Firstly, I’d like to wish you all a Happy New Year. I’m excited and hopeful for 2018 and I believe that we could see some exciting changes in the U.S. economy and markets across the globe. At T&T Capital Management, we are focused on protecting and growing your hard-earned capital. We understand that your money is a means to a comfortable retirement, your child’s education, and a better standard of living. Our role as a fiduciary is an obligation that we take with the utmost seriousness, and we prove this by investing our own money in the same way that we do for clients.
“Our role as a fiduciary is an obligation that we take with the utmost seriousness, and we prove this by investing our own money in the same way that we do for clients.”
Investing is all about maximizing risk-adjusted returns over the long-term. It is not trying to replicate an index or follow the crowd as they jump of a cliff. The surest way to achieve long-term investment success is by buying securities at large discounts to intrinsic value. There are very few stocks in the Dow or the S&P 500 that meet our standards of selling at a 20-30% discount to a conservative estimate of intrinsic value, matched with the ability to grow that intrinsic value by 10% per annum over the next 3-5 years. That doesn’t mean that those expensive stocks can’t do well, as we saw in 2017. 2017 was a year where growth trounced value investing. These periods come from time to time, but over the long-term, value investing has always been the best way to grow capital. I see incredible parallels between the late 1990’s and 2017, as baristas are posting technical analysis on crypto-currencies on social media to prove their investing genius, similarly to when day-trading became an acceptable profession for the masses. Remember what Warren Buffett says, “It’s only when the tide goes out that you learn who’s been swimming naked.”
“Over the long-term, value investing has always been the best way to grow capital.”
As we move into 2018, it is helpful to start with a look at valuations. The S&P 500 ended the year at 2673.61, which is 26 times earnings, or 62.5% higher than the historical mean of 16. On an inflation-adjusted basis, the Shiller P/E is 32.6, which is 94% higher than the historical mean of 16.8. 2017 was a year in which the global markets saw virtually no major selloffs, which is exceptionally rare. Investor optimism is at all-time highs and expectations are that the stock markets should continue to do well. Volatility has been low for longer than just about any could have anticipated. I don’t need to be Nostradamus to tell you that this won’t last forever.
The U.S. economy is picking up growth as is Europe, while China is still seeing above-average growth, despite worrisome debt levels. Nearly 10 years removed from the Financial Crisis, Central Banks are finally starting to dial down the monetary stimulus, and interest rates should continue to move higher. I believe that if we begin to see higher wages and ultimately inflation starts to emerge, financial markets could potentially be rattled due to the end of the nearly 40-year bond bull market. North Korea is the most obvious geopolitical risks with its constant military threats, but markets haven’t appeared to be too shaken by the increasingly dire rhetoric.
The overall market to me is horribly unattractive. If you must own mutual funds in a 401K or something like that, I’d recommend being very conservative. For TTCM clients, we are taking an incredibly disciplined approach and are ecstatic to have found some of the best value opportunities I’ve seen in my career; but to be clear, there are just a handful of them. In 2017, we had a number of major long-term investment victories from which we were able to profit, including C, BAC, MS, ALLY, QCOM, GM, DAL, AAL, VOYA, etc. These victories were somewhat overshadowed when the hurricanes that devastated the United States caused major selloffs in some of our larger insurance positions, particularly our bond insurance investments that have exposure to Puerto Rico.
Keep in mind that these stocks were major reasons we outperformed significantly in 2016 and we locked in millions of dollars in profits on AGO, MBI, and AIG in early 2017. We did this via owning the stock and having it called away at much higher prices than what we bought it for. Most of the year, the stocks continued to do well until the hurricanes and other natural disasters caused the most destruction we have seen in decades. As these stocks came down in price in late 2017, we were able to add materially.
“Keep in mind that these stocks were major reasons we outperformed significantly in 2016 and we locked in millions of dollars in profits on AGO, MBI, and AIG in early 2017.”
We bought very little stock initially but instead sold substantial amounts of put options to manufacture cheaper entry prices. This strategy allows us to generate very attractive double-digit income yields if the options expire as worthless, or allows us to own the stock at better prices than if were just to buy them outright, if the options expire in the money. Now with some of those stocks so incredibly cheap and offering some of the best value we have seen, we are also aggressively buying the stock outright, particularly on Assured Guaranty.
