Murray Stahl is the Chairman of Horizon Asset Management Inc. The firm's fourth-quarter letter, below, contains an overview of the market environment as well as discussions on individual stocks:
It was intended, after last quarterâs identification of the exchange-traded fund (ETF) bubble and a review of its scope, to now dwell on some narrower portfolio-specific topics. Yet, many of the currents and stresses undergirding the broad stock market are of such importance, and the investing public is so unaware of them, that it seems a greater and timelier virtue to discuss some of those.
It is easy to be unaware that a given environment we inhabit or make use of is actually anomalous, unstable or simply in transition. A circumstance merely needs to have persisted for some reasonable span of time or be tacitly accepted by the great majority of our co-travelers for the appearance of stability or normalcy. When dealing with that for which our sensory apparatus was not evolved, such as very large or very small numbers, or very rapid or very slow phenomena, it is entirely normal to be misled. How were the California settlers of the 1850s or the later settlers of the 1950s to know that that particular century of balmy Mediterranean weather that came to be thought of as the norm for coastal California was actually a historical aberration? What is known as the Little Ice Age was a roughly 500-year period of cooler temperatures that along the California coastline was manifested by severe, coastline-altering winter storms. That this characteristic had abated by the opening decades of the 20th century no doubt contributed to a misperception that invited massive overbuilding. Similarly, in the sphere of financial markets, we are unconsciously influenced by a whole range of factors, among them social anchoring effects (knowledge of the norm or of a specific variable or expectation, such as a 10% return from stocks or that indexation is less risky), availability error (reliance on the most readily available data, irrespective of its completeness or applicability), and insufficient tutelage in market history and market models such as the self-reinforcing cycles that lead to booms and busts.
One of the broad, deep currents presently characterizing the financial markets is indexation. This phenomenon has grown tremendously and now affects virtually everything around it, often in extreme and counterintuitive ways. Yet, it is so large and so much a part of daily practice that one can be unaware of its scope, the manner in which it affects securities prices, or the implications of its use. Therefore, it should be studied, which we do, and we will continue to describe it and share observations about it. The following paragraphs merely illumine some of these critical issues; they are insufficient to be characterized as discussions.
The Deception of Classification â A Small Sample
The S&P 500 Index; there is a foundational ring to the term and an implicit assumption that there is a breadth and sameness to what it represents and to the various industry sectors that comprise it. Over $5 trillion of assets are benchmarked to this index, largely on this basis. But its character changes. It wasnât so long ago that the Technology sector represented 35% of the S&P 500 Index.
On a picayune front, ExxonMobil (XOM, Financial), which within the S&P 500 Index has a 3.5% weighting, is one of the ten largest holdings in 83 different ETFs1 each ETF itself being based upon a distinct index. There are nine ETFs in which it has a weighting ranging from 9% to more than 25%. Among those nine it is included in both the Wisdom Tree LargeCap Growth Index and, oddly, the Wisdom Tree LargeCap Value Index. Itâs in the Vanguard High Dividend Yield ETF, the Russell 1000 Growth ETF, and the Russell U.S. Large Cap Low P/E ETF. It is a 15% weighting in the S&P Global Energy Index Fund, but also represents a 26% weight in the Dow Jones U.S. Energy Sector Fund. If one happened to have chosen this particular variety of ETFs for their differing characteristics, as suggested by their names, such as Growth, Value, International, Domestic, and so forth, the large exposure to this single common variable would confound the intended diversification. What if the 2010 British Petroleum disaster off the Louisiana coast had been the ExxonMobil disaster?
Apple, Inc. (AAPL, Financial), which represents about 4.3% of the S&P 500 Index, and which is among the ten largest holdings in 80 different ETFs, and between a 10% and 21% weighting in a dozen of those, presents even greater implications for S&P 500 Index investors. Apple has approximately $100 per share of cash on its balance sheet, so although it trades at 13.5x, its consensus estimated earnings for 2012, it is only 11.2x earnings if the share price is adjusted to exclude the balance sheet cash, from which it essentially earns nothing. In only a few months, the stock will begin to trade relative to the consensus earnings estimate for 2013, which is $48.65 per share. If, by some happenstance, the shares were to trade at 20x the 2013 forecast, exclusive of balance sheet cash, the share price would be far higher. Appleâs trading price in that scenario, plus cash, would be $1,073 per share, and its market capitalization would be almost exactly $1 trillion. All else equal, its weight in the S&P 500 Index would be 7.8%, a not implausible outcome. This has never before happened. But wait, thereâs more.
If Apple TV is announced by September 2012, and if analysts are duly impressed, earnings estimates would likely be increased, which would further amplify Appleâs weight in the S&P 500 Index. Moreover, success at Apple comes at the expense of companies like Microsoft, Intel, Hewlett-Packard and Dell, among others, and therefore, should Apple earnings estimates rise due to improving business results, we may witness a decline in the business results of the aforementioned companies. By virtue of that factâif indeed it becomes a factâthe weight of Apple in the index would rise yet more. The notion of a 10% weighting in the S&P 500 Index in Apple is not implausible.
That outcome would create its own problems. Consultants and due diligence controls prohibit fund managers from permitting individual holdings to reach excessive levels, and 10% is well beyond the typical limits. What, then, would holders of the S&P 500 Index do if they are, by definition, insufficiently diversified by holding that index, yet are both instructed to mimic the index and are measured against the index? It would be a problem. As large as the S&P 500 Index is, it nevertheless appears to hold the possibility of becoming undiversified.
The Current Exposures of the S&P 500 IndexâA Sample
The Dow Jones US Technology Sector Index ETF (IYW) has a 22.1% weighting in Apple.2
The largest ten constituents of this ETF are listed on the next table, and their weight in total is 69.2%.
