Sunday, December 22, 2013

Intertemporal Arbitrage: "Winning Big by Playing Long-Term Trends" (CNI; PNR)

From our December 3 post "UPDATED--The Economist On How the Commodity Quants Lost It":
I am having great difficulty with the idea that hedge funds couldn't find a way to make money, more after the jump....

...The bolded bit points up one of the failures of the fund managers.
They get paid to figure out the intertemporal arbitrage, a fancy way of saying the task at hand is to understand the time period that gives the fund the greatest advantage versus the market.

The classic example is the individual investor realizing that he can't compete with HFT and looking at longer than nanosecond time periods. This opens up the possibility of not just not-competing with the traders with the lowest latency but of taking advantage of mispricings caused by their behavior. This is exemplified by one of Buffett's baseball metaphors (he has quite a few):
In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw a ball right down the middle; and if it's General Motors at 47 and you don't know enough to decide on General Motors at 47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss.
The point is, you don't have to be at the market every second You are afforded the luxury of just waiting for the perfect pitch.

Now for a fund manager it get's tricky writing the quarterly report and saying "We didn't do much in Q3, we're waiting for Mr. Market to give us the high hanging curve ball" but if you've been honest with the investors that the tactic you've pulled from the toolbox is akin to the military's hurry-up-and-wait sense of time it is doable.

As a side note anyone who considers a move that is measured in weeks to be a trend is nuts. A trend is John Templeton going into the Japanese markets at 2 times earnings and catching a 40-fold move 1965-1989.
Here is a guy who gets it.
And just for the record I don't do the buy/sell/hold thing, our readers are sharp and can figure out what they (or their advisors) want to do. In the case of the headline symbols, Pentair is a class business and Canadian National got a mention back in 2009's "Pssst, Besides Warren Buffet, Which Berkshire Hathaway Director is a Railroad Fan? (BRK.a; BNI, CNI CSX; NSX; UNP)" when we noted that Bill Gates through the Foundation had 8.4 million shares. Additionally his Cascade Investment LLC owns a bunch (43 million shares), enough to make him the largest shareholder at 12% or so of the company.
From Barron's:

Why Atlanta money manager Harold J. Bowen likes Canadian National Railway and Pentair. 
In asset management, where fund managers can come and go quickly after a bad quarter or two, 39 years is an awfully long time. Atlanta money manager Bowen, Hanes & Co. began running the Tampa fire and police pension fund in 1974, and still is its lone manager, testament to a long run of solid and consistent performance. The fund's stocks, which account for about 75% of its $1.8 billion portfolio, have beaten the S&P 500 in 20 consecutive 20-year rolling periods, dating to 1974. The rest of the portfolio includes investment-grade bonds and cash. As of Sept. 30, the fund's annual 25-year gross total return was 10.48%, tops in its institutional peer group, according to Wilshire Associates.

Bowen, Hanes is led by Harold J. (Jay) Bowen III, 51, its CEO, chief investment officer, and president. The relationship with the Tampa fund was forged by Bowen's father, Harold J. (Jay) Bowen Jr., now 83 and nonexecutive chairman. Like his father, the younger Bowen hews to a long-term approach, trying to discern a stock's outlook for the next three to five years. With about 110 clients, the firm oversees about $2.5 billion. Barron's spoke recently with Bowen to learn about his macro view and a couple of his stock picks.

Barron's: Your firm is bit of a maverick, Jay—one asset manager overseeing an entire pension fund in a world where the consultants shy away from that approach.
Bowen: Yes, it has been that way for quite a while, and it is really sold from a fiduciary standpoint as a way for these boards to best oversee their funds. That's fine, and I am sure there are plenty of examples where that's been successful. But our model is also a very valid one, and as the Wilshire rankings demonstrate, it can actually be better than the multi-manager, consultant-driven model.

You spend a lot of time putting together a macro view. What's important right now?
The past five years have shown that the Federal Reserve really doesn't have much control over monetary velocity or the money supply and that basically the monetary transmission mechanism is broken. That mechanism is the connection between the Fed's balance sheet, which has been expanding rapidly, and the impact that it is having on the real economy in terms of bank lending and job creation. You are not seeing it show up in capital spending or the money supply, or an increase in monetary velocity. So the reserves are just lying fallow on these banks' balance sheets. That's been very important in terms of why these deflationary issues are still out there.

So the most powerful theme over the next five years is going to be how the Fed unwinds its balance sheet. Those reserves are not being put to work, because we are not in an environment where we have a lot of capital formation, risk-taking, and entrepreneurship. That's why I don't see inflation being a problem over the next couple of years. But longer term, I expect that to change.

What are policy makers concerned about right now?
It is going to be very important for investors to focus on how all this monetary stimulus from the Fed is going to end over the next few years. A shorter-term theme, which is kind of a prequel to the longer-term theme, is the increasing emergence of a global confederation of inflationists. We are going to see, particularly with [Janet Yellen expected as the new Fed chair], explicit targeting of both inflation and nominal GDP growth. And there are several pretty powerful special-interest groups that will start calling for higher inflation. Of course, some companies want it because it means higher profits. You also have workers who want it because, although it is nominal, it means higher wages. Politicians see it as the easiest choice in dealing with debt.

But most importantly, many policy makers, including the new Fed chair, are wedded to the belief that targeting our inflation rate and nominal GDP is really what should be done. In 2014, they are going to take it to the next level. These deflationary demons still scare them. This is not just a domestic situation; it is really a global event. If you look at what is going on in Japan, taken as a percentage of GDP, their quantitative easing is big enough to make even [Fed Chairman Ben] Bernanke and Yellen blush.

How is the current stock-picking environment?
During this bull market, which is more than 4½ years old, the market is up over 160%, and we've seen gradual price-earnings multiple expansion. So it's harder now to find stocks selling at 10, 11, and 12 times earnings. But we are not as concerned with the current earnings, if we think a company has potential looking out five years.

What sectors are you staying away from?
We got a hint of our biggest concern this spring, with the taper talk and the sharp run-up in interest rates. You saw what happened to some income-oriented stocks, viewed as bond substitutes, like the utilities and some real-estate investment trusts, which sold off. We remain somewhat leery of those holdings. We're staying away from that group—not that we are looking for, at least in the next year, a major increase in interest rates. But the tapering will commence, the yield curve will steepen [with long-term rates rising faster than short-term rates], and that could hurt those stocks. We also are avoiding retail, which doesn't fit into our long-term top/down approach.

On the other hand, we see the potential for global capital reallocation into the industrial sector, because of a pickup in global growth, relatively attractive valuations, and good total-return potential. In 2014, we see a continuation of this trending up of the dividend-payout ratio. It's gone from about 27% [in 2007] to about 33%, which is still well below its historical average around 50%. The other trend we expect to continue is sluggish top-line growth.

What do you like?
One sector is consumer staples, which provides a nice balance to a portfolio in terms of not being quite as economically sensitive; we can see holding some of these stocks for the next couple of years, although, longer-term, we are going to have to reassess this situation. But these companies have been the beneficiary of significant tailwinds from this disinflationary environment, in terms of falling raw-material costs. It has really allowed them to expand their profit margins, and helped their bottom line. Colgate-Palmolive [CL] and Kimberly-Clark [KMB] are both good examples of companies that have benefited from not only their global approach, but also from this disinflationary tail wind of lower raw-material costs....MORE, including the rationale forCNI and PNR.