The Fed’s Unlimited QE, PE Discrepancies and Michael Mauboussin’s Latest Paper

The FED threw the kitchen sink, refrigerator, dining room table and the chairs at this market on Monday. Markets didn’t seem to care, shrugging off another 3% after the news alert. Yet as I sit here typing, futures are locked limit-up.Crazy times.What did the Fed announce? Oh, you know. The casual UNLIMITED QUANTITATIVE EASING plan. We’ll dive into the specifics in a second.In the meantime, check out our latest podcast episodes. This week I’m releasing my conversation with a full-time credit and options trader. Excited to learn how f**ked the credit markets are? Make sure you tune in.While you’re at it, please subscribe and leave a rating/review of the podcast on Apple Podcasts. It goes a long way in spreading the word about the show.Our Latest Podcast Episodes:

• • Episode 17: The Power of Owner Operators with Chris Mayer, Woodlock House Family Capital (NEW)
  • Episode 16: Reminiscences of a Deep Value Investor, ValueStockGeek

Here’s what we cover this week:

• • The Fed’s Solution To Market Woes
  • The Opportunity in Small Cap Miners
  • Energy’s PE Space Has Mark-To-Market Issues
  • How To Reduce Forecasting Errors with Michael Mauboussin

I got a lot smarter after reading this week’s content. I hope you have similar feelings.—March 25, 2020We All Prefer Profits: There’s one word I’m hearing around the FinTwit community: “preferred”. I’m referring, of course, to preferred stock. There’s a lot of preferreds trading at ridiculous values. Values that assume total bankruptcy of the underlying company.In these times, bankruptcy isn’t a non-zero probability. But there’s certainly lots of value hidden at current prices.Here’s Dave Waters’ latest preferred idea …

No position here, but Sotherly Hotels cumulative preferreds look interesting. Total collapse, 15% of par. Company likely goes BK but for prefs to have value, $566mm in gross property value only has to be worth more than the $359mm in mortgage debt. Speculative, to be sure.

— Dave Waters (@alluvialcapital) March 18, 2020

Andrew Walker also wrote about a preferred stock idea (link here).Do you have a favorite preferred stock? If so, let me know and I’ll feature it on next week’s newsletter!__________________________________________________________________________Investor Spotlight: Crescat Capital’s Big Opportunity

GIFs by tenor

Last week, Crescat Capital released a research piece on small cap gold and silver miners. According to the firm, this is an area of true blood in the streets.Here’s their pitch (emphasis mine):

“There is one area of the stock market that already offers historic low valuations and an incredible buying opportunity right now. Small cap gold and silver mining companies just retested the lows of a 9-year bear market. Last Friday, they were down 84% from their last bull market peak in December 2010! This was a double-bottom retest at a likely higher low compared to the January 2016 low when they were down 87%.”

Crescat focuses on the absolute price drop in mining stocks and the relative divergence between the underlying commodity and the miner. Here’s their explanation (emphasis mine):

“In the chart below, we show that precious metals juniors reached record low valuations last Friday relative to gold which is still up 18% year-over-year. Mad value.”

Divergence. That’s what matters. Crescat provided a photo for illustration (see below):Crescat’s Macro Trade of The CenturyAlong with the miners trade, Crescat sees another (larger) trade during the decade. That trade: long gold denominated in Chinese Yuan ($CNY) while shorting global stocks. Here’s their reasoning:

“The global economy has just entered a recession and the fundamental damage of the virus outbreak on an already over-leveraged economy will be greater than anything we have ever seen. We have massive underfunded pensions with governments and corporations record indebted, while wealth inequality is at an extreme across the globe.”

How To Play AlongFor those interested in following Crescat’s logic, there’s a few ways to play this:

1. 1. Invest in individual small cap gold/silver miners
      1. Gold: GDXJ
      2. Silver: SILJ
   2. Invest in a gold or silver mining ETF
      1. Gold: GDX
      2. Silver: SIL

__________________________________________________________________________Movers & Shakers: The Fed Came In Like A Wrecking Ball

The Fed announced an unprecedented QE program Monday morning. QE without limits.Jeff Cox of CNBC reported the story. Here’s what you need to know:

• • Open-ended commitment to Quantitative Easing (QE)
  • Initiation of Main Street Program, designed to keep credit flowing to small businesses
  • For the first time ever, the Fed will buy corporate bonds from primary and secondary markets.