Dow Jones US Technology Sector Index ETF (IYW)
% IYW Holdings
Apple
22.1%
Microsoft
9.1%
IBM
8.9%
Google
6.1%
Intel
5.6%
Oracle
4. 5%
Qualcomm
4.4%
Cisco
4.2%
EMC
2.3%
Hewlett-Packard
1.9%
Total
69.2%
Source: iShares website as of 4/17/2012
IYW is structured to be a diversified technology index. Clearly, the fortunes of Apple, Google (GOOG), and Qualcomm (QCOM, Financial) are affected by mobile/internet/smartphone technology. With Apple weighing in at 22%, Google at 6%, and Qualcomm over 4%, more than 32% of the technology index revolves around smartphone technology. Itâs hardly a diversified index and itâs actually less diversified still, since if the sub-group in question were to be successful, that success would clearly be problematic for other index members such as Microsoft, Intel, and Hewlett Packard. The result would be that this index, such as it is, could become yet more concentrated.
If one thinks about these types of companies as if they are in an ecosystem, using only Apple, Microsoft, Google, Intel (INTC, Financial), Qualcomm, and Hewlett Packard (HPQ, Financial), they all revolve positively or negatively around the smartphone/tablet/personal computer business. The sum of the weights of these companies in the S&P 500 Index is 10.12%, which means that one industry variable is now approximately 10% of the S&P 500 Index. Something has happened over time to the S&P 500 Index to change its diversification mix.
SPDR S&P 500 Index (SPY)
% SPY Holdings
Apple
4.55%
Microsoft
1.86%
Google
1.28%
Intel
1.13%
Qualcomm
0.91%
Hewlett-Packard
0.39%
Total
10.12%
Source: https://www.spdrs.com/product/fund.seam?ticker=spy as of 4/13/2012.
Formally speaking, when one looks at the S&P 500 Index, the largest individual index weight is Information Technology, at 14.8%. However, employing only the smartphone/tablet/personal computer companies, and ignoring those outside of that ecosystem, such as Visa and IBM and MasterCard, the weight is about 10%. The other largest sector weights are Energy at 11.05% and Health Care at 11.33%. These are sizable factors in a broad index; accordingly, they deserve studyâthat an index is passive in its construction does not mean that, as an investor, one should be passive about its composition.
The Delusion of Correlation and the Dangers of Time Series Modeling
By Sector
Correlation, as it is used in the investment profession, implies a sort of scientific precision that simply does not exist in the real world. It seems reasonable to assert that the same can be said for concepts such as earnings variability and volatility. For instance, the healthcare industry is considered one of the so-called âdefensiveâ sectors that are characterized by low levels of earnings variability. It also seems reasonable to assert that this segment of equities should be uncorrelated with defense companies. After all, healthcare companies cure people and defense companies perform the opposite function.
Given that assertion, it is interesting to view the following table, which includes selected data from the 2012 edition of the Budget of the United States. It provides data on healthcare and national defense spending from 1940, when that data begins, to the most recent year. These figures are not adjusted for inflation; they are the absolute numbers that were reported at the time.
Clearly, both national defense and health expenditures have been powerfully correlated, with over a half-century of extensive data to prove it. But thatâs not an intrinsic property of the nature of the beast. Itâs simply that the United States Congress chose to spend monies in that manner and, therefore, the healthcare industry was said to be âdefensiveâ in the sense that more money was spent each year irrespective of the condition or direction of the rest of the economy. Itâs not a property that is immutable like those of an element like nitrogen in the Periodic Table; it is discretionary spending that one day will stop, and that day may well be fast approaching.
According to the U.S. Government budget estimates for 2017, defense expenditures will be cut to $589 billion, which is a big change versus the 2010 figure of $693 billion. For the first time in nearly eight decades, it is presumed that the United Stated defense budget will not expand, and that forecast has implications for the valuation of defense companies. Major defense contractors trade at only about 11x this yearâs estimated earnings, versus about 13.2x for the overall S&P 500 Index.
Contrarily, Medicare expenditures are expected to rise from $451 billion in 2010 to $641 billion in 2017, while expenditures by the Department of Health are expected to rise from $369 billion in 2010 to $613 billion. Even with the reduction in the Defense budget, it is hard to imagine how that is affordable. The more established healthcare sector companies, with existing products that sell at high profit margins, trade at low P/E ratios, probably in recognition of the fundamental reality that ultimately the government reimbursement rates for healthcare are going to change negatively. Even the so-called biotech majors like Amgen and Gilead sell for merely 11x this yearâs expected earnings; generic drug companies like Mylan and Teva trade at P/Es of 9x or lower. Who can say that these seemingly low valuations are not actually too high, if true margin compression is the central theme of their future?
It seems reasonable to suppose that the diminution of defense expenditures will create some type of volatility in the defense industry. It is interesting to observe that defense companies are excluded from the Russell Low Volatility ETF, and perhaps it is right to exclude them. Is it realistic to believe that the healthcare expenditure growth trends of the past 60 years will remain in place? If it proves not to be the case, healthcare companies, which are included in the Russell Low Volatility ETF, will experience a certain quantity of volatility. Itâs possible for a low volatility index to become a high volatility index, just as itâs possible for a diversified technology index to become concentrated, and for a seemingly diverse portfolio of ETFs to be rather undiversified.
The Whole Enchilada
Such observations apply not only to individual sectors of the S&P 500 Index, but to the entire index. The estimated total of outlays in the U.S. budget for 2012 is $3.7 trillion. Since revenues are only about $2.6 trillion, we have a $1.1 trillion deficit. Even according to the always-optimistic estimates of the U.S. Office of Management and Budget, in 2016, when the economy is anticipated to be far more robust than it is right now, the deficit is still expected to be $648 billion.3
Total Federal Outlays in 1940 were a bit less than $9.5 billion, which represented 9.8% of GDP. As previously noted, the 2012 estimate for total Federal outlays is $3.7 trillion, which is 24.3% of GDP. The Federal government by itself expends almost a quarter of the U.S. GDP, and that does not include the state and local expenditures, which add greatly to it. Clearly, the U.S. government spends a tremendous amount of money. Its proportion has increased over the years but, since it cannot ever be 100%, it has to stop at some point. A good question to ask is: âIf this phenomenon were to halt, what would the strategy of indexation be like?â
Although some might disagree with the estimate, U.S. GDP is expected to rise from the 2012 estimate of $15.8 trillion to an estimate of $19.8 trillion in 2016, which is about a 25% increase in 48 months. Assuming that GDP estimate is accurate and that spending also increases at the forecasted rate, the government share of GDP in outlays would decline by about 2% points to 22.5%. Of course, if GDP does not approach $20 trillion by 2016, the governmentâs share would probably rise.
