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The Investing Game

by Victor K. Lai, CFA

Year in review


In 2017 the US faced multiple natural disasters, dysfunction in Washington, and even the threat of nuclear war. The wall of worry stood tall, but the truth is it never gets any lower. Whether political, economic, or social, problems don’t go away; they just reinvent themselves with different monikers. Meanwhile we’re on the wall and can either keep climbing or look down and freeze in fear.


Those who got stuck missed another double-digit year for US equites. Foreign markets advanced even farther with emerging markets leading the way. But the blockbuster news of the year was, by far, digital currencies like Bitcoin. Many tokens were up by thousands of percent. We’ll consider what may happen with digital currencies and the markets ahead. But as usual, let’s start with a review of last year’s fortune telling.


Learning to KISS


It may have been luck that all my “seeking value” calls from 2017 were in the money. Specifically, I called out investments in solar and uranium stocks as well as the Greek and Nigerian stock markets. Solar and uranium were both tied to the secular case for alternative energy, which is well-known (albeit more for solar than nuclear). Something less obvious was how far stocks in both industries sold off. I argued valuations looked attractive and our Macro Value strategy took positions in each. They paid off, with solar stocks up 57.8% and uranium stocks up 24.3% in 2017.


The country calls also worked in our favor. Everyone knew Greece was a mess and its stock market had been long left for dead. But pessimism was so pervasive few noticed green shoots were emerging. Likewise, Nigeria was so widely derided, few took seriously how quickly its economy was growing. I thought valuations were compelling enough to take positions in Macro Value. The Greek and Nigerian markets gained 37.1% and 29.9%, respectively.


2017 Total Returns

Source: ETF Replay, Fidelity, BCM

Of course, this was a year when MSCI ACWI (global stock market) was up 24.3%, impressive in its own right. The reality is most managers are unable to keep up with strong market rallies. There are many reasons like fees, mandates, or just mistakes. Whatever the reason, it’s just hard to consistently beat the market, and utterly impossible without a clear and disciplined strategy.


Refining my strategy over the years I’ve increasingly recognized the importance of simplicity. The concept is nothing new. Albert Einstein advocated it saying “The definition of genius is taking the complex and making it simple.” I tend to agree with Einstein as much as possible. But when I forget his words of wisdom, I manage to remind myself to “KISS,” or “Keep it simple, stupid.” It took a long time for my investment process to go full circle from being totally and unnecessarily complicated to as simple as possible. Along the way I learned a couple of important lessons which I share next.


Lessons from the investing game


First, when it comes to investing, accuracy can be more important than precision. For example, if I predict IBM will be the best performing stock over the next 10 months, I’ll most likely be wrong. It doesn’t matter how smart I am or how sophisticated my tools are. The simple truth is the markets are inherently unpredictable and the more precise a prediction is the more likely it will be wrong.

On the other hand, if I predict the S&P 500 will be higher in 20 years, we don’t need any fancy tools to know I’ll probably be right. We may criticize the S&P prediction as simple, but that doesn’t change the fact it’s more likely correct. Ultimately investors are paid to be right, not to be fancy or precise. Warren Buffett nailed it when he said “I’d rather be approximately right than precisely wrong.” Maintaining a big picture, high-level, macro perspective allows us to emphasize accuracy over precision, and it improves our chances of being right.

However, just being right is not enough. If everyone agrees something is right and crowds into the same position, there could be more money lost than gained. That brings us to the second lesson, and the single most important investing principle there is – “buy low, sell high.” Easier said than done I know. Is a $10 stock price high or low? We don’t know because price only tells us what we pay. Investors really need to know what they get. In other words, if we can understand an investment’s fair value then we have a much better chance of knowing if market price is too high or low.

But even then, uncertainty looms because both market prices and valuations fluctuate. That may not sound reassuring, but the reality is markets provide no guarantees and the best we can do is be “approximately right.” Investing is ultimately a game of chance. And as with any such game, our chance of winning increases over time when we have a strategy that tilts the odds in our favor. Investors try to do that in many ways, from complex trading systems to simple buy and hold techniques.


