February 25, 2019 – Kraft Heinz Kitchen Sink Quarter, Barrick Bluffs Newmont, PMO SNC Scandal, Walmart’s Blowout Results, Fed’s Balance Sheet Plans, Value Funds Aren’t Value, Dr. Herbie Wertheim, Innovators, Imitators and Idiots, What’s Arbitrage?
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by Accelerate Financial Technologies.
Accelerate, because performance matters. Find out more at www.AccelerateShares.com.
Julian: Kraft Heinz – with the stock market decline of 30 percent on Friday as it posted an absolutely disastrous fourth-quarter report. Now the four major reasons that led to the sell-off in the stock number one, they wrote down 15 billion dollars of value on brands they previously acquired and number two, they registered a twelve point six-billion-dollar operating loss. Number three, they had a 36 percent dividend cut and to top it all off for number four, they disclosed that the securities and exchange commission (the SEC) was making an investigation into their accounting practices. So, four things that investors absolutely do not want to hear. Let alone one of them independently, we’re calling this a kitchen sink quarter. Where they absolutely throw all the bad news that they can into the market, such that they can start next quarter with a clean slate and hopefully build off new gains. But it’s for now the stock is near an all-time low and things aren’t looking great. Mike what are your thoughts?
Michael: So, I just want to bring it back to the two main investors in Kraft Heinz. The two main investors being Warren Buffett, Berkshire Hathaway and 3G Capital. So, for those of you that aren’t familiar with 3G Capital, they’re a Brazilian private equity firm that has a notable investment successes with Burger King, Tim Horton’s and AB InBev and what their most famous for being known for is their zero based budgeting and so in 2015 they partnered with Berkshire Hathaway to merge Kraft and Heinz where investors expected 3G to work their magic in creating cost efficiencies. Most recently in early 2017 it was leaked that Kraft Heinz with the backing of Berkshire and 3G approached Unilever with a takeover bid. So, at 143 billion dollars, this would have been the second largest takeover in history following the AOL Time Warner merger which was the largest at 165 billion. Ultimately, they were rebuffed by Unilever, which was really the first public defeat for 3G actually showed some that they were actually human as investors. But ultimately the decision to not go forward with a hostile Unilever bid was Buffett is traditionally against the practice of going hostile. So that just kind of this is another kind of defeat for 3Gg and yeah it shows kind of their humanity.
Julian: And 3G was really taking the consumer products sector by storm taking over businesses, slashing costs, cutting capital expenditures to the bone and really just trying to create shareholder value increasing margins just through cost reductions and using a lot of leverage to accomplish that and it worked like a charm for a while. But now we’re seeing chinks in their armor and the whole game plan is kind of falling apart here. So, Kraft Heinz, it does have a significant amount of leverage and the future of its business by focusing on refined carbohydrates such as brands as jello, Kool-Aid and just really unhealthy foods as consumers begin to make healthier decisions. It doesn’t seem like it necessarily has a bright future and perhaps a lot of their brands are heading into secular decline and judging by the stock market reaction of comparable companies and other companies in their sector, such as Campbell’s soup and others typically have very stable results, they’re known as consumer staples for a reason. But perhaps things are changing rapidly as consumers move on to healthier foods.
Big news in the gold mining sector with Barrick confirming that it is considering an unsolicited proposal to acquire Newmont Mining. So, to give you some background on this deal, Barrick has been a very acquisitive company, they were formerly the largest gold miner in the sector. They recently merged with Rangold in a zero premium takeover bid. Such that Rangold management got to take over at Barrick’s assets and merge into a very large entity. And over the past decade, Barrick has had friendly conversations with Newmont with respect to merging their operations. Which would recognize pretty significant synergies or cost savings. But no deal has come to fruition and so what Newmont has been up to as they recently announced the friendly acquisition of Goldcorp, which is ongoing. So what Barrick is doing here is trying to be the interloper. Break up the Newmont / Goldcorp deal to acquire Newmont on its own and once again regain its crown as the world’s largest gold miner. So, I view this as a battle of the egos and in my opinion, it seems highly unlikely that Barrick will be successful in its pursuit of Newmont. Number one, they’re offering a zero-premium bid. That means no additional value to where Newmont stock is trading in the market currently. So, it really provides no incentive for investors to tender into the takeover bid. Not there is one yet, but if there was to be one Barrick is going to have to put a lot more on the table than a zero percent premium bid. Typically, takeover bids contain what’s called a control premium. Where an acquire needs to incentivize shareholders to tender their stock or vote for the merger, such that it becomes successful and control premiums i.e.; a price for the stock above where it’s trading in the market are typically in the 25 to 30 percent range. So, a zero percent premium really just aunt going to cut it. On the other hand, Barrick I don’t believe necessarily has the resources to buy Newmont here. They barely have a larger market cap. I think if they were to offer a large premium that their stock would decline markedly and Mike you can comment on some of their past acquisition successes or lack thereof.