Government spending is reaching certain fiscal limitations. A reduction in government spending would have major consequences for many of the large companies in the S&P 500 Index that benefit from such government spending. Therefore, those companies would exhibit a type of correlation in a negative sense that has never been seen before, in which case indexation might prove to be a rather problematic strategy.
As a matter of fact, those analysts who make assertions about the âintrinsic characteristicsâ of equities as an asset class as measured by the S&P 500 Index, are actually engaging in the same type of time series analysis that analysts performed in 2007 with regard to the housing industry. It was observed, over a span of five decades, that housing prices never seemed to decline. They always seemed to increase at a constant rate until such time as they ceased to increase at that rate, and many tears were shed as a consequence.
These comments are all by way of saying that the S&P 500 Index, viewed through the prism of the U.S. budget, should naturally become less diversified as U.S. budgetary stresses place unequal pressures on different business models. It should become clear that the S&P 500 Index is not, by any stretch of the imagination, a diversified series of investments, as is generally believed.
Whatâs the Opposite of Indexation?
The purpose of the preceding discussion is not to suggest that the outlook for equities is poor; it is to suggest that in the customary fashion of the marketplace, a great deal â which is to say an excessive amount â of capital has flowed into particular sectors and instruments. A great deal of capital has come to be invested in the same manner and in the same securities, inspired by beliefs and data that will not ultimately support the valuations and behavior expected of these securities and instruments. To reprise an exhibit from last quarterâs commentary, the mere fact of having been selected for inclusion in (or exclusion from) popular ETFs is sufficient to inflate the valuations of a selection of otherwise comparable companies in the same industries by a factor of nearly 100%:
It is simultaneously the case that there are populations of securities and instruments that, because they are outside the sphere of the indexation bubble, have been orphaned from both analytical attention and the flow of funds. They exhibit different valuation and, often, business characteristics. They will have different return vectors. A sub-set of these, the owner-operator companies upon which we have expended some attention, will exhibit yet another sort of return vector over time. This is not about whether to be âin the marketâ, but about where in the market to be.
Holdings Review
This section will focus on four companies, of which two operate in the same ecosystem. They were chosen for their shared characteristic: each has a non-mainstream return vector.
Howard Hughes Corporation (HHC, Financial)
Unlike the typical publicly traded and perhaps ETF-centric real estate company, Howard Hughes Corp. (Howard Hughes) is not a REIT, nor does it pay a dividend, nor does it focus on a single type of real estate; accordingly, it is not a mainstream public stock. According to ETFdb, Howard Hughes is not a top 10 holding in any ETF. Howard Hughes is a real estate holding company with geographically diverse properties, including master planned communities, strategic development properties, and shopping district properties. Many of these properties are held on the books at very conservative valuations. For instance, the companyâs properties in Hawaii include a prime real estate ranch on the books at zero and a prime shopping district on the books at approximately $350 million, but with a market value which is likely more than $3 billion. For a sense of proportion, the entire Howard Hughes stock market capitalization is presently $2.5 billion. )
An even more striking example is the South Street Seaport in lower Manhattan, for which Howard Hughes holds a long-term ground lease with the City of New York. This property is held on the books at $5.9 million. In 2011, the South Street Seaport generated operating income of over $5.6 million; however, one must keep in mind that the economic climate under which legacy leases and tenants were negotiated was unfavorable to lessorsâthus even the recent operating income from the property is only a conservative estimate of its potential to generate revenues. The company is in continuing discussions to obtain the necessary approvals to renovate the property. We believe that this property is likely worth more than $100 million.
These are just a few examples of properties held on the books at conservative valuations. Many of the properties are on the books at costs that were established decades ago. The land for the enormous Summerlin master planned community in Las Vegas, for instance, was acquired in the 1950s.
As of December 31, 2011, HHC had $2.3 billion in shareholdersâ equity, $3.4 billion in assets, and $1.1 billion in liabilities. The companyâs market capitalization as of April 16 was approximately 2.4 billion. The shares are trading at book value. This suggests that, not only do investors believe that the company is worth no more as an operating company than it would be in liquidation, but they also believe that the conservative values at which properties are held on the balance sheet are reflective of what they would fetch if the company were to liquidate.
HHC is an owner-operator company. William Ackman and Brookfield Asset Management were sponsors of the creation of HHC through a spin-off from General Growth Properties during that companyâs restructuring process. Mr. Ackman serves as Chairman and remains active in management decisions. Brookfield Asset Management and William Ackman control 15.8% of the shares outstanding. This figure fails to incorporate the warrants also held by these companies, which when exercised will increase the ownership to almost 27%.
Management has been careful to limit asset sales at current depressed levels and to find strong strategic partners for the future property development, and is not afraid to take action when opportunities present themselves. As an example, in 2011 HHC acquired Morgan Stanleyâs 47.5% economic interest in The Woodlands master planned community in Houston, TX.
The assets of HHC will take time to develop and monetize; the long-term nature of the projects may make this company unappealing to investors with a short-term view. HHC currently trades at approximately book value. As noted above, book value represents a significant discount to market value for this portfolio of high quality assets. We believe that, in time, the multiple of book value will continue to expand, generating an attractive long-term return for investors.
Dish Network (DISH, Financial) and ViaSat (VSAT, Financial)
As noted above, a substantial percentage of the S&P 500 Index revolves around mobile phone companies. Whether by conscious decision or not, mainstream investors have significant exposure to the smartphone/tablet/personal computer category. In turn, the leading companies in this category continue to invest heavily in developing new functionality in models and growing their footprint in the market; those companies which did not expend sufficiently on meeting end user demand now find themselves rapidly losing market share.
