Thursday, July 31, 2014
Twenty-Two Years of Massive Outperformance - What Can We Learn?
By Dr Van Tharp Trading Education Institute
A recent CNBC interview with hedge fund honcho Leon Cooperman, founder of Omega Overseas Partners, caught my attention for several reasons. The first was a genuine curiosity as to how this guy has been able to continually outperform the market with a huge account for so many years. Second, I wanted to see if there are any lessons that we could learn from him. And third, my business partner had run money for Cooperman for a number of years and had told many Cooperman stories already but I couldn’t wait to ask him a few more questions about this maven.
One Maven Talks About Another
My business partner, Christopher Castroviejo, is a 35+ year Wall Street veteran who worked both the sell side (brokerage) and buy side (hedge fund, money management). In the mid-1990s, Christopher and his firm were well known as one of the few hedge funds who successfully ran a short book. Cooperman had heard this and sent his right-hand man, Doug Kass, over to check out the operation. Kass and Cooperman were impressed enough to give Christopher’s firm $50 million to run on the short side as a hedge for the rest of their book. And for the next five years, Christopher and Cooperman had frequent discussions about how this chunk of money was being managed.
I asked Christopher what stood out about those interactions, and here’s a list of Christopher’s thoughts on Leon Cooperman in no particular order:
One thing that stood out plainly was that Cooperman was (and remains!) a superb fundamental analyst. He took nothing at face value and always dug deeper into the information in order to form his own opinions.
Christopher was impressed by his intense discipline – he believed hard work always paid off.
He always advocated “love what you do”.
Cooperman played the game in line with what he believed and where he saw his strengths. He was not going to play an institutional-style game with low volatility returns.
When Christopher ran Cooperman’s short book, he noted Cooperman’s great courage in his convictions. Even with the courage to stay the course, however, he always challenged his positions to make sure that nothing fundamental to the trade had changed. He asked Christopher three words countless times, “Are you sure?” and that refrain still rings in Christopher’s ears. Even with his constant checking and curiosity he would stick with many (though not all) positions that were well-reasoned.
Cooperman would frequently call and ask for a review of the position, and he wasn’t shy about changing course with his whole book, even if he liked individual positions. He realized how important — as well as how difficult— hedging was on the short side and he would insist on long periods of holding his short account totally in cash or mostly in cash.
As you can tell from these comments, he was very hands on — very on top of what was happening, and thanks to his work ethic, he really knew the details.
Like Christopher’s grandfather, Bernard Smith — Cooperman believed that you always had to be bullish on something. This is undoubtedly why he cashed in recoveries better than anyone in the business (see his return figures below).
One of his main edges is a thorough knowledge of the fundamentals that he matched so well to his ability to foresee upcoming business cycle trends.
Now for That Head-Spinning Track Record:
Here is Cooperman’s Omega Partners’ track record that was included in the CNBC interview:
Click the Image Below for a Larger View
Cooperman averaged an annual return of 14.6% compounded vs. 9.3% for the S&P 500 during the same period. If that isn’t impressive enough, note that his figures are net of fees — meaning that the actual returns were significantly higher!
Here are some observations:
He does have down years, but knows who he is & what his strengths are.
He can have significant drawdowns, but his returns on rebounds (1993, 2003 and 2009) are nothing short of stunning.
Looking at his current top holdings (none more than 3.2% of capital): Sprint, SandRidge Energy, AIG, Sirius XM, Citigroup, Tribune, Tetragon Financial, Telenet Group, Dish Network and Chimera Investment, you can tell that he is a stock picker (and a value guy) and not one to jump on the same bandwagon just because other managers are.
What Can We Learn From Mr. Cooperman?
The first thing that leaps out after talking to Christopher and digging into the CNBC interview is that Cooperman is a guy who trades his beliefs. He believes in the long-term bullish bias of the equities market and is quick to capitalize on upturns after down periods. In addition, specialization works — his specialty is fundamental analysis. Lastly, when you have edge, have the courage to stick to your convictions; don’t get shaken out after a few rough trades. Let the law of large numbers and the confidence in your plan carry you through.
