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The Daily Reckoning | Monday, August 6, 2012
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Hard Habits to Break Ignoring the Effects of 40 Years of Money Printing
Reporting from Laguna Beach, California...
Eric Fry
Here’s some great news for all of our pot-smoking Daily Reckoningreaders! A recently-concluded study by researchers at the University of Alabama at Birmingham determined that one marijuana joint per week for 49 years does no harm to lungs!
But even though five decades of pot-smoking causes no meaningful lung damage; it can cause plenty of damage to one’s potato chip budget. What’s more, a large percentage of the folks participating in this study could no longer recall what a lung was. “It’s that marijuana-inhaling thing, right?” one participant responded when pressed to describe a lung’s purpose.
Kidding.
The important take-away here is that 50 years of cannabis inhalation is not necessarily healthy, just because a five-decade pothead is still able to draw smoke through a bong. For the sake of metaphor, we’ll call 50 years of pot-smoking a “bad habit.” Like most long- term bad habits, the consequences unfold unevenly and sporadically. And often the consequences unfold so slowly that you barely notice them at all.
The US Treasury has been printing paper dollars, backed by nothing but paper and ink, for more than 40 years. That’s a bad habit. And yet, the greenback is still with us and it is still the reserve currency. So it looks like this particular bad habit has produced no harm. And that is absolutely true, provided you don’t mind paying $4.33 for the same Big Mac that cost 50 cents in 1971.
That’s right, the price of a Big Mac has soared 866% since the year President Nixon severed the dollar’s convertibility into gold. Your California editor ate a Big Mac yesterday and it was very good, but not 866% better than the Big Mac he used to eat after his Little League games in 1971.
“We live in a technological golden age,” asserts Jim Grant, editor of Grant’s Interest Rate Observer, “but in a monetary and fiscal Dark Age...Science and technology may hurtle forward, but money and banking race backward.”
The proof of Grant’s assertion: A 1971-vintage dollar has lost an astonishing 88.5% of its value. That’s a bad habit. Revoking Constitutional rights is also a bad habit. So isfanning class warfare. So is militarizing local police departments. So is expanding the role of government in the private sector. So is manipulating interest rates in the name of “monetary policy.”
Incredibly, all of these bad habits are unfolding at the same time. Right now. Right before our eyes. And yet, our national “lung function” feels entirely normal. So does our eyesight and our hearing and every other vital sign. We feel completely healthy...even as we are becoming terminally ill.
But these bad habits — these incremental changes for the worse — produce their bad consequences so slowly that almost no one will notice them...until it is too late to prevent them. No one knows, of course, the exact date that “too late” might arrive. But according to the research of Peter Turchin, the US is drawing near to an ominous timeframe.
Specifically, Turchin says the United States is approaching a period of violent upheaval. He bases his prediction on a field of study called, “cliodynamics,” which identifies significant behavioral patterns in a nation’s history. US behavior, according to Turchin, operates on a 50-year pattern.
Turchin did not pull the 50-year number out of the air. He compiled copious historical data about major violent incidents in US history between 1780 and 2010 and concluded that a cycle of violence repeats itself every 50 years in America.
“Circa 1870, the North fought the South in the Civil War,” livescience.com explains. “Half a century later, around 1920, worker unrest, racial tensions and anti-Communist sentiment caused another nationwide upsurge of violence. Then, 50 years later, the Vietnam War and Civil Rights Movement triggered a third peak in violent political, social and racial conflict.
“Why 50-year cycles?” livescience.com asks. “After a period of sustained violence, [Turchin explains], citizens begin to ‘yearn for the return of stability and an end to fighting.’...The prevailing social mood swings toward stifling the violence at all costs, and those who directly experienced the civil violence maintain the peace for about a human generation — 20 or 30 years. But the stability doesn’t last. Eventually, ‘the conflict-scarred generation dies off or retires, and a new cohort arises.’...As a result, periods of intense conflict tend to recur with a period of roughly two generations (40-60 years).”
“My model suggests,” says Turchin, “that the next [peak in violence] will be worse than the one in 1970 because demographic variables such as wages, standards of living and a number of measures of intra-elite confrontation are all much worse this time...After the last eight years or so, notice how the discourse in our political class has become fragmented. It’s really unprecedented for the last 100 years. So basically by all measures, there are social pressures for instability that are much worse than 50 years ago.”