Elsewhere in the telecommunications sector, cable companies continue to fight for market share by making staggering capital expenditures and sacrificing margin. In addition to other cable providers, these companies now face competition for content distribution from recent entrants; as digital distribution gains traction, cable companies face growing pressure on their subscription bases.
Many investors believe that satellite cable companies have the same, unappealing characteristics. We do not dispute that with regard to their content distribution business, these companies face growing competition and margin pressure. While this phenomenon appears to be a threat to satellite cable providers, for some it also presents an opportunity. Dish Network Corp. (DISH) and ViaSat, Inc. (ViaSat) each own satellite spectrum capacity. The accessibility and speed of internet connections have made streaming viable to the point where investors are concerned that customers will âcut the cordâ and elect to use the internet for television and movie viewing instead of a multi-channel video programming distributor (MVPD). Conversely, the burgeoning demand for wireless data is likely to allow DISH and ViaSat to leverage the spectrum capacity that is currently under-utilized. According to the FCC, smart phones utilize 24 times more data than conventional mobile phones, and tablets utilize 122 times more data than conventional mobile phones. Mobile applications grew from 300 million in 2009 to 5 billion in 2010âa 16-fold increase. FCC analysts expect a 35 times increase in wireless demand over the next 5 years, yet the wireless network is barely able to support current demand. This suggests to us that spectrum capacity will be increasingly in demand in the next few years.
Owner-operator Charles Ergen has voting control over DISH, although he recently appointed James Clayton as CEO (Mr. Ergen remains Chairman) in order to focus his efforts on strategic initiatives. DISH is presently the third largest pay television provider in the United States, with nearly 14 million subscribers. Over the past year DISH acquired Blockbuster Entertainment and now provides a physical mail order DVD rental and online streaming service to customers. DISH also spent nearly $3 billion to acquire spectrum licenses DBSD North America and TerreStar. DISH is currently valued at a modest 10x trailing earnings despite the significant optionality provided by the enhanced customer services and spectrum purchases.
ViaSat is currently engaged in satellite communications primarily under contract with the United States Governmentânotably the U.S. military. The company also has a commercial networks division providing high quality satellite communications such as in-flight broadband services to customer on Continental Airlines and JetBlue. The final operating division is consumer satellite services, which provides wireless broadband services primarily to customers in locations that cannot receive such services terrestrially. ViaSat is in the process of expanding its network to include more bandwidth at a lower cost that was never previously considered economically feasible. The launch of Eutelsatâs KA-SAT and anticipated launch of ViaSat-1 satellitesâreported by the company to be the worldâs highest capacity satellitesâprovides the company with over 200 gigabits per second throughput to bandwidth hungry customers. The high current price to earnings multiple of ViaSat masks the true earnings power of these assets, which have the potential to improve and expand all business segments of the company.
Interestingly, a cursory overview of the companies that have effectively cornered satellite spectrum capacity over the past several years reveals that they are almost exclusively owner-operators. There is vigorous debate regarding whether the investment in satellite spectrum capacity will prove to be prudent. However, it is clear that the marginal profit multiplier from increased demand for this business model has the potential to be enormous. If the owner-operators turn out to be correct, they are merely early in comparison to general market recognitionâit would not be the first time that owner-operators made prescient, though controversial investments.
Jardine Strategic (âJardineâ)
Jardine Strategic is part of the Jardine Matheson family of companies, founded as a trading company in 1832. It is a Singapore-listed holding company with principal interests in Jardine Matheson, Hongkong Land, Dairy Farm, Mandarin Oriental, Jardine Cycle & Carriage and Astra International. As of December 31, 2011 the reported net asset value per share of these businesses equaled $48.36; compare this to a March 31, 2012 traded price of $30.51: a 37% discount to stated NAV. In the post-financial crisis world, many holding companies in Southeast Asia have traded at historically unprecedented discounts to NAV or book value. While we understand that such discounts may be justified for certain holding companies with concentrated, private and illiquid assets, this does not describe Jardine. Jardine Strategic has a diversified portfolio of liquid, market listed assets, including the following:
⢠A 78% interest in Dairy Farm valued at approximately $11.1 billion. Dairy Farm is a rapidly expanding pan-Asian retail group with 5,400 outlets across Asia including supermarkets, hypermarkets, health & beauty stores and convenience stores. The businesses are regionally diversified across North, East and South Asian operating units.
⢠A 71% stake in Jardine Cycle and Carriage valued at approximately $7.660 billion. JC&C is an Indonesian conglomerate that controls the largest independent retail auto dealership group in Southeast Asia, including a roughly 50% market share in automobiles and motorcycles in Indonesia, in addition to being an exclusive Indonesia distributor for manufacturers such as Toyota, Daihatsu, Isuzu, BMW and Peugeot. In addition to automotive interests, Jardine Cycle subsidiaries have businesses in financial services, industrial equipment, agribusiness, among others.
⢠A 50% stake in Hongkong Land valued at approximately $7.325 billion. Hongkong Land is a leading commercial real estate company with over 450,000 square meters of commercial real estate in downtown Hong Kong and other strategic locations in mainland China. Over 75% of revenue is generated in Hong Kong, and over 65% of revenue is in commercial properties, both of which are relatively stable market segments.
⢠A 74% stake in Mandarin Oriental valued at approximately $1.170 billion. Mandarin Oriental operates a chain of 42 first class hotels worldwide.
Jardine Strategic owns a diverse set of operating assets across Asia. Despite the concerns over emerging market growth, Asia is home to several of most robust economies in the world. We believe that such an aggregation of businesses merits a market premium to NAV, not a discount on the order of 35%. However, even in the event that the market doesnât assign Jardine an appropriate multiple, we are content to allow the underlying businesses to drive our investment return.
DISCLAIMER
Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest.
This information is intended solely to report on investment strategies as reported by Horizon Kinetics LLC. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable.
No part of this material may be: a) copied, photocopied, or duplicated in any form, by any means; or b) redistributed without Horizon Kineticsâ prior written consent.