Time and experience have taught me that maintaining a macro-level perspective and focusing on valuation is a sustainable strategy for gaining the proverbial edge. If you have been keeping track, all of our successful “seeking value” calls of the past few years have been achieved through this same simple but effective approach. I will share some of our calls going into 2018, but before we get to that, let’s address the 800-pound cryptocurrency in the room.


Crazy for crypto


There’s no denying that digital currencies (aka “cryptocurrencies”) like Bitcoin made the biggest investment headlines in 2017. Prices shot up in spectacular form, and everyone from seasoned investors to teen-aged kids wanted a taste of the crypto (disclosure, I own insignificant amounts of digital currency).


BTC Prices 2017

If you missed out on the raging rally, don’t be too hard on yourself. You were in good, really good company. Here’re what some legendary investors have said on the topic.


· Warren Buffett - "Stay away from it. It's a mirage, basically...the idea that it has some huge intrinsic value is a joke in my view."


· Jack Bogle - “Avoid Bitcoin like the plague. Did I make myself clear?”


· Ray Dalio - "Bitcoin today you can't make much transactions in it. You can't spend it very easily. It's not an effective store-hold of wealth because it has volatility to it, unlike gold. Bitcoin is a highly speculative market. Bitcoin is a bubble."


· Howard Marks - “Digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none beyond what people will pay for it."


· Carl Icahn - "It's sort of amazing to me. If you read history books about all these bubbles, like in Mississippi — where John Law went around selling all this land in Mississippi that was sort of worthless and the French were going crazy giving him all this money. And then one night it all blew up ... to me, this is what this is. Seems like a bubble."


· Richard Bernstein - “One would have thought that investors would have learned their lesson from the deflation of the technology and housing bubbles, but that doesn’t appear to be the case. The sad reality is that many more investors will likely get sucked into this bubble too.”


I’m no expert in digital currencies and I don’t expect to make a fortune off the crypto I own. Also, I mostly agree with what the legends are saying. But I don’t agree digital currencies are a total fraud or will evaporate into nothing. Well, some tokens probably will. But the mainstays like Bitcoin are likely sticking around, albeit probably not for their original intended purposes. I don’t see Bitcoin (and by Bitcoin, I mean all digital currencies in general) replacing the US Dollar or becoming the world’s reserve currency. But it could be a tool for facilitating currency exchange or money movement. If nothing else, it could have a place as “digital gold” for speculators.


In addition, it’s entirely possible for Bitcoin to continue its remarkable climb, at least short-term. Those who deny that possibility may be blinded by rationality. Intelligent investors tend to approach Bitcoin with logic and reason. The problem is Bitcoin has reached a state of “irrational exuberance,” and you just can’t reason with crazy! I’m not calling Bitcoin proponents nuts – but I do think any price chart that plots at 90 degrees qualifies as such.


The point is anything can happen in the short-run. But in the long-run, I agree with the legendary. Those piling into Bitcoin now and expecting to get rich off sustained parabolic price increases are more likely to find themselves in a bubble than in the money. Like all bubbles, it will burst, that much I agree with. But when all is done, I don’t think we hear last of Bitcoin. Rather I think it matures and finds its place, wherever that may be.


One last comment before moving on. Some fear the bursting of a crypto bubble will lead to a wider market crash, like the great financial crisis. It's possible, but I doubt it. While many people are talking about crypto, most people do not own any or have any exposure to it. That makes it less dangerous than the problems we saw in housing during the 2000s, in my opinion.


Seeking value


The markets are in a peculiar state. Save for a few insolvent concerns (Venezuelan or Puerto Rican bonds anyone?), market prices and valuations look elevated all around the world. Unlike years past, I don’t see any obviously, absolutely undervalued markets. That’s clearly a challenge for a strategy like Macro Value. In times like these, even relative bargains must do.


Emerging leading the way


Forced to choose right now, I prefer emerging market equities over developed markets. That may come as a surprise since emerging markets ran up the most in 2017, compared to US and EAFE.


2017 Total Returns


To be clear, US, EAFE, and EM equity markets all look overvalued at present, it’s just emerging markets look the least expensive, relatively speaking. Combine that with favorable long-term growth expectations and it’s a straightforward call.