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Tuesday, July 29, 2014
Click Here to Read Part 1
Click Here to Read Part 2
First, in the last three decades, low interest rates and increases in productivity are mostly responsible for record amounts of corporate balance sheet cash. That cash needs to go somewhere.
Second, banks devised a pawn-like scheme to take corporate balance sheet cash and use it to finance the purchase of higher-yielding securities, earning the difference in what they pay to borrow and what they earn on the purchase.
Third, the borrowed cash needed to be backed by AAA-rated collateral. To fulfill this need, Wall Street securitized packages of loans, thereby creating a new form of AAA-rated collateral.
This spawned the “shadow banking system”: corporations would lend money to banks through repo and commercial paper markets in exchange for a low interest rate and the banks would back these loans with securitized products. Even after Dodd-Frank, this system still remains largely unregulated.
Today, I’ll explain how the whole process led to higher asset prices through the creation of more credit.
Think of it like this: banks enter a pawn shop with a gold chain. The pawnbroker lends the banker $1000 at a 1% interest rate and keeps the gold chain as collateral. Banks take the $1000 and purchase another gold chain, and promptly return to the pawn shop to borrow another $1000. This process is repeated ad infinitum until all the cash on corporate balance sheets has been lent to finance the available supply of gold chains.
Suppose these gold chains weren’t your average run-of-the-mill gold chains. These gold chains have Mr T-like mystical powers and pay a 6% dividend to the owner. For every $1000 that the bank borrowed from the pawn shop at 1%, they earn a 5% return (the difference between what the bank borrows and what it receives). Each time the bank is due to pay the pawnbroker back the original $1000, he tells him to keep the gold chain and renews the agreement on the funds for 1%. Thus, borrowing money from the pawn shop to finance the purchase of higher yielding gold chains is a very lucrative endeavor.
So what happens to the market in gold chains? Well, if banks are using borrowed money to purchase gold chains, the price of gold chains is going to increase rapidly as demand outpaces supply. And the bankers can now take these gold chains with inflated valuations and use them to extract even more money from lenders.
However, the value of gold chains is increasing not as a function of buyers’ incomes, but through the introduction of more leverage from corporate balance sheets. As the leverage in the pawn system increases, so does the ratio between price and incomes. At some point, buyers’ incomes can no longer support the price of gold chains.
And this is precisely what happened to the housing markets in the early aughts as the price to income ratio of homes was boosted by the shadow banking market.
However, as the available supply of gold chains dissipated, bankers would sometimes deposit fool’s gold (subprime). The pawnbrokers started to worry about phony loans in early 2007, and began requiring more collateral to back their loans. Instead of lending at 100% of the collateral deposited, pawnbrokers would only issue funds equal to 90% of the value of the collateral. Slowly, this started to drain leverage from the system.
And as leverage fell, so did the value of the gold chains, which further arrested the flow of cash from corporate balance sheets. This vicious cycle repeated itself until the pawnbrokers decided that all gold chains were worthless and wanted their money back. Since the banks didn’t have the cash on hand, they needed to immediately liquidate gold chains into a market where there were no buyers. Lehman failed overnight, and the government was forced to respond by providing the banks with $1 trillion in capital.
The 2008 financial crisis was a run on the shadow banking market caused by a loss of confidence in the debt owed by banks. There were similarities to the bank runs of the 19th century, however, this time it was institutions that were lining up to retrieve their cash and not retail depositors.
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Monday, July 28, 2014
2014 has been an interesting year for retailers to say the least. Several clothing stores have had horrendous first half results as changing tastes have hit many companies hard. Meanwhile, in the restaurant side of the retail space, a similar trend has taken place as ‘higher quality’ companies are leaving their value-oriented counterparts in the dust.