Read the original letter here.
It was intended, after last quarterâs identification of the exchange-traded fund (ETF) bubble and a review of its scope, to now dwell on some narrower portfolio-specific topics. Yet, many of the currents and stresses undergirding the broad stock market are of such importance, and the investing public is so unaware of them, that it seems a greater and timelier virtue to discuss some of those.
It is easy to be unaware that a given environment we inhabit or make use of is actually anomalous, unstable or simply in transition. A circumstance merely needs to have persisted for some reasonable span of time or be tacitly accepted by the great majority of our co-travelers for the appearance of stability or normalcy. When dealing with that for which our sensory apparatus was not evolved, such as very large or very small numbers, or very rapid or very slow phenomena, it is entirely normal to be misled. How were the California settlers of the 1850s or the later settlers of the 1950s to know that that particular century of balmy Mediterranean weather that came to be thought of as the norm for coastal California was actually a historical aberration? What is known as the Little Ice Age was a roughly 500-year period of cooler temperatures that along the California coastline was manifested by severe, coastline-altering winter storms. That this characteristic had abated by the opening decades of the 20th century no doubt contributed to a misperception that invited massive overbuilding. Similarly, in the sphere of financial markets, we are unconsciously influenced by a whole range of factors, among them social anchoring effects (knowledge of the norm or of a specific variable or expectation, such as a 10% return from stocks or that indexation is less risky), availability error (reliance on the most readily available data, irrespective of its completeness or applicability), and insufficient tutelage in market history and market models such as the self-reinforcing cycles that lead to booms and busts.
One of the broad, deep currents presently characterizing the financial markets is indexation. This phenomenon has grown tremendously and now affects virtually everything around it, often in extreme and counterintuitive ways. Yet, it is so large and so much a part of daily practice that one can be unaware of its scope, the manner in which it affects securities prices, or the implications of its use. Therefore, it should be studied, which we do, and we will continue to describe it and share observations about it. The following paragraphs merely illumine some of these critical issues; they are insufficient to be characterized as discussions.
The Deception of Classification â A Small Sample
The S&P 500 Index; there is a foundational ring to the term and an implicit assumption that there is a breadth and sameness to what it represents and to the various industry sectors that comprise it. Over $5 trillion of assets are benchmarked to this index, largely on this basis. But its character changes. It wasnât so long ago that the Technology sector represented 35% of the S&P 500 Index.
On a picayune front, ExxonMobil (XOM, Financial), which within the S&P 500 Index has a 3.5% weighting, is one of the ten largest holdings in 83 different ETFs1 each ETF itself being based upon a distinct index. There are nine ETFs in which it has a weighting ranging from 9% to more than 25%. Among those nine it is included in both the Wisdom Tree LargeCap Growth Index and, oddly, the Wisdom Tree LargeCap Value Index. Itâs in the Vanguard High Dividend Yield ETF, the Russell 1000 Growth ETF, and the Russell U.S. Large Cap Low P/E ETF. It is a 15% weighting in the S&P Global Energy Index Fund, but also represents a 26% weight in the Dow Jones U.S. Energy Sector Fund. If one happened to have chosen this particular variety of ETFs for their differing characteristics, as suggested by their names, such as Growth, Value, International, Domestic, and so forth, the large exposure to this single common variable would confound the intended diversification. What if the 2010 British Petroleum disaster off the Louisiana coast had been the ExxonMobil disaster?
Apple, Inc. (AAPL, Financial), which represents about 4.3% of the S&P 500 Index, and which is among the ten largest holdings in 80 different ETFs, and between a 10% and 21% weighting in a dozen of those, presents even greater implications for S&P 500 Index investors. Apple has approximately $100 per share of cash on its balance sheet, so although it trades at 13.5x, its consensus estimated earnings for 2012, it is only 11.2x earnings if the share price is adjusted to exclude the balance sheet cash, from which it essentially earns nothing. In only a few months, the stock will begin to trade relative to the consensus earnings estimate for 2013, which is $48.65 per share. If, by some happenstance, the shares were to trade at 20x the 2013 forecast, exclusive of balance sheet cash, the share price would be far higher. Appleâs trading price in that scenario, plus cash, would be $1,073 per share, and its market capitalization would be almost exactly $1 trillion. All else equal, its weight in the S&P 500 Index would be 7.8%, a not implausible outcome. This has never before happened. But wait, thereâs more.
If Apple TV is announced by September 2012, and if analysts are duly impressed, earnings estimates would likely be increased, which would further amplify Appleâs weight in the S&P 500 Index. Moreover, success at Apple comes at the expense of companies like Microsoft, Intel, Hewlett-Packard and Dell, among others, and therefore, should Apple earnings estimates rise due to improving business results, we may witness a decline in the business results of the aforementioned companies. By virtue of that factâif indeed it becomes a factâthe weight of Apple in the index would rise yet more. The notion of a 10% weighting in the S&P 500 Index in Apple is not implausible.
That outcome would create its own problems. Consultants and due diligence controls prohibit fund managers from permitting individual holdings to reach excessive levels, and 10% is well beyond the typical limits. What, then, would holders of the S&P 500 Index do if they are, by definition, insufficiently diversified by holding that index, yet are both instructed to mimic the index and are measured against the index? It would be a problem. As large as the S&P 500 Index is, it nevertheless appears to hold the possibility of becoming undiversified.
The Current Exposures of the S&P 500 IndexâA Sample
The Dow Jones US Technology Sector Index ETF (IYW) has a 22.1% weighting in Apple.2
The largest ten constituents of this ETF are listed on the next table, and their weight in total is 69.2%.