Michael: Yeah so Barrick has always been an acquisitive company as Julian had mentioned. Peter Munk has pursued that strategy, the founder of the company Peter Munk has pursued that strategy all the way through the life of the company. But it’s really been the involvement of John Thornton who is the former co-president of Goldman Sachs, where he played a major part of Goldman Sachs’ Asian expansion. But he’s really been the driving force of in the recent years of their acquisition strategy. Where he became involved with the company in 2012 and has become the chairman in 2014. This has been to limited success. Barrick stock price since his involvement in the company is down about 25% since he took over as chairman. So, the market would say that that this acquisition strategy to grow scale hasn’t been successful.
Julian: And if we look at the stock price reactions with Newmont up, Barrick down and also Goldcorp down. Obviously, there’s more risk to the friendly Newmont / Goldcorp merger. But ultimately, I think it will succeed and Barrick really is just bluffing here. They don’t really have much of a hand.
Massive scandal in the prime minister’s office with SNC Lavalin, who has been charged with committing fraud and bribery in a case when they were seeking contracts in Libya four to five years ago. So, what happened here was there was a recent resignation, the woman named Jodi Wilson Raybould. So, she’s the former justice minister under prime minister Justin Trudeau. So, she resigned due to what she claimed to be inappropriate pressure from the Prime Minister’s office in order to help SNC Lavalin get out of the fraud charges and just admit to wrongdoing and leave it at that – go on without a trial. So, this is fairly controversial, because the government is supposed to stay out of private affairs. They’re not supposed to be engaging in crony capitalism, especially trying to play favorites with respect to corporations. Especially when those corporations have committed fraud. So, what happened this week is prior those were just allegations, but the prime minister’s right-hand man Gerald Butts resigned. So, heads are rolling here where there’s smoke there’s fire and clearly Justin Trudeau’s denials are no longer accurate and it’s increasingly looking that this scandal is really spiraling out of control. With Butt’s resignation he category denied obviously that anyone else in the Prime Minister’s office but any sort of pressure on Wilson Raybould to give assistance to SNC Lavalin. In addition, Prime Minister Justin Trudeau has obviously denied any wrongdoing. If we look across the aisle, the conservative leader Andrew Sheer stated quote “It’s the clearest indication yet that there is much more to the SNC Lavalin affair than the prime minister has so far admitted.” I want to talk about implications here, so since the liberals have come into power what have they done? Well a number of things that they have done is implement a carbon tax. They have raised corporate tax and income tax. If this does spiral out of control and leads to effectively the demise of Trudeau’s government. If he loses in the October re-election bid of his and the conservatives come to power, well what can we expect? We can expect lower personal taxes, so a better economy, lower corporate taxes. So, a higher stock market. So ultimately, I think there’s a potentially brighter side to this story if these things do play out and I’d be remiss if I didn’t mention the joy and adulation coming out of certain energy executives, because Gerald Butts the guy who resigned recently really had very very unfriendly policy towards the oil patch.
Michael: I think another implication that that can be thought through is I guess whether there will be any second-order effects on other companies that have traditionally had closed government ties thinking exactly of Bombardier. So far, the market would say no as the stock is up eleven percent over the past week. But keep in mind that Bombardier is still down about thirty percent over the past year. Our listeners are likely well aware that the government has injected capital into Bombardier multiple times throughout the company’s history. But that’ll be something interesting to watch as this situation escalates.
Julian: The U.S. consumer is still going strong with Walmart kicking off their Q4 results with pretty exceptional numbers. If you are a shareholder you’ve got to be pretty happy the stock was up 4% Walmart showing its largest rise in domestic sales for the holiday period in 15 years. So, the reason we wanted to discuss this is last week the government reported retail sales figures that were very bad. We’re talking about U.S. retail sales that declined the most since 2009. So many found that number hard to believe given the economic backdrop which is quite positive. A number of market participants were skeptical, and this Walmart quarter really supports their skepticism and perhaps the consumer is doing significantly better than that government report last week indicated and Walmart increasing sales as it did almost three percent they are now over five hundred billion annually. So, I mean that’s quite the feat right there.
Michael: Yeah and I just wanted to highlight this scale of Walmart as well. Everybody’s familiar with Walmart, but this puts their revenue north of five hundred billion dollars and so they’re actually growing their revenue on an annual basis at about just about three percent. Which is actually above inflation meaning that you know it just adds to the operational efficiency of the Walmart management team.
Julian: Chief Executive Doug McMillon stating quote “we experienced a favorable economic environment in the us for much of the year”. So, there it is.