This move blows my mind. And although a thorough analysis is above my paygrade (this is where Alex comes in), it’s truly stunning to think about.Unlimited Quantitative Easing.How The Markets ReactedThe masses initially welcomed the news of unlimited QE. S&P futures gained nearly 300 points in pre-market trading. Yet as the market opened, futures rolled over. They’re down around 2.50% as of writing this.If the market shakes off unlimited QE and heads lower, we could see a real capitulation. One that would get us closer to the illusive 50% drop.Then we could see these “compounders” trade at attractive valuations. I’m not seeing that many no-brainers in the compounder space.For instance, here’s the P/E’s of a few blue-chip “compounders”:

• • Visa, Inc. (V): 27x P/E
  • McDonald’s (MCD): 18x P/E
  • Abbott Labs (ABT): 33x P/E
  • Microsoft (MSFT): 24x P/E

Those names don’t scream “no-brainer” to me.__________________________________________________________________________Resource of The Week: Mark-To-Market Mix-Up

GIFs by tenor

Private equity funds have a luxury. Unlike their public market cousins, their performance isn’t judged on day-to-day or tick-by-tick basis. Private funds value their companies once (or four times) per year. Limited partners accept such infrequent mark-to-market measurements in light of higher expected returns.This is fine, but what happens when there’s an obvious discrepancy? What happens when, for instance, energy-specific private funds report better returns than public equity energy investments?You get questions -- lots of questions.Luckily for us, Institutional Investor asked those questions to Dan Rasmussen.Dan Rasmussen’s ConundrumDan realized something while analyzing the private vs. public returns. Public energy stocks experienced a large loss between 2015 - 2019, yet private energy investments did well. Here’s what Dan found (from the article):

“Rasmussen found 83 percent of the funds were marked as profitable — remarkable performance considering the S&P SmallCap 600 Energy Index lost 78 percent from the end of 2012 through September 2019.”

This begs the question … How in the hell does that happen?Valuation.Valuation As An Art, Not ScienceWe know valuation isn’t hard science. It’s elegant and unique to each investor. Give ten investors one company to value and you’ll get eleven different valuations.James Span, CCO of Energy Trust Partners, explains this idea (emphasis mine):

“The swings in the stock market for energy companies have no impact on our fund valuations … The underlying value of the oil and gas reserves and related acreage is where the value is based.”

If that’s the case, what’s the best way to track energy-specific private equity investments? Texas’ Public School Teachers pension fund can help.How Texas Teachers Monitors Private InvestmentsHere’s their process (from the article): “The pension monitors private-equity performance from quarter to quarter and takes a close look at returns when firms are asking investors for money for new funds, according to Auby.”Texas Teachers on volatility in private markets: “You can’t simply look at the volatility of a smoothed return stream … You have to proxy that return stream at the equivalent public-markets risk level.”Jumping Around: The Sin of ValuationWhen valuing a company, pick one method and stay with it. Nicholas Tsafosa of EisnerAmper agrees. Here’s his take (emphasis mine):

“If we see jumping around” — from, say, a discount[ed] cash flow model to a revenue model, or to one that’s tied to observable public companies — “we start asking a lot of questions … If nothing has really changed and they’re just jumping around, that’s a reason for concern.”

Be consistent. This has tremendous application to public equity underwriting. If you’re valuing a company based on its cash-flows, don’t switch to a dividend model. Why might investors jump around in valuation? Simple: Their model doesn’t show a large enough discount to warrant an investment. Don’t jump around the valuation, move on to the next idea.__________________________________________________________________________Whitepaper of The Week: Reducing Noise with Mauboussin

GIFs by tenor

Michael Mauboussin (along with Dan Callahan, CFA) released a new research paper titled: BIN There, Done That.The piece focuses on one main topic: reducing sources of forecast errorBreaking Down BINBIN refers to three ways forecasters gain edges over others in their field (definitions from the paper):

• • Bias
    • A bias is the result of an inappropriate application of a heuristic to come to a decision.
  • Information
    • Information measures the subset of signals that forecasters use relative to full information.
  • Noise
    • Noise is “the chance variability of judgments”.

Invest on Signals, Not NoiseMauboussin offers ideas on how to use the BIN model in asset-priced environments (i.e., the stock market). He suggests, “The obvious recommendation is to avoid being a noise trader or noise allocator. That means investing based on signals, which requires gathering and properly assessing information.”“Investing based on signals.” Said another way: your edgePosition Sizing Matters (More)But it’s not just your edge. It’s position sizing. In fact, Mauboussin argues a lack of awareness (or at least lack of importance) on position sizing reduces overall returns. It doesn’t matter how good your edge is if you don’t have proper position sizing.

“Research shows that investment managers leave returns on the table by failing to follow the position sizes suggested by their own processes.”

How To Reduce NoiseIf you want to become a better trader or investor, you need to reduce noise. Mauboussin provides a training regime:

• • Combining Judgements
  • Using Algorithms
  • Adopting “Mediating Assessments Protocol”

How To Reduce BiasMauboussin offers three methods for reducing bias in our forecasts:

• • Incorporate base rates into a forecast
  • Create formal mechanisms to open the mind to alternative possibilities
  • Create a rigorous process to provide accurate and timely feedback

How To Use Information EffectivelyFinally, Mauboussin provides three ways to use information effectively:

• • Getting an informational edge when you can
  • Updating your view accurately and promptly to reflect new information
  • Placing the proper weight on the information at your disposal.

__________________________________________________________________________ That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.Tell Your Friends!Do you love Value Hive?Tell your friends about us! The greatest compliment we can receive is a referral (although we do accept Chipotle burrito bowls).Click here to receive The Value Hive Directly To Your Inbox!