Dow Jones US Technology Sector Index ETF (IYW)
% IYW Holdings
Apple
22.1%
Microsoft
9.1%
IBM
8.9%
6.1%
Intel
5.6%
Oracle
4. 5%
Qualcomm
4.4%
Cisco
4.2%
EMC
2.3%
Hewlett-Packard
1.9%
Total
69.2%
Source: iShares website as of 4/17/2012
IYW is structured to be a diversified technology index. Clearly, the fortunes of Apple, Google (GOOG), and Qualcomm (QCOM, Financial) are affected by mobile/internet/smartphone technology. With Apple weighing in at 22%, Google at 6%, and Qualcomm over 4%, more than 32% of the technology index revolves around smartphone technology. Itâs hardly a diversified index and itâs actually less diversified still, since if the sub-group in question were to be successful, that success would clearly be problematic for other index members such as Microsoft, Intel, and Hewlett Packard. The result would be that this index, such as it is, could become yet more concentrated.
If one thinks about these types of companies as if they are in an ecosystem, using only Apple, Microsoft, Google, Intel (INTC, Financial), Qualcomm, and Hewlett Packard (HPQ, Financial), they all revolve positively or negatively around the smartphone/tablet/personal computer business. The sum of the weights of these companies in the S&P 500 Index is 10.12%, which means that one industry variable is now approximately 10% of the S&P 500 Index. Something has happened over time to the S&P 500 Index to change its diversification mix.
SPDR S&P 500 Index (SPY)
% SPY Holdings
Apple
4.55%
Microsoft
1.86%
1.28%
Intel
1.13%
Qualcomm
0.91%
Hewlett-Packard
0.39%
Total
10.12%
Source: https://www.spdrs.com/product/fund.seam?ticker=spy as of 4/13/2012.
Formally speaking, when one looks at the S&P 500 Index, the largest individual index weight is Information Technology, at 14.8%. However, employing only the smartphone/tablet/personal computer companies, and ignoring those outside of that ecosystem, such as Visa and IBM and MasterCard, the weight is about 10%. The other largest sector weights are Energy at 11.05% and Health Care at 11.33%. These are sizable factors in a broad index; accordingly, they deserve studyâthat an index is passive in its construction does not mean that, as an investor, one should be passive about its composition.
The Delusion of Correlation and the Dangers of Time Series Modeling
By Sector
Correlation, as it is used in the investment profession, implies a sort of scientific precision that simply does not exist in the real world. It seems reasonable to assert that the same can be said for concepts such as earnings variability and volatility. For instance, the healthcare industry is considered one of the so-called âdefensiveâ sectors that are characterized by low levels of earnings variability. It also seems reasonable to assert that this segment of equities should be uncorrelated with defense companies. After all, healthcare companies cure people and defense companies perform the opposite function.
Given that assertion, it is interesting to view the following table, which includes selected data from the 2012 edition of the Budget of the United States. It provides data on healthcare and national defense spending from 1940, when that data begins, to the most recent year. These figures are not adjusted for inflation; they are the absolute numbers that were reported at the time.
Clearly, both national defense and health expenditures have been powerfully correlated, with over a half-century of extensive data to prove it. But thatâs not an intrinsic property of the nature of the beast. Itâs simply that the United States Congress chose to spend monies in that manner and, therefore, the healthcare industry was said to be âdefensiveâ in the sense that more money was spent each year irrespective of the condition or direction of the rest of the economy. Itâs not a property that is immutable like those of an element like nitrogen in the Periodic Table; it is discretionary spending that one day will stop, and that day may well be fast approaching.
According to the U.S. Government budget estimates for 2017, defense expenditures will be cut to $589 billion, which is a big change versus the 2010 figure of $693 billion. For the first time in nearly eight decades, it is presumed that the United Stated defense budget will not expand, and that forecast has implications for the valuation of defense companies. Major defense contractors trade at only about 11x this yearâs estimated earnings, versus about 13.2x for the overall S&P 500 Index.
Contrarily, Medicare expenditures are expected to rise from $451 billion in 2010 to $641 billion in 2017, while expenditures by the Department of Health are expected to rise from $369 billion in 2010 to $613 billion. Even with the reduction in the Defense budget, it is hard to imagine how that is affordable. The more established healthcare sector companies, with existing products that sell at high profit margins, trade at low P/E ratios, probably in recognition of the fundamental reality that ultimately the government reimbursement rates for healthcare are going to change negatively. Even the so-called biotech majors like Amgen and Gilead sell for merely 11x this yearâs expected earnings; generic drug companies like Mylan and Teva trade at P/Es of 9x or lower. Who can say that these seemingly low valuations are not actually too high, if true margin compression is the central theme of their future?
It seems reasonable to suppose that the diminution of defense expenditures will create some type of volatility in the defense industry. It is interesting to observe that defense companies are excluded from the Russell Low Volatility ETF, and perhaps it is right to exclude them. Is it realistic to believe that the healthcare expenditure growth trends of the past 60 years will remain in place? If it proves not to be the case, healthcare companies, which are included in the Russell Low Volatility ETF, will experience a certain quantity of volatility. Itâs possible for a low volatility index to become a high volatility index, just as itâs possible for a diversified technology index to become concentrated, and for a seemingly diverse portfolio of ETFs to be rather undiversified.
The Whole Enchilada
Such observations apply not only to individual sectors of the S&P 500 Index, but to the entire index. The estimated total of outlays in the U.S. budget for 2012 is $3.7 trillion. Since revenues are only about $2.6 trillion, we have a $1.1 trillion deficit. Even according to the always-optimistic estimates of the U.S. Office of Management and Budget, in 2016, when the economy is anticipated to be far more robust than it is right now, the deficit is still expected to be $648 billion.3
Total Federal Outlays in 1940 were a bit less than $9.5 billion, which represented 9.8% of GDP. As previously noted, the 2012 estimate for total Federal outlays is $3.7 trillion, which is 24.3% of GDP. The Federal government by itself expends almost a quarter of the U.S. GDP, and that does not include the state and local expenditures, which add greatly to it. Clearly, the U.S. government spends a tremendous amount of money. Its proportion has increased over the years but, since it cannot ever be 100%, it has to stop at some point. A good question to ask is: âIf this phenomenon were to halt, what would the strategy of indexation be like?â
Although some might disagree with the estimate, U.S. GDP is expected to rise from the 2012 estimate of $15.8 trillion to an estimate of $19.8 trillion in 2016, which is about a 25% increase in 48 months. Assuming that GDP estimate is accurate and that spending also increases at the forecasted rate, the government share of GDP in outlays would decline by about 2% points to 22.5%. Of course, if GDP does not approach $20 trillion by 2016, the governmentâs share would probably rise.