A lot of our winners on which we have been able to profit have freed up cash that we have deployed towards these most attractive opportunities. Surely, the late-year declines in the stocks hurt us in 2017, especially considering such a buoyant (and overvalued) overall market, but long-term it will lead to far greater returns, setting the stage for future outperformance. Did Assured Guaranty’s business perform poorly, or why did the stock end the year at a 52-week low, nearly 28% below its highs?
“The business has literally never been stronger, more profitable, or more undervalued!”
Actually, the business had one of its best years in its history. Book value per share grew from $50.82 at the end of 2016, to $58.32 at the end of the 3rd quarter of 2017, for 16.37% growth. The 4th quarter will likely show further robust growth when earnings come out in February. Adjusted book value per share is around $75 and I see clear catalysts that should allow it grow by at least 10% per annum. New business production has been the best in nearly a decade as AGO is writing very profitable new business in public finance, international infrastructure, and structured finance. Higher interest rates would be an enormous benefit for this company. The $4.62 per share in operating income that AGO has earned through three quarters, has been achieved despite the company aggressively increasing reserves for Puerto Rico, including a major increase after the hurricanes. The business has literally never been stronger, more profitable, or more undervalued! That is saying something since we have been buying it for over 9 years now when the stock was trading in the single-digits.
Needless to say, we are buying aggressively with the stock trading below $34. Surely, there will be short-term negative headlines due to a politically toxic and public bankruptcy process that is unfolding on the hurricane-ravaged island. As Sir John Templeton said, “Invest at the point of maximum pessimism.” We are there or close to there for Assured Guaranty, MBI, AMBC and frankly bonds in Puerto Rico. Prices are absurd and are impossible to justify. The bear case is basically that all rules of law that are the foundation of municipal markets, will no longer matter, so severities on losses will be greater than any responsible analyst could ever justify. I’ve spent an enormous amount of time and effort on understanding the financial, political, and legal realities of this situation. I believe that the stage is set for us to make a tremendous amount of money. In a market where we are not nearly as sanguine as the consensus, these fertile grounds offer a tremendous reprieve!
“I think it is as clear of an opportunity to grow wealth over the next 3-5-year period, as I’ve seen.”
Outside of a few specific investments like those that I’ve mentioned where we feel the opportunities are extraordinary, we are structuring our strategies conservatively. We’ve discussed a few of our high-yield REIT investments that we are optimistic about as we see mean reversion in the retail space, from depression-like prices that have arisen from the dominance of Amazon’s impact on the industry. There are some undervalued healthcare names that we believe offer very attractive long-term potential as they restructure. At some point, there will be far better buying opportunities for the overall market than there are right now. Patience will be rewarded. Greed will be punished. Strong financial analysis and understanding of basic investment principles will matter, as they always have over the long-term.
“Patience will be rewarded. Greed will be punished. Strong financial analysis and understanding of basic investment principles will matter, as they always have over the long-term.”
I’ll conclude this letter with what I’d want to know if I were in your shoes. I personally am adding materially to my account and my investments in these opportunities that I’ve been discussing. I think it is as clear of an opportunity to grow wealth over the next 3-5-year period, as I’ve seen. Not everyone will agree, but I’ve yet to see anything that gives me a concern that our analysis is not correct on these key positions.
At T&T Capital Management, we are not interested in following the crowd. We don’t believe that ignoring stretched valuations and rising interest rates is a smart move. I don’t want to see the devastation that so many endured to their investment accounts during 2000 or 2008 happen to any of you, or me! At the same time, when we have investments where we can’t blow them up despite the most dire scenarios we can imagine, we want to buy in bulk. It is not uncommon for us to look quite silly for a few months or even a year, but as the fundamentals play out, the big money is made. We are incredibly thankful for your trust and faith in us with your hard-earned capital and we will not let you down. Those of you that have been with us for nearly a decade, know that we play a long-term game.
“We are incredibly thankful for your trust and faith in us with your hard-earned capital and we will not let you down.”
We don’t believe it is possible to outperform every quarter or every year, and attempting to do so is actually counterproductive to maximizing long-term performance. If your goals are building and protecting wealth in a smart and disciplined approach with a firm that has enormous skin in the game, you will not be disappointed. Here is to an excellent 2018 and future!