Monday, June 17, 2013

Self assessment Monday: an old letter to a client...

About two years ago I wrote a letter to our foundation client about how we viewed the equity markets. Mike* had sent Bronte a profoundly bearish broker note.

I posted the letter on the blog. The original (reproduced below) can be found at this link.

Dear Mike 
The bear case always sounds intellectually more convincing than the bull case. And it is in this broker note too. Intellectual sounding and convincing. 
But America is still an amazingly innovative country, humans are ingenious and most of the imbalances will sort themselves out. Big cap equities are cheap relative to almost all other assets (especially relative to small cap equities, cash and bonds and to many assets such as commercial property that require leverage). Cash yields almost minus 3 percent after inflation and less post tax. Bonds are scary as hell and yield minus 1% after tax and inflation. 
Big though difficult-to-run companies are at low teens multiples.  Great franchises are at mid-teens multiples.  Tesco (UK) which is a truly great franchise - is at a 14 PE ratio. And the Pound is historically cheap. WalMart and Target - both slightly less good franchises - are at 12 times. The difficult parts of Silicon Valley (eg HP) are well under 10 times PE ratios (and we feel no need to own that one). The less difficult parts of Silicon Valley (Google for instance) are at a high teens PE ratio once you take out the excess cash. We own that. 
Own equities.  Don't kid yourself.  Mega-cap equities are generationally cheap compared to other assets - and certainly compared to the cash/bond/levered asset complex. 
Just don't be blind about it. The places that there have been high returns (Asia, small caps, smaller resource companies) are riddled with fraud. Twenty five years of deregulation and the high levels of innovation mean we have high and rising levels of stock fraud. Fortunately there is much less fraud risk in mega-caps. 
Don't own Australia or the iron-ore-coal-steel complex. It has run too far and has been too easy to make money. Too many stupid/aggressive/greedy people are doing too much expansion. Some of these people are stupid - but they have made much more money than you or me so they must be right!
I can find dozens of reasons to be bearish - but I look at it dispassionately and I am bullish on big caps, and bullish on America. The problems will sort themselves out and the American exceptionalism (decent institutions, free enough markets and a willingness to take risks) will work their magic again. 
Anything that takes you out of real assets (businesses and property that generate real cash flow) and puts you into nominal assets is - with a ten year time-frame - a bad idea. (And why is your personal account any shorter dated than that?) 
Just don't get greedy by buying things you do not understand: you will be ripped off. The underlying fraud level is as high as I have ever seen it.
Oh, and we are also bullish on France and Germany. Old Europe has manufacturing and production power of enormous levels. (Remember what they produced to fight wars? Their productive capacity is very high and Americans have forgotten that. They do engineering as well as anybody. And Germany no longer has a restrictive monetary policy to crush its consumer market.) 
Also the French are in that lovely position of having convinced newly rich Asians that they are the arbiters of good taste. There are few higher ROE businesses. France has played Asia better than America.
We can see plenty of reasons to be bearish - but just the frauds makes our portfolio short enough. Indeed we are plenty short and likely to remain so until I can't find frauds with ease.
Beyond that, there is a lot of pessimism around. It has got to be time to be bullish. We certainly do not desire being 125 percent net long or hyper-aggressive like that - but we will take steps to become incrementally longer. We are if anything too short.


At Bronte we have done pretty well in the past two years - and a good part of the reason can be seen in this letter. Still it is worth assessing how we went on a line by line basis.

The starting call - Tesco which we still own has not been great and the turnaround is appearing more difficult. That was a dud.

The Great British Pound is slightly cheaper compared to the USD so that was also a dud. It was a dud we doubled down on by buying a large stake in Vodafone.

Walmart and Target have both been fine investments; up about 40 percent plus dividends. We only owned Target. It is pretty hard to pick the charts apart but we suspect that operationally we might be in the wrong stock. We did not think that income disparity in the US would continue to widen. However it has and a widening income disparity favors Walmart over Target. [Target is just too up-market.] Also we think the very-cheap-very-diversified retailers are the last ones displaced by the web. Walmart is about the safest name in retail.