This trend of high end outperforming lower end or value in the retail world is one of the bigger stories in this sector so far this year. And for a classic stock example of this that may still have more room to run as we close out the year, investors have to look no further than Tiffany & Co (TIF).
TIF in Focus
Tiffany & Co is a New York City-based jewelry retailer, specializing in fine and solitary jewelry, though the company also sells watches, perfumes, and accessories as well. The company is obviously operating in the high end corner of the market, and like many of its high end peers across the retail world (no matter the industry), it is really turning up the heat as of late in terms of stock price appreciation, including a 20% move higher in the past six months alone.
A big reason for this jump is the recent earnings picture for the company, and TIF’s beats at earnings season. TIF posted EPS of 97 cents, easily crushing the consensus estimate of 77 cents a share.
The beat was thanks to strong sales, which were up 13% from the year ago quarter, while comparable-store sales also saw a double digit increase as well. And perhaps the best news from the sales beat was the strength across geographic divisions, as Asia-Pacific saw 17% growth, while Japan saw 20% growth, showcasing the strong demand for TIF products across global markets.
Given the strong trend in the luxury and high end corners of the retail world, and TIF’s continued dominance of the space, it shouldn’t be too surprising to note that earnings estimates have been rising for Tiffany stock.
Estimates have risen for both the current year and the next year time frames, with not a single estimate going lower for either period. Now, TIF is projected to see double digit EPS growth for both this year and next, suggesting a strong, durable trend for the company.
And though higher expectations can be difficult to match, investors should take comfort in TIF’s recent history at earnings season. The company has beaten estimates in three of the last four reports, with an average surprise of roughly 15%, so raised expectations shouldn’t be too hard to hit this time around either.
Thanks to these factors, TIF has earned itself a Zacks Rank #1 (Strong Buy). This means that we are looking for more outperformance in the months ahead, and that we expect the positive momentum in TIF shares to continue into the fall.
Not only is TIF in a great position, but there is strength in the industry too. In fact, the retail-jewelry industry is ranked in the top 2% of all industries (at time of writing), so investors can rest assured that a rising tide is lifting all boats in this space.
But while this industry is looking solid overall, TIF is really the pick that is shining bright. The company has seen solid sales growth and earnings beats, while it remains well-positioned to take advantage of the focus on high end retailers and the great trends that are underpinning the space.
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Tuesday, July 22, 2014
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Monday, July 21, 2014
The PC industry isn't dead yet.
Intel (INTC - Trend Report) recently posted strong second quarter results, driven in part by strong demand in its core server and PC markets.
Following the Q2 report, analysts revised their estimates significantly higher for both 2014 and 2015. This sent the stock to a Zacks Rank #1 (Strong Buy).
Intel is the world's largest supplier of microprocessors with over 75% of worldwide market share among traditional PCs and servers.
Second Quarter Results
Intel delivered strong second quarter results on July 15. Earnings per share came in at 55 cents, beating the Zacks Consensus Estimate of 52 cents. It was a 41% increase over the same quarter last year.
Net revenue grew 8% year-over-year to $13.831 billion, well ahead of the consensus of $13.622 billion. This was driven by solid demand in its core server and PC markets. Intel's Data Center (server) group saw top-line growth of 19% year-over-year, while its PC Client Group saw revenue growth of 6%.
Gross profit as a percentage of total revenue improved greatly. The gross margin rose from 58.3% to 64.5%. Meanwhile, marketing, general and administrative expenses declined 5% and fell from 16.9% to 14.9% of revenue.
These factors led to a whopping 41% surge in operating income as the operating margin expanded 21.2% to 27.8%.
Following the strong Q2 results, analysts have unanimously raised their estimates for both 2014 and 2015. This has sent the stock to a Zacks Rank #1 (Strong Buy).
