When markets become volatile my job gets a lot more exciting and this year is off to a good start, so I thought I’d continue the education process. Emerging markets are experiencing extreme volatility out of concerns that money is flowing out of their economies, making them unable to pay off debt in U.S. dollars. This causes the currencies to drop, ultimately requiring these countries to raise interest rates to attract foreign investment. Turkey doubled their key interest rate and it still didn’t halt the currency sell-off, but ultimately this should be a resolvable problem. The depreciating currencies should bolster exports and increase foreign investment over the long-term, but in the interim the fluctuations can certainly be quite violent.
At T&T Capital Management (TTCM), we only have one significant emerging market investment that is not at serious risk to these issues. The great thing about this volatility is that it has caused many stocks that are already greatly undervalued and have very strong prospects moving forward to become even cheaper, allowing us to buy more. From a sector standpoint, we have heavy investments in financials and in gas-centric energy companies. Most of our financials are focused primarily in the United States where increasing loan demand, rising interest rates and an improving housing market should bolster earnings. Just as importantly, these stocks still trade at large discounts to book value in many cases, and their historically high capital ratios will very likely allow them to be market leaders in dividend and stock buyback growth. Stock buybacks done at large discounts to intrinsic value allow create huge potential returns for investors and we are finally at the stage where financial companies will have the regulatory leeway to really ramp up buybacks and dividends.
Back in in 2011, financial stocks tanked during the year, but capital ratios and regulatory restraints prohibited the companies from being able to buy back their own shares, which would have been highly accretive. This is no longer the case so any pullback in these stocks presents a huge opportunity for compounding value. We’ve already taken advantage of this and we will only do more so if given the opportunity. Selling puts is an even higher probability, lower risk strategy that we have also employed aggressively.
Natural gas prices have had a dramatic rally to about $5.21 mmbtu. This is up from around $2.00 mmbtu just a couple of years ago and this increase provides considerably more earnings leverage for our gas-centric energy holdings. In addition, crude oil prices have held steady but the stocks of many E&P’s have dropped considerably along with the overall market, allowing us the opportunity to buy the stocks and sell puts at huge discounts to intrinsic values. We are doing this with many of the same stocks that we have already sold at much higher prices last year, which is why we are aggressive in taking profits when our investments approach intrinsic value. Last year, any profit taking seemed like a mistake because stocks kept rallying, but a disciplined approach without using leverage is by far the best way to compound profits over the long-term without exposing yourself to the risk of disaster during short-term market spells.
Many stocks and industries are still really expensive and offer very little value. Even high quality companies such as Boeing, MMM, JNJ and General Dynamics trade at very high multiples at peak profits. Then there are the bubble stocks such as Netflix, Tesla, DDD and Salesforce.com, which have valuations reminiscent of the tech bubble. It should be said that these businesses are more attractive than the joke businesses of those years such as Pets.com and Web Van, but even the Cisco’s and Microsoft’s performed horribly when they were valued at such extreme levels in the decade proceeding the bubble. The key point is that this will be a stock picker’s market. Mutual funds and ETF’s offer very little protection in an expensive market and the global economy is still fragile.
The key for our clients’ and the strategy in place will really be allowing time to pass. Our long-term put options on deeply undervalued stocks have provided us with a huge margin of safety as the options age towards expiration. In the interim, there will be large swings in value, but I’m very confident that those that can be patient, disciplined and that can avoid panicking when the news gets even uglier, will be quite happy as the investments mature. Adding capital as volatility increases and valuations go down is always advisable as well if you are indeed able to. Thank you very much and if we can be of assistance in any way please don’t hesitate to contact us!