Hewlett Packard, which we explicitly stated we did not own, was an okay short over that time. We were short but we did not do as well as the chart suggests as we were too aggressive with put options on the premise of an underfunded pension fund – which proved unfounded.

Google which we owned has been a fine stock. However after the appreciation we own much less of it. We were about 7 percent in the stock at $550 and are just above 4 percent in the stock at $870.

Explicitly not owning the Australian iron-ore-coal-steel complex has been a good call. We were short a few iron-ore names. Those mostly worked for us.

Our French and German industrial names have had more than adequate returns. Our French liquor companies have continued to sell a lot of highly priced Cognac in Asia.

The place we have been mostly wrong is on shorting some frauds. We have had irregular wins in this [alas we will not name names]. We have also had a few losses. This is a bull market and bull markets tend not to be the time-or-place for exposing frauds. Still our short book is not an abject failure.  It contains a few wins and very few disasters. The most prominent loss was that we bet hard that the Focus Media acquisition would not close. Focus Media has very funky accounts - but that did not stop a multi-billion dollar acquisition.

The general call to be long big-cap stocks and avoiding Asia/China/Resources was not a bad call. This continues to be our call but we are far less convinced about it now than we were two years ago simply because the price has changed.

Where to now?

I have another person - a close friend - who has just lost her job and wants some financial advice. I would love to give it to her - but I am finding it extremely difficult to write anything as clear and well supported as the advice above.


*Mike is not his real name.


Anonymous said...

What is your theory on what happened with FMCN? How will you protect against this going forward?

Loving your work btw.

John Hempton said...

My theory on FMCN is real company fake accounts - and if the earnings were half real then the buyout still worked.

I am having a hard time reconciling real company fake accounts - but have found a few.

I still do not now entirely how I defend...


Gordon said...

For more on Tesco see on a recent Robert Peston post. Click on 'Your Comments' then select 'Highest' to get the overall flavour of their standing.

Anonymous said...

Can you share more of your thoughts on Tesco? So many value guys seems to have got this one wrong. You call it a dud, but would it still be a dud over a longer investment horizon?

Anonymous said...

How did you as an Australian manager of money miss the largest slam dunk short of a lifetime? One that was more suspect than any Chinese company you had sold short.

BBG - BIllabong.

Anonymous said...


I recall a while back you had a piece on Clearwire (CLWR)that has turned out to be a fantastic call. It definitely deserves a notable mention in your self-assesment (especially if you hung on till it was in play).


I can't find the original piece and would very much appreciate if you could tell us the month it was published.

Anonymous said...

I've been consoling myself on FMCN that it went up less than the market. At least there was some "alpha" even though the absolute return wasn't there. And they undeniably had fake accounts. Still a risk-reward I'd take all day long.

DangerousDave said...

Hi John,

Am a little concerned, recessions are cycles but I fear the innovation will not lift the gloom.

Candidly the scary bit is that not only are company accounts on more frequent occasions proven to be fraudulent, the institutions we hope to safeguard us are too...


Anonymous said...

thanks for the post

CrocodileChuck said...

Its the end of the line for Walmart's business model (big box stores). They can't even keep items in stock, now:

And their demographic is increasingly enfeebled, with the % of US population on food stamps increasing to 16% (and growing).

About five years back, I read a v interesting comparison of retail between the US and Finland: the former had 90X as many square feet of retail space as the latter.

With Amazon providing free shipping > $25, expect to see much more of legacy retail business migrating to this channel.

BestBuy's already carked, JC Penney and Sears are pawing at the ground, eager to be interred.

Whither the big box stores? One 'rebirth opportunity': suburban data centres.

John Hempton said...

The Clearwire piece was published in a letter to clients - we were inclined to describe it as our favorite - although riskiest long.

It worked very well - and yes - we held some all the way - and indeed increased positions at the right time.

I only wish they all worked like that.


Anonymous said...

Are you still long Europe, with emphasis on Germany and France? I tend to think Spanish companies are best on a purely valuation basis nowadays...

dearieme said...

Congratulations on the success of your predictions of 2011.

Our best investment of the last half dozen years has been a Physical Silver ETF. Trouble is, I have not the faintest idea of when to sell it, or what to replace it with.

Everything seems too expensive to me.

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