Part of the catalyst for the upward revisions was encouraging guidance from management, which stated in the Q2 report that it expects about 5% revenue growth in 2014. That is slightly higher than its previous guidance.
The Zacks Consensus Estimate for 2014 is now $2.14, up from $2.04 before the report. The 2015 consensus is now $2.31, up from $2.18 over the same period.
Intel still faces long-term challenges as it struggles to gain traction in the growing tablet and smartphone markets. But the near-term outlook looks bright for the stock as the PC industry appears to be stabilizing after two years of contraction.
Shares of Intel soared after the Q2 report and have been on a tear this year, rising more than +32%. But the valuation picture still looks reasonable. Shares trade around 16x 12-month forward earnings and about 9x cash flow.
In addition, the company pays a dividend that yields a solid 2.7%.
The Bottom Line
Intel has a dominant position in the microprocessor industry for traditional PCs and servers. And thanks to recent strength in these end markets, along with solid cost controls from the company, earnings growth - and earnings estimates - are soaring for Intel.
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Friday, July 18, 2014
How Financial Crises Start, Part 2 by Market Authority
Click Here to Review Part 1
Yesterday, I highlighted the financial panics of the 19th Century (aka bank runs), how they start, and the government’s response to prevent future runs (the Fed and FDIC). As noted, regulators and economists are only able to locate the problems with the engine after the car breaks down.
Today, let’s take a look under the hood of our current financial system to better understand how the economic machine overheated and was left stranded by the side of the road.
Businesses are more profitable than ever with record amounts of cash on balance sheets. The following chart depicts the rise of corporate cash as a % of GDP:
Since this cash must be invested somewhere (usually short-term), Wall Street created the repo and commercial paper markets. This allowed Wall Street to borrow cash from Main Street on a short-term basis. Just like a pawn shop, lenders of cash need some type of collateral that they can liquidate if the borrower doesn’t pay back the cash on time. Wall Street took the borrowed money to finance higher-yielding assets, profiting on the spread between what they paid on the corporate cash versus what they received on the higher-yielding assets.
Historically, the collateral that Wall Street pledged in order to borrow short-term corporate cash was AAA-rated US Treasuries. However, the government surplus of the late 90s mopped up too much Treasury supply. Wall Street needed another asset to use as collateral. And then Wall Street developed a game changer: securitization.
This process moves long-term bank loans off balance sheets by packaging them together and selling them to the capital markets. Securitized loans, also knowns as Asset-Backed Securities (ABS), are backed by mortgages, auto loans, credit card loans, or student loans and now comprise one of the largest markets in the world. A market large enough to provide collateral for the enormous amount of short-term borrowing.
Technology made securitization possible. Software programs can easily package millions of similar loans, something impossible to do by hand. Furthermore, easy-to-obtain credit scores allow lenders to assess the likelihood of default of each individual loan.
Here’s a brief primer on how these loans work:
Let’s say you live in a town called Springfield where 10,000 residents own houses with $200,000 mortgages that are held at the local Citibank. The average resident is paying a 10% rate on their mortgage and they all have 20 years to maturity. Since the bank can expect interest payments totaling $200mm per year (10,000 x $200,000 x 10%), they can create a new special purpose vehicle which separates these payments into different buckets. Because the bank can guarantee that the first $50mm of interest payments will go to the first bucket, the rating agencies give this a higher rating (even though the underlying collateral may be lower rated).
Securitization provided the necessary AAA collateral for Wall Street to borrow from the rest of the private sector.
Now think of this operation like the world’s largest pawn shop. The corporations (with the cash) are the pawnbrokers willing to lend cash to the banks as long as they provide adequate collateral. Typically, the corporations would lend cash at a rate of 1 to 1. So if Wall Street brought in a gold chain (or a AAA ABS) that was valued at $1000, the pawnbroker would lend them $1000 and hold onto the gold chain until Wall Street paid them back.
Wall Street would then take this cash and use it to securitize more loans, which could then be used as more collateral. This process drove the credit super-cycle in a very pyramid-scheme like way.
