incentive fees too, but their inventive fees are nothing like hedge fund/private equity incentive fees so are very small in proportion to management fees.

But still, due to fee pressures across the industry, let's just use 0.4% as the average fee rate.

Also, operating margin has averaged around 50%-51% in the last five years and since 2007.  So let's use 50% as the operating margin. Pretax margin has also averaged around 50% since 2002.

OK, and there are around 69 million fully diluted shares outstanding, so let's use that to get operating EPS, or as a proxy for pretax earnings (remember, we like to price things at 10x pretax earnings).

Using the above assumptions, we get to $0.87/share in operating earnings.  There are non-operating items below the operating income line, but I ignored that because that is mostly due to investment gain/losses (which I can't predict and would imagine it wouldn't average out to much over time), and adjustments in tax related things (due to exchanges of units into class A shares etc.) which are non-operational.

10x this $0.87/share figure is around $8.70/share, not far from where it is trading now.

Non-GAAP EPS in 2014 and 2015 were $0.51/share and PZN likes to pay 70%-80% of non-GAAP earnings out as dividends.  So that would be around $0.40/share, which is pretty much what they paid out in 2015.  And 2015 wasn't even a great year by any means (funds were down).

Anyway, $0.40/share on a $8.90 stock price is a 4.5% dividend yield. PZN is trading at 17.4x the $0.51 2015 EPS, so it is not a screaming bargain, but not terribly expensive either. Asset managers are cheap now, but they used to typically trade at 20x P/E or so.

Operating Leverage
Asset managers are great businesses because if you have a team in place, any increase in AUM due to investment inflows and increase in portfolio value leads to increases in fee income which fall straight to the bottom line (net of some bonuses).

The problem with some of the alternative managers is that sometimes they grow assets by adding new strategies; this requires increasing overhead.  Of course, over time, if the new teams can increase AUM, that would be great for earnings.

PZN seems to add strategies more organically.  Their expenses have been creeping up lately, but that may just be due to returning expenses to where they were before considerable belt-tightening during and after the financial crisis and there have been additions in sales (increase distribution, mutual funds, London office etc). 2015 operating expenses were higher at $61 million than the $50 million or so back in 2007. First nine months of 2016 is running a little lower than 2015. There were $1.8 million non-recurring expense, though, in 2015.

Conclusion
So even here, PZN is reasonable priced.  Not really cheap or anything as is, but the company is positioned well for any recovery in active value investing.

I do believe things are cyclical, especially on Wall Street, and value investing has been in a bear market for a long time. If that rubber band in the above chart snaps back, PZN could be one of the huge winners. They made money through the crisis so PZN is not going to blow up either.