Government spending is reaching certain fiscal limitations. A reduction in government spending would have major consequences for many of the large companies in the S&P 500 Index that benefit from such government spending. Therefore, those companies would exhibit a type of correlation in a negative sense that has never been seen before, in which case indexation might prove to be a rather problematic strategy.
As a matter of fact, those analysts who make assertions about the âintrinsic characteristicsâ of equities as an asset class as measured by the S&P 500 Index, are actually engaging in the same type of time series analysis that analysts performed in 2007 with regard to the housing industry. It was observed, over a span of five decades, that housing prices never seemed to decline. They always seemed to increase at a constant rate until such time as they ceased to increase at that rate, and many tears were shed as a consequence.
These comments are all by way of saying that the S&P 500 Index, viewed through the prism of the U.S. budget, should naturally become less diversified as U.S. budgetary stresses place unequal pressures on different business models. It should become clear that the S&P 500 Index is not, by any stretch of the imagination, a diversified series of investments, as is generally believed.
Whatâs the Opposite of Indexation?
The purpose of the preceding discussion is not to suggest that the outlook for equities is poor; it is to suggest that in the customary fashion of the marketplace, a great deal â which is to say an excessive amount â of capital has flowed into particular sectors and instruments. A great deal of capital has come to be invested in the same manner and in the same securities, inspired by beliefs and data that will not ultimately support the valuations and behavior expected of these securities and instruments. To reprise an exhibit from last quarterâs commentary, the mere fact of having been selected for inclusion in (or exclusion from) popular ETFs is sufficient to inflate the valuations of a selection of otherwise comparable companies in the same industries by a factor of nearly 100%:
It is simultaneously the case that there are populations of securities and instruments that, because they are outside the sphere of the indexation bubble, have been orphaned from both analytical attention and the flow of funds. They exhibit different valuation and, often, business characteristics. They will have different return vectors. A sub-set of these, the owner-operator companies upon which we have expended some attention, will exhibit yet another sort of return vector over time. This is not about whether to be âin the marketâ, but about where in the market to be.
Holdings Review
This section will focus on four companies, of which two operate in the same ecosystem. They were chosen for their shared characteristic: each has a non-mainstream return vector.
Howard Hughes Corporation (HHC, Financial)
Unlike the typical publicly traded and perhaps ETF-centric real estate company, Howard Hughes Corp. (Howard Hughes) is not a REIT, nor does it pay a dividend, nor does it focus on a single type of real estate; accordingly, it is not a mainstream public stock. According to ETFdb, Howard Hughes is not a top 10 holding in any ETF. Howard Hughes is a real estate holding company with geographically diverse properties, including master planned communities, strategic development properties, and shopping district properties. Many of these properties are held on the books at very conservative valuations. For instance, the companyâs properties in Hawaii include a prime real estate ranch on the books at zero and a prime shopping district on the books at approximately $350 million, but with a market value which is likely more than $3 billion. For a sense of proportion, the entire Howard Hughes stock market capitalization is presently $2.5 billion. )
An even more striking example is the South Street Seaport in lower Manhattan, for which Howard Hughes holds a long-term ground lease with the City of New York. This property is held on the books at $5.9 million. In 2011, the South Street Seaport generated operating income of over $5.6 million; however, one must keep in mind that the economic climate under which legacy leases and tenants were negotiated was unfavorable to lessorsâthus even the recent operating income from the property is only a conservative estimate of its potential to generate revenues. The company is in continuing discussions to obtain the necessary approvals to renovate the property. We believe that this property is likely worth more than $100 million.
These are just a few examples of properties held on the books at conservative valuations. Many of the properties are on the books at costs that were established decades ago. The land for the enormous Summerlin master planned community in Las Vegas, for instance, was acquired in the 1950s.
As of December 31, 2011, HHC had $2.3 billion in shareholdersâ equity, $3.4 billion in assets, and $1.1 billion in liabilities. The companyâs market capitalization as of April 16 was approximately 2.4 billion. The shares are trading at book value. This suggests that, not only do investors believe that the company is worth no more as an operating company than it would be in liquidation, but they also believe that the conservative values at which properties are held on the balance sheet are reflective of what they would fetch if the company were to liquidate.
HHC is an owner-operator company. William Ackman and Brookfield Asset Management were sponsors of the creation of HHC through a spin-off from General Growth Properties during that companyâs restructuring process. Mr. Ackman serves as Chairman and remains active in management decisions. Brookfield Asset Management and William Ackman control 15.8% of the shares outstanding. This figure fails to incorporate the warrants also held by these companies, which when exercised will increase the ownership to almost 27%.
Management has been careful to limit asset sales at current depressed levels and to find strong strategic partners for the future property development, and is not afraid to take action when opportunities present themselves. As an example, in 2011 HHC acquired Morgan Stanleyâs 47.5% economic interest in The Woodlands master planned community in Houston, TX.
The assets of HHC will take time to develop and monetize; the long-term nature of the projects may make this company unappealing to investors with a short-term view. HHC currently trades at approximately book value. As noted above, book value represents a significant discount to market value for this portfolio of high quality assets. We believe that, in time, the multiple of book value will continue to expand, generating an attractive long-term return for investors.
Dish Network (DISH, Financial) and ViaSat (VSAT, Financial)
As noted above, a substantial percentage of the S&P 500 Index revolves around mobile phone companies. Whether by conscious decision or not, mainstream investors have significant exposure to the smartphone/tablet/personal computer category. In turn, the leading companies in this category continue to invest heavily in developing new functionality in models and growing their footprint in the market; those companies which did not expend sufficiently on meeting end user demand now find themselves rapidly losing market share.