The minutes to the federal reserve’s latest policy meeting came out this week and indicated that they are considering ending their balance sheet run off this year, which previously was earlier than market participants expected. How this happened was during the financial crisis about ten years ago, the federal reserve came into the market utilizing its balance sheet to buy up a tremendous number of treasuries and mortgage-backed securities up to four point five trillion in a bid to support markets at liquidity and get the economy turned around in those dark days. It’s 10 years later and the fed still has a massively inflated balance sheet in which they have been allowing to run off over the past 12 to 18 months, perhaps longer than that and if you remember in q4 of 2018 the market really declined quite a bit into December. The S&P had a peak to trough decline of 20%. So, it entered a bear market. Number one on concerns that the fed was going to be rapidly raising rates and they’re going to be mechanical in their balance sheet runoff and perhaps take their balance sheet down to where it was pre-credit crisis which I believe was in the trillion-dollar range. So, it was a significant amount of balance sheet runoff. But what this recent news indicates is that they are comfortable holding a significantly larger amount of assets that they used to have. The most important implication for investors is that they’re really willing to do whatever it takes to please the market, to support the stock market and they really got sucked when the S&P500 declined in December and really they’re showing their hand that they’re here to support markets and if you look at the Dow Jones industrial average, I mean it’s been up for nine straight weeks and really the markets loving the fed right here.
Michael: Julian do you think this kind of pick is an example of the fed caving in to pressure from Trump who has been quite critical of the monetary policies.
Julian: I do. Jay Powell, I don’t blame the guy he came under tremendous criticism from Donald Trump constantly when he was rapidly raising rates and engaging in quantitative tightening or this balance sheet runoff. So, I don’t blame him for doing what he’s doing. No one wants to oversee an economy that goes into a recession, he doesn’t want to cause a recession. He doesn’t want to see the stock market go down. Everyone wants happy times. I don’t blame Jay Powell, he’s really just doing his job here. But is the fed really independent? No, I don’t think so.
A recent paper got released that’s very interesting, it’s called Where Are the Value Funds and it points to the fact that there are virtually no funds in the U.S. market that actually hold only cheap stocks. Now why is this important? Well historically studies have shown that cheap stocks are those with a low valuation be it on book value, Ebit, a number of valuation metrics. These cheap stocks typically outperform especially stocks that have very high valuations and this is why value funds outperformed. They pitched themselves as value funds and when you buy a value fund, you expect to be exposed to this value factor that investors think will lead to outperformance. But the study shows that a lot of funds that brand themselves value, if you do the analysis as these researchers did they actually hold more expensive growth stocks i.e. high valuation stocks instead of the cheap value stocks that they’re named after. So, it was a pretty tremendous study, very interesting. It supports the fact that are the recent evidence that most value funds have really been doing poorly over the past decade and perhaps that’s because we could call them fake value funds. They actually don’t hold cheap stocks, they’re more so likely to hold high growth high valuation momentum or even story stocks and I like this comment by Dan Rasmussen of Verdad Advisors and in his analysis he seemed to indicate that there’s a reason why value stocks or value funds don’t actually hold value stocks and that’s because the cheapest one or two decile value stocks are actually micro-cap and small cap stocks. Therefore, value funds who obviously want to grow such that they can earn greater revenue for the fund management companies, once they get to become a certain size they can no longer hold micro-cap small cap stocks. Ultimately as they grow they’ll have to ignore those stocks and go for the big stocks and so they’re really missing out on the cheapest one or two deciles which tend to reside in the micro and small cap sector.
Michael: I also think that this paper really highlights the importance of looking beyond the labels of a fund that you’re looking into and looking at the actual holdings and the investment strategies of fund to see if the actual label applies to their strategy. The other interesting aspect that I took away from the article was the discussion of the academic research demonstrating the benefit of momentum strategies. But most funds don’t seem to take advantage of this anomaly. Now Cliff Asness from AQR has long been a proponent of adding a momentum factor to traditional risk premia and the other interesting aspect of what AQR is done with momentum and value is combining the two factors in achieving greater results.
Julian: Awesome story at Forbes here on a man named Herbert Wertheim, a 79-year-old former optometrist who had tremendous success in investing. He’s a self-made billionaire now worth $2.3 billion verified by Forbes looking at his account statement. So, what makes Herbert unique is that he bought common stocks and held them for a very very long time and they compounded or built in value to become tremendously valuable. They give one example here he has an $800 million stake in a firm called Heico. He has held Apple and Microsoft since their IPOs – which is multi-decade holding periods. So, it’s really a testament to the power of compounding as well as the resilience of American innovation over the past half-century and so they have a quote here from Herbert where he says quote “I wanted to be able to have free time. To me having time is the most precious thing” and he really made it count, he made very intelligent stock picks and the implications here are just look at what he’s done. They don’t really get in a process. But he really lets his winners ride, obviously has a talent for picking the winners, that’s number one. If he does make a mistake he tends to drop it – if it falls 25%. But if he’s got a big winner then he tends to keep reinvesting in that and I mean the proof is in the pudding. He’s really done a tremendous job here. They also detail his entrepreneurial success.