Price Multiples


Source: Reuters, BCM

In years past I favored specific emerging markets like Russia. Currently, China has been my favorite, but after significant price rallies, I can’t say any specific market looks absolutely undervalued in a compelling way. So, in the spirit of accuracy over precision I’m taking a step back this year and calling out emerging markets at large rather than any specific market.


The risks to owning emerging markets are well-known. In addition to wider swings in growth and earnings, investors need to be wary of geopolitical and currency risks as well. After the runup in 2017 investors are already pricing in higher expectations. Should those expectations not be met, or should any number of macro shocks strike, emerging market stocks can fall fast and hard. Let’s not forget emerging market stocks saw a drawdown of 63% during the financial crisis. The point is don’t bite off more than you can stomach.


Digger deeper for energy


The table below shows trailing price to earnings ratios for US equity sectors based on forecasted 2017 earnings. US stocks look expensive across the board.


Sector PEs

Source: AltaVista Research

At first glance the most expensive sector is energy, at over 36 times earnings. But digging deeper reveals energy could actually be the least expensive sector. Energy took large write downs to earnings in 2016 and 2015 when oil prices collapsed from over $100 a barrel down into the $20’s. Reported earnings were actually negative for both years. Not only was that abnormal, but it also makes valuing the sector based on historical earnings quite difficult (a 0 denominator in P/E does not compute).


The 36.1 sector P/E estimate assumes an EPS value of $14.75 for 2017. Relative to history, that’s a low figure, but it makes sense since earnings are bouncing off of a negative starting value. Over the past decade normalized earnings (excluding the abnormal reads in 2015 and 2016) averaged about $36 per share (coincidently). If we assume energy sector earnings normalize moving forward, that brings the P/E (at current prices) down to about 14x. That looks much better than the 36x read, and actually makes energy look relatively attractive to other sectors.


Energy Sector EPS

Source: Standard & Poor's, AltaVista Research, BCM

Other measures seem to agree, even without adjustments. The table below shows additional valuation multiples by sector. Energy looks relatively undervalued to the broad market across all measures. In addition, energy is tied for least expensive in terms of growth and sales, is second least expensive in terms of cash flow, and is third least expensive in terms of book value.


Valuation Multiples

Source: AltaVista Research

Keep in mind this relative value exists even while other sectors are reporting historically high sales and earnings, which should technically make their price multiples appear less expensive versus energy.


Energy looks relatively undervalued, but honestly, I’m not thrilled about it. This is like wearing the least smelly of the dirty laundry. But in the US where stocks look widely overvalued, energy is just one of few things that pass the valuation sniff test. But since valuations are not outright cheap, there’s less cushion. Many companies are still recovering from the oil rout and still wobbly. Should oil prices slump again, or should economic conditions deteriorate, the sector would surly take a tumble. And though energy is seen as a conservative, value oriented sector, let’s not forget the sector saw a drawdown of 53% during the financial crisis, just saying.


Fear and greed


There’s actually one thing I can think of that looks really undervalued, but it’s not a traditional asset class or investment. I’m talking about stock market volatility, as measured by the CBOE’s VIX index (aka the “fear index”). In the US, strong stock market returns have increased risk appetite and investors are turning shades of green. At year end, CNN Money’s Fear and Greed index reached “extreme greed” territory.


Fear and Greed Index

Source: CNN Money

Greedy investors are fearless and so the VIX index has been abnormally low. Historically the VIX has averaged around a reading of 20. Since 2012, however, the index has remained stubbornly below the 20 level, save for a few intermittent spikes. In fact, over the past year the VIX has been bouncing around 10. The VIX doesn't look much different from other periods of market calm, but it is still one of few things that looks absolutely low.


CBOE Volatility Index

Source: Yahoo Finance

The problem is the VIX is not really an investable asset (nor is volatility). It's an index derived from option trading activity on another index, the S&P 500. The closest investors can get to it is indirect exposure through financial products designed to track the VIX (which adds yet another layer of intangible-ness).


To that end investors should understand the products they use. For example, options on the VIX are European in style. They can only be exercised or assigned at maturity, which causes deltas to be muted until the options are close to expiration. The options can work well for investors who expect movement (or no movement) in the VIX within a specific time frame. But they may not work well for profiting from short-term swings.