Elsewhere in the telecommunications sector, cable companies continue to fight for market share by making staggering capital expenditures and sacrificing margin. In addition to other cable providers, these companies now face competition for content distribution from recent entrants; as digital distribution gains traction, cable companies face growing pressure on their subscription bases.
Many investors believe that satellite cable companies have the same, unappealing characteristics. We do not dispute that with regard to their content distribution business, these companies face growing competition and margin pressure. While this phenomenon appears to be a threat to satellite cable providers, for some it also presents an opportunity. Dish Network Corp. (DISH) and ViaSat, Inc. (ViaSat) each own satellite spectrum capacity. The accessibility and speed of internet connections have made streaming viable to the point where investors are concerned that customers will âcut the cordâ and elect to use the internet for television and movie viewing instead of a multi-channel video programming distributor (MVPD). Conversely, the burgeoning demand for wireless data is likely to allow DISH and ViaSat to leverage the spectrum capacity that is currently under-utilized. According to the FCC, smart phones utilize 24 times more data than conventional mobile phones, and tablets utilize 122 times more data than conventional mobile phones. Mobile applications grew from 300 million in 2009 to 5 billion in 2010âa 16-fold increase. FCC analysts expect a 35 times increase in wireless demand over the next 5 years, yet the wireless network is barely able to support current demand. This suggests to us that spectrum capacity will be increasingly in demand in the next few years.
Owner-operator Charles Ergen has voting control over DISH, although he recently appointed James Clayton as CEO (Mr. Ergen remains Chairman) in order to focus his efforts on strategic initiatives. DISH is presently the third largest pay television provider in the United States, with nearly 14 million subscribers. Over the past year DISH acquired Blockbuster Entertainment and now provides a physical mail order DVD rental and online streaming service to customers. DISH also spent nearly $3 billion to acquire spectrum licenses DBSD North America and TerreStar. DISH is currently valued at a modest 10x trailing earnings despite the significant optionality provided by the enhanced customer services and spectrum purchases.
ViaSat is currently engaged in satellite communications primarily under contract with the United States Governmentânotably the U.S. military. The company also has a commercial networks division providing high quality satellite communications such as in-flight broadband services to customer on Continental Airlines and JetBlue. The final operating division is consumer satellite services, which provides wireless broadband services primarily to customers in locations that cannot receive such services terrestrially. ViaSat is in the process of expanding its network to include more bandwidth at a lower cost that was never previously considered economically feasible. The launch of Eutelsatâs KA-SAT and anticipated launch of ViaSat-1 satellitesâreported by the company to be the worldâs highest capacity satellitesâprovides the company with over 200 gigabits per second throughput to bandwidth hungry customers. The high current price to earnings multiple of ViaSat masks the true earnings power of these assets, which have the potential to improve and expand all business segments of the company.
Interestingly, a cursory overview of the companies that have effectively cornered satellite spectrum capacity over the past several years reveals that they are almost exclusively owner-operators. There is vigorous debate regarding whether the investment in satellite spectrum capacity will prove to be prudent. However, it is clear that the marginal profit multiplier from increased demand for this business model has the potential to be enormous. If the owner-operators turn out to be correct, they are merely early in comparison to general market recognitionâit would not be the first time that owner-operators made prescient, though controversial investments.
Jardine Strategic (âJardineâ)
Jardine Strategic is part of the Jardine Matheson family of companies, founded as a trading company in 1832. It is a Singapore-listed holding company with principal interests in Jardine Matheson, Hongkong Land, Dairy Farm, Mandarin Oriental, Jardine Cycle & Carriage and Astra International. As of December 31, 2011 the reported net asset value per share of these businesses equaled $48.36; compare this to a March 31, 2012 traded price of $30.51: a 37% discount to stated NAV. In the post-financial crisis world, many holding companies in Southeast Asia have traded at historically unprecedented discounts to NAV or book value. While we understand that such discounts may be justified for certain holding companies with concentrated, private and illiquid assets, this does not describe Jardine. Jardine Strategic has a diversified portfolio of liquid, market listed assets, including the following:
⢠A 78% interest in Dairy Farm valued at approximately $11.1 billion. Dairy Farm is a rapidly expanding pan-Asian retail group with 5,400 outlets across Asia including supermarkets, hypermarkets, health & beauty stores and convenience stores. The businesses are regionally diversified across North, East and South Asian operating units.
⢠A 71% stake in Jardine Cycle and Carriage valued at approximately $7.660 billion. JC&C is an Indonesian conglomerate that controls the largest independent retail auto dealership group in Southeast Asia, including a roughly 50% market share in automobiles and motorcycles in Indonesia, in addition to being an exclusive Indonesia distributor for manufacturers such as Toyota, Daihatsu, Isuzu, BMW and Peugeot. In addition to automotive interests, Jardine Cycle subsidiaries have businesses in financial services, industrial equipment, agribusiness, among others.
⢠A 50% stake in Hongkong Land valued at approximately $7.325 billion. Hongkong Land is a leading commercial real estate company with over 450,000 square meters of commercial real estate in downtown Hong Kong and other strategic locations in mainland China. Over 75% of revenue is generated in Hong Kong, and over 65% of revenue is in commercial properties, both of which are relatively stable market segments.
⢠A 74% stake in Mandarin Oriental valued at approximately $1.170 billion. Mandarin Oriental operates a chain of 42 first class hotels worldwide.
Jardine Strategic owns a diverse set of operating assets across Asia. Despite the concerns over emerging market growth, Asia is home to several of most robust economies in the world. We believe that such an aggregation of businesses merits a market premium to NAV, not a discount on the order of 35%. However, even in the event that the market doesnât assign Jardine an appropriate multiple, we are content to allow the underlying businesses to drive our investment return.
DISCLAIMER
Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest.
This information is intended solely to report on investment strategies as reported by Horizon Kinetics LLC. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable.
No part of this material may be: a) copied, photocopied, or duplicated in any form, by any means; or b) redistributed without Horizon Kineticsâ prior written consent.
Read the original letter here.