Tomorrow, I’ll discuss how the system began to crack when the pawnbrokers began requiring more collateral.
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Wednesday, July 16, 2014
How Financial Crises Start, Part 1 by Market Authority
Today is the start of a multi-part series on the financial crisis: what was the cause and what have we learned.
When I lived overseas, I was the proud owner of a 1982 Toyota FJ40. Designed as an offroad vehicle, this 4-cylinder diesel could climb just about anything. I’m no gearhead, so once the truck started experiencing problems, fixing it was quite the learning experience. Some issues were easy to fix, such as replacing cheap glow plugs with a higher quality set or a worn down hose with a newer one. While I’m still not an expert on diesel engines, I’m now more familiar with how they operate and can diagnose simple problems when they arrive. The universal truth is that nobody really wonders how the engine works until it fails to start in the morning.
And the same principle applies to financial markets. Only when a crisis happens, do we pop open the hood and take a look at the problems with the system. We discover issues that a previous mechanic may have installed incorrectly or parts that need to be entirely replaced due to overuse. Some of these may be quick fixes while others may require a complete rebuild.
Every financial crisis starts with a complete loss of confidence in what’s under the hood. When fear is prevalent, investors sell assets and raise cash. Because of this action, the economy loses the financing necessary to grow and output falls.
The financial crisis of 2008 allowed us to diagnose the problems in our financial system and propose solutions to avoid similar events in the future. This is how economic systems evolve, through a crisis/recovery process leading to a better understanding of how the entire system operates.
For instance, before the Federal Reserve was created in 1914, bank runs were a national pastime. At every peak in the business cycle, depositors would worry that their local bank had underwritten too many bad loans. Fearing their cash was no longer safe, they would line up outside the local bank demanding their money back. This was a powerful signal. If you were walking through town and witnessed your neighbors waiting anxiously (and sometimes angrily) in line, you were likely to inquire what all the fuss was about. When you were told your money was at risk, you would likely join the line, reinforcing the signal. The risk of losing all of your deposit was much greater than the reward earned from keeping it in the bank.
In a fractional reserve banking system, banks never keep enough deposits on hand to pay everyone back at the same time. They don’t need to, unless a crisis occurs and all depositors are suddenly fearful of what might happen to their deposits. The bank run became a self-fulfilling prophecy, with the bank usually closing down, halting withdrawals, and declaring a “bank holiday” while it went about selling assets (in a fire sale) to raise the cash needed to satisfy withdrawals. As a result, the bank would usually close and it would take years for a new bank to repair relations with depositors and get the economy moving again.
This is essentially why the Fed and FDIC insurance were created: to stop bank runs and smooth out the business cycle. The Fed will provide the needed liquidity for the bank (they can borrow at the discount window) and the FDIC gives depositors the peace of mind that their cash will always be protected. If a crisis occurs, there’s no longer a need to withdraw your cash and bury it in the backyard. Thus, the bank runs of the 19th Century are all but extinct.
The Federal reserve as a backstop and FDIC insurance led to what Yale economist Gary Gorton describes as “the Quiet Period” in our economy: the period from 1934 to 2007 when “properly designed bank regulations prevented financial crisis for a significant period of time, until innovation and change necessitated their redesign”. Crisis brought about an evolution in understanding, which allowed for the development of regulatory systems targeted at preventing future crises.
And things got really quiet towards the end of the quiet period during the “great moderation”. Between the mid-1980s and 2007, economic volatility declined dramatically. The Fed had seemingly smoothed out the business cycle.
While economists understood some of the factors causing the great moderation (central bank independence and counter-cyclical economic stabilization), they didn’t foresee the problems under the hood until the 2008 financial crisis occurred.
Tomorrow, we’ll take a look under the hood and discuss the shadow banking system. This will allow us to understand how bank runs can still occur in the 21st Century.
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