But there’s a silver lining to all this: After the next worse-then- ever peak in civil upheaval, we are supposed to get a 50-year break until the next one. For some folks, that’ll mean 50 years of hassle- free pot-smoking. Urgent:
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Mutual funds are too often just a kind of financial junk food. Investors get a quick and easy portfolio, habitually stuffed with hundreds of stocks. No wonder their returns are frequently poor.
Chris Mayer
But there are exceptions.
The folks at Gabelli & Co., led by the stock picking gourmand Mario Gabelli, have cooked up a profitable recipe for serving quality ideas. From January 2006 to the end of 2011, these ideas have returned 210%, versus a negative 5% return for the market overall. There is now a surprisingly easy way to get yourself a seat in Gabelli’s exclusive kitchen.
Meet Dan Miller. I’ve known Dan since 2006. He’s been managing Gabelli & Co.’s research business for about eight years now. Six years ago, Gabelli’s research team started publishing the Focus Five report. It revealed just their five best ideas, updated every quarter. Sometimes names would carry over. Sometimes not.
“We decided to start publishing this report to draw attention to the quality of our ideas,” Dan said. “We thought we had a unique fundamental process where we would estimate a company’s private market value.”
Private market value is what an acquirer would pay to buy the whole business. Wide gaps between stock market value and private market value are what attract team Gabelli. This private market value approach is also a cornerstone in these pages. It’s one of the elements of the “C” in our CODE system. (“C” standing for cheap). Our buying of such stocks is one reason why one out of every 10 recommendations ever made here has received a buyout offer.
“We also identify a catalyst,” Dan adds. “Not just a catalyst, but a near-term event, which to us meant between three and 12 months.” And perhaps most importantly: “We have to speak to management and trust them. We have to understand how they are going to create value for shareholders.”
As mentioned, this recipe has delivered excellent results. “The Focus Five report showcased a truly superior research process and team, and our ability to find really good ideas. Our picks as a whole were up even in 2008, for example,” Dan noted.
Over time, the Focus Five report got a lot of attention. “We would get phone calls from people asking how they could get a copy of the report,” Dan remembers, “and they would sometimes ask for a fund that did this.” So Dan convinced Mario to turn the idea into a fund. They converted a tiny small-cap fund that Dan took over in January. The Gabelli Focus Five Fund was born.
“For IRS purposes,” Dan continued, “we can’t have just five investments. So the fund will have anywhere from 25-35 investments, but up to half of the fund could be in just five investments — if we have a high level of conviction. Today, the top five names are about 35% of the fund. It’s really a concentrated, high-conviction, best ideas strategy.”
So importantly, the fund is not the report. But the Focus Five Fund grew out of the same process. “We’ve got 35 analysts that cover various industries,” Dan says. “In addition, we’ve got about a dozen portfolio managers with certain specialties. We all convene every day at 8 a.m. in a firmwide morning meeting. We have a fluid flow of info about ideas. My job is to look at these ideas and determine the high-conviction names. Mario is our best analyst, for example. I talk to him every day. And I can tell you when he likes a stock and when he loves it... and when he really loves it.”
Unlike the report, Dan is not beholden to the turn of the calendar marking a new quarter. He has no problem holding an idea for a year or two or longer. “But I’m not buying it and waiting three years for something to happen,” he says. “I have to have a near-term event.”
As an example, Dan started buying Barnes & Noble in mid-March at $13.50. He bought all the way down to $11.50. “I had very high conviction in the valuation,” Dan said. “We thought, at that price, we were paying zero, or less than zero, for the Nook business. And we liked the college bookstore, which is a cash cow.”
In addition, insiders were intent on unlocking that value. In a matter of weeks, Microsoft decided to make an investment in the Nook business. “The stock was trading pre-market at $27 and I sold my entire position at $27.21,” Dan remembers. “At that price, it was trading very close to our private market value estimate of $30. The stock traded down all day to $21, and today it’s $17. I got lucky. But my point is that we have no problem taking short-term gains. Or losses, for that matter.”
Dan talked about how he bought Ivanhoe Mines at $15 in January. He liked the business, the CEO and the valuation. By April at $12, he decided he got it wrong. “I have no problem admitting when I’m wrong,” Dan said. “I don’t need to sit in a stock for a year and then find out I was wrong.”
When I talked to Dan, his fund was up about 6% for the year. He had a slow start in January and February because he held a lot of cash. In January, the fund averaged 40% in cash. He had money coming in and was selling the old fund’s holdings. But that is behind him now. In the second quarter, he was down half what the market was down. Now he’s fully invested in high-conviction ideas.