Michael: Yes, so the article mainly focuses on his investing prowess. But he also built his company Brainpower Inc into the one of the world’s largest manufacturers optical tents with 25 million of annual revenue. Netting him ten million dollars a year that he was able to reinvest into his stock holdings.
Julian: So certainly, didn’t become a billionaire only through stocks, but they really propelled them to the whole another level of wealth at 2.3 billion is pretty insane actually.
In a blog post this week that I wrote called Innovators, Imitators and Idiots we highlighted the always wonderful Charlie Munger. He was in the Wall Street Journal recently with a pretty amazing quote. So, he said that the “money managers among them are like a bunch of cod fishermen after all the cods been overfished. They don’t catch a lot of cod, but they keep on fishing in the same waters. That’s what happened to all these value investors. Maybe they should move to where the fish are”. Ouch. Charlie Munger, he’s old, he’s rich mid-90s and he really has no filter left and investors love it and especially when he’s even making fun of them and what he’s trying to say is that the methods that they made famous perhaps don’t work anymore and in the blog I showed Berkshire Hathaway’s performance. And Berkshire is run by Charlie Munger and of course his partner Warren Buffett. Berkshire’s performance versus the S&P500 ETF over the past ten years and up until recently Berkshire used to absolutely trounce the S&P500 by many, many percentage points. But over the past ten years Berkshire is actually trailing the S&P500 which is pretty much unprecedented. What caused this? Have they lost their touch? I don’t think so. Perhaps Berkshire, their size plays a bit of a part. But ultimately there’s so many copycats out there that they kind of negate Berkshire’s old advantages of buying quality businesses, quality stocks at cheap prices. The major point of this blog post was to really stress on being unique in your investment process. You’ll never be successful just replicating what other investors do. Certainly, it makes sense to follow the best investors and learn from them. But ultimately you need to acquire your own style and be your own investor and that will ultimately lead you to better success and Warren Buffett’s maxim that three I’s that the post was named after. So, number one can the innovators, are those who create something unique and novel. Those really pushing the envelope with unique and new ideas. Then come the imitators, those who see the innovators success and seek to copy it and finally come the idiots – those who see other people getting rich being successful and their greed ruins what the innovators and imitators have created and there you go.
We received a couple questions from listeners of the podcast today. So, Mike why don’t we go get into it.
Michael: Yeah so Julian the first question is what arbitrage is.
Julian: So, arbitrage it’s an advanced trading strategy utilized by hedge funds. It’s not new, it’s been around for a very long time and I believe the quote is “feed a man a fish and he’ll eat for a day. Teach a man to arbitrage and he’ll eat for a lifetime.” So, I’ll give you a really simple example of how someone can profit from arbitrage which effectively means buying and selling the same thing or something very closely equivalent at the same time at different prices to capitalize and profit off those different prices. For example, say you have someone on Amazon who’s willing to buy an Xbox for $400, then you check eBay, and someone is willing to sell an Xbox for $350. So, what the arbitrageur can do is buy the Xbox for $350, go to the other marketplace immediately sell it to the buyer for $400 to capitalize on those price differentials and pocket $50 and so that’s just a real simple version of arbitrage in the markets, in the stock markets, bond markets, commodities. There are thousands of market participants conducting arbitrage and there’s many different strategies that entail those buy and sell dynamics. So, ladies and gents that is what arbitrage means. Next question Mike.
Michael: Awesome. So the next question is what are the benefits of alternative strategies?
Julian: Alternative strategies such as hedge fund strategies be a market neutral all the way to short selling or as we just discussed arbitrage strategies, each one can add various benefits to an investor’s portfolio. At number one hedge funds many of them actually hedge. Which means they mitigate risk and they help cushion the downside. For example, if you have a market neutral fund, that means it is equally long and short stocks; i.e. a fully hedged portfolio. Say the market declines 30%, your market neutral fund likely isn’t going to suffer any setbacks. It is just as likely to be up or down in that scenario. It tends to move independently of what happens to the general market indices. Next, they can cushion a volatility in your portfolio. Some alternative strategies are what we call negatively correlated to typical stock market indexes. What this means is that the market zigs that your alternatives might zag; i.e. move in the other direction. Which also it adds diversification benefits and helps with the downside. Lastly alternative strategies, many can add to outperformance. Many people talk about private equity and how they can beat the market and a lot of hedge fund strategies historically have beaten the market when looked at a risk adjusted basis. I believe that is all our questions. We hope you enjoyed episode 2 of the absolute return podcasts and we’ll see you next week for episode 3, cheers.
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