Meanwhile, most VIX exchange traded funds and notes are susceptible to contango. The products can lose value to time decay as they roll from front month to longer dated and higher priced contracts. That makes these products better for short-term trading, and terrible for long-term "buy and hold" (even more so for the leveraged variety). The chart below shows price over time for VXX, one of the most popular VIX exchange traded products.


VXX Price

Source: Yahoo FInance. BCM

Since volatility is difficult to time and is prone to sudden spikes, I favor holding a note versus trading options. Of course, this is susceptible to the contango problem, which is akin to a slow and painful death if wrong. You should only go this route if you believe volatility will rise this year and if you have the patience of a plant. Don’t try to predict when volatility will rise, but just know it will and wait for it to happen. If all goes well, when the VIX eventually spikes the gains should more than offset the time decay. No, this is far from a sure thing, but in a game of chance, this looks approximately right to me.


Blockchain and a bag of chips


I end on one final mention of cryptocurrency. Like I wrote earlier, even after the crypto bubble bursts, I don’t think we’ll have heard the last of digital currencies. Even if the tokens themselves become worthless, there is likely a secular opportunity in blockchain, or the technology underlying digital currencies. A blockchain is basically a digital ledger that records transactions between parties. Each transaction is recorded as a block of code linked to previous blocks in a chronological chain visible to all parties involved. The technology is secure, efficient, and has many practical applications.


Blockchain Example

Source: World Economic Forum

A good analogy I read (I can’t remember where) really puts blockchain’s potential in context, “digital currency is to blockchain what email is to the internet.” Real world applications include streamlining the transfer of assets like securities or real estate. Currently the sale and purchase of such things requires layers of middlemen (brokers, clearing houses, title companies, etc). Each layer adds time, cost, and complexity to the process, but they're necessary because there's no standardized, automated, and secure way to simultaneously record a transaction for all parties involved. Blockchain could be all that and a bag of chips.


Application doesn't stop at asset transfers either, blockchain could disrupt everything from medical records to inventory management as its development is still in infancy. Ironically, one of blockchain's most practical applications is for modernizing the infrastructure behind existing currencies. Applied successfully it could actually weaken the case for cryptocurrencies. It's much simpler to upgrade incumbent currencies than to replace them.


The point is despite the surging interest in Bitcoin the currency, the real long-term opportunity may actually be in blockchain the technology. Companies small and large are still scrambling with how to capitalize on blockchain's huge potential. As with any emerging opportunity, new ventures are proliferating rapidly in this space. Most are unprofitable and financially unstable. And while some look attractive, some are total frauds, and they’re all generally difficult to value. The point is investing in this space requires special insight and significant due diligence. Buyer beware.


The bottom line


Though 2017 was a year full of uncertainties, it certainly ended being positive for the markets. Looking ahead we remain cautiously optimistic in 2018. Yes, economic growth has been lackluster, but still moving in the right direction. Yes, market valuations are high, but not the highest we’ve seen. We don’t see a looming, near-term catalyst for an all-out market meltdown. Some think digital currencies are the next shoe to drop, but we think not yet. Yes, most have heard of Bitcoin, but most also don’t own any. A crash in digital currency markets seems probable, but would also probably be concentrated (unlike housing or stock markets which have wider reach).


Barring any unforeseen catalyst, we expect a text-book unfolding of the business and market cycles. We also don’t expect another 20%+ year for equity markets, but as long as economic activity continues to hum along, we think that provides the support needed to keep markets afloat. The bottom line is we’re on the wall, we’re climbing, and doing our best not to look down.


Thanks for reading. We’d like to say thank you to our clients and all those who support us. Your confidence in us is what keeps us moving forward year after year. It’s an honor and a privilege to be your trusted investment adviser. Thank you for always thinking of us and don’t please don’t hesitate to reach out with any questions, whether for you, your family, or friends. Happy New Year and we wish you the very best in 2018!


Be Great,


Victor K. Lai, CFA


Bellwether Capital Management LLC (BCM) is a registered investment adviser (RIA). It provides investment management services for people and organizations. Please visit www.bellwethercm.com to learn more.


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