We got to talking about some of those high-conviction ideas.
“I just started buying Federal-Mogul (NASDAQ:FDML) at $13.50. We know it well. We know the catalyst is Icahn doing something, like spinning off the aftermarket business. I also own Dana and Tenneco. I like all three.”
“Auto parts suppliers, in general, seem like a place that ought to do well,” I said. “The valuations are compelling.”
“Yeah, these three companies make up about 13% of the fund. I think all of them have the potential to be doubles,” Dan said. “My top position today is Brink’s. That’s a very interesting business.”
Brink’s (BCO) is in the business of ensuring the safe delivery of valuables. Markets outside of the US account for more than 30% of sales and could grow by 50% by 2015. Brink’s is already profitable in Brazil, Russia, India and China.
Trading around $23, and with a new CEO, Brink’s trades for just 4 times Gabelli’s 2012 EBITDA estimate of $365 million. (EBITDA is earnings before interest, taxes, depreciation and amortization. Think of it as a broad earnings measure.) On a sum-of-the-parts basis, Dan believes the shares are worth $45 per share.
Another interesting business is RealD (RLD). Dan takes us through it:
RealD is a manufacturer of a 3-D projector device that goes on top of a 2-D projector. It has a very good business model. RealD manufactures these devices and it costs them about $10,000 each. They then give them to the theaters for free. But in exchange, RealD gets a 10-year contract whereby it collects 50 cents per 3-D ticket.
The US market is close to saturated, but RealD continues to grow fast overseas. At some point soon, this will turn into a real cash cow. The catalyst is further growth in the 3-D movie market, which is being fueled by the major studios repurposing their old content.
“So for example,” Dan says, “The Lion King came out years ago, but Disney re-released it in 3-D. It cost them $5 million to convert it and they generated $100 million in ticket sales.” Studios, then, have a big incentive to follow suit. And RealD gets 50 cents per ticket. The stock today is $11 and Dan thinks it is worth closer to $20 per share. “We think a logical buyer might be someone like Dolby,” he added.
How about one more? Dan told me about Rochester Medical (ROCM).
“They make catheters,” Dan says. “They have very good technology. The management team is very smart and focused on shareholder value. There is a board member who is also the CEO of a competitor — Teleflex — and I think he’s a buyer for the whole company. 3M has also started to nibble at Rochester’s products and for the very first time had Rochester speak at one of their customer conferences. I think 3M could buy Rochester. The stock is about $10, but I think it’s worth $18 in a transaction.”
Rochester is the fund’s fifth-largest position. “I have a very high level of conviction in their business. We speak to them all the time. We trust them. I could wake up any day now and find that we got taken out at $18 per share. That would be a 4% move in the fund. That’s what we want to do here.” High conviction, big impact.
“My philosophy on this fund is very simple,” Dan summed up. “If I don’t have to own it, if I don’t feel compelled to own it, then I don’t own it. I can do that running a very concentrated fund. I don’t want to mimic the market. I want to beat the market.”
The Gabelli Focus Five Fund is a small fund, with about $11 million under management. It’s just starting out, giving you a chance to get in practically on the ground floor. The ticker is GWSVX. I love the idea of the fund and Gabelli’s approach. I think it will be a winner in the years ahead. It’s a smart option if you are looking for something other than mass-produced pink slime served up by the big mutual fund houses.
We’ll keep an eye on this fund and check back with Dan again in the future.
Regards,
Chris Mayer,
for The Daily Reckoning
Joel’s Note: Interesting, huh? Even in difficult markets, where price indicators and market mechanisms are under constant attack from the Feds, it is possible to develop and evolve reliable, index- beating methods for prudent investing. And, when and where such methods exist, you can bet Mr. Mayer will be there...asking questions, probing inquisitively, scratching his head and wondering, “Will this work for my Mayer’s Special Situations readers? Can we employ this strategy — or part thereof — to better our own portfolio’s returns?”
Fellow Reckoners should know that Chris consistently ranks as the Agora Financial editor with the most loyal following. (We measure this by cancellation rates, testimonials, the number of people who buy Chris a congratulatory beer in Vancouver each year...and a bunch of other data points.) In fact, his investment services are considered required reading around Daily Reckoning H.Q.
As such, we invite you to take Mayer’s Special Situations for a test spin. Try it, risk-free, for 30 days. See if it works. Decide if it helps improve you as an investor. Then work out if you want to join his readership full time. Here’s the sign-up page.
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Tuesday, 7 August 2012
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