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Sale of Aviat Networks (AVNW) and 3 purchases

I haven’t been posting much recently; I’m a little gun shy since shares in the companies I wrote about in my last 2 posts dropped 30%+ after I mentioned them. Today I’m updating my portfolio for a sale and 3 recent buys. First, the sale; I’ve finally sold out my small position in Aviat Networks. I initially purchased shares in the company because it was a holding of Steel Partners LP and they have a history taking a minority position in small companies, influencing (or replacing) management, turning the company around and taking out the public shareholders at a decent premium. However, Aviat had a few problems I did’t see when I first purchased my position, and after I purchased in 2014 losses continued and, in fact, began to grow. The shares, reflecting a 3:1 reverse split, fell from the mid teens down to almost $5 a share. Then, and only in the past 6 months, the price begun to climb. I don’t know exactly what’s behind this surge; there have been some recent  announcements about new products but earnings have certainly not been anything to write home about. Earnings are due out after the market close tonight (sorry, didn’t publish this until the day after!) but with the share price up some 50% since I purchased I’m happy to gracefully exit and put my funds to use in a more depressed sector (read CASH or perhaps natural resources).

OK, so where and why have I been putting funds to work since my last post in February? I’ve taken 3 small positions: Awilco Drilling (AWLCF), Rite Aide (RAD) and Tropicana Entertainment (TPCA). The first, Awilco Drilling, was a darling of the value investing community until 2 years ago when oil prices tanked and the stock cratered, dropping almost 90%. Awilco is a simple company; it owns and operates 2 semi submersible drilling rigs in the North Sea. That is, it owns 2 but operates one as the demand for drilling rigs in the North Sea is currently low or non existent. The one operating rig is under contract only until next April. What then? Either demand picks up and both rigs are put back into operation or the second rig could also be stacked like the first, and the company basically put on hold. Alternatively, the 2 rigs could be sold (for scrap or otherwise) and the proceeds distributed to shareholders. My bet here is that there is some recovery in oil prices or that at the very least there is some recovery in day rates for rigs in the North Sea. There should be at least $.60 in dividends before the end of the year from cash generated by the one operating rig.
My second new position is Rite Aid. I know, I know, merger arbitrage is generally a no win game for the non-professional. I’ll admit I have no edge here, but my thoughts on this long drawn out acquisition are simple: 1) the proposed acquisition has dragged on for so long it’s likely most arbitragers have given up and sold their position, 2) the terms of the acquisition have worsened since the initial offer by Walgreen creating further incentive to dump the shares and 3) even if the acquisition doesn’t go through (I give it a 50 50 chance) I think that the company is worth more than the current $4 and change a share based on operating results over the past 10 years.

And my final new position is Tropicana Entertainment (TPCA), an idea that I purloined from.. well, I can’t remember where. The narrative behind this is that Icahn, who owns a majority of shares, values the company on his LP’s balance sheet at $49/share. If its worth so much more than the market price might he not just step up and purchase all the remaining shares at even a 10% discount to his estimate of intrinsic value?

The above is just a shorthand narrative for these three new investments. I’ll try to put something together a little more in depth shortly.

The Company Previously Known as Imation: Glassbridge Enterprises (GLA)

I’ve been following the vicissitudes of Imation for a number of years, ever since it first showed up as a net-net on one of my screens. I have never been close to investing in it, primarily, I think, because the track record of management looked horrendous. Perhaps it was just a function of luck; by the time I became aware of the company management had established a multi-year track record of deplorable asset allocation. So I was surprised to read about their latest transformation in a recent post at Shadow Stock. Despite some misgivings about the nature of the transformation I decided it might be worthwhile to take a second look, and the Shadow Stock analysis further peaked my interest. I have to admit that the opaqueness surrounding the transformation really intrigued me. When deals are opaque, they usually are so for a reason; either the dealmakers create opaqueness to derive some benefit for themselves or the complexity of the deal, combined with reporting requirements, creates unintended opaqueness. In the former case, you want to stay as far as away as possible since the dealmakers are merely out to fleece  investors. In the latter case, the opaqueness of the deal can create an opportunity for those who are inquisitive as it may induce most investors to indiscriminately sell the offending company.

So what kind of ‘deal’ is the Imation transformation? On the face of it, one might think it is the former; Clinton Group, an activist investor, has taken the lead in transforming Imation from a data storage company to an alternative asset manager. “Huh?” you may say, “What do the two have in common?” or “How is the management expertise of the former supposed to transfer to expertise in the latter?” First I should remind the reader that the so-called management expertise in the former didn’t really produce favorable results did it? So, no loss there. OK, so now the company is to be transformed into an asset manager using the leftover cash that prior management didn’t have time to dissipate to seed the new company. Next step, issue Clinton Group  12.5 million shares of Imation (renamed Glassbridge Enterprises) stock for use of its investing platform for the next 5 years. “WHAT! That’s egregious self dealing.. shareholders getting ripped off!” or so was my first thought. Furthermore as part of the transformation, the last operating business, Nexsan, was to be ‘sold’ for a $25 million promissory note and 50% of the equity in a successor operating entity; Nexsanwould be combined with a similar company owned by a private equity firm. “Huh?” my thoughts exactly. So you spin-off the only operating entity, merge it with some other operating company owned by a private (read PIRATE) equity firm and you get an IOU and some ‘equity’ in the new entity? Great deal! So far it adds up to a lot of nothing, at least superficially. Oh, I forgot to add a 1 for 10 reverse stock split just to further complicate the financials.

Then I had a think about this. Clinton Group, while being the activist on this company, wasn’t by any means the largest institutional investor; Ariel Capital Management, Wells Fargo and Renaissance were much larger investors than Clinton Group. In fact, prior to the 12.5 million share issue, Clinton Group was only a 3% owner. So why were the other ‘sophisticated’ investors letting Clinton Group up their ownership to 28% without putting up a penny and diluting the other investors by almost 1/3? Hmm.. is there something I’m missing or are the other investors just making the best of a bad situation? After all, they had all invested in Imation at much higher levels.

Just to be sure about ‘invested at higher levels’, lets take a look at the price history of Imation stock. UGH! 10 years ago Imation shares were trading at around $40. Then, over the next two years they traded down to the $8-9 range, gradually trending down over the next 8 years to around $1/share a year ago. Not particularly good for long-term investors! Today, Glassbridge Enterprises is trading around $6-$7 (after the 1:10 reverse split). This means that almost every investor, unless very recent, is sitting on a significant loss in their position. This, of course, doesn’t rule out the ‘making the best of a bad situation’ mentioned above.

How to value Glassbridge? Not so easily as it turns out, at least not until the next quarter’s financials are filed. It is not clear to me how to break out the Nexsan operating business that has now been ‘sold’ from the Imation’s last consolidated balance sheet. Nor is it clear how to evaluate some of the assets and liabilities from discontinued operations on last quarter’s balance sheet. But let me take a stab at a liquidation valuation

Cash & marketable securities $10.00
Resricted cash A/P $2.18
A/R DO $0.36
Other Discontinued Ops $1.15
subtotal $13.69
Current liabilities $1.29
Disputed A/P $5.77
Pension Liabilities $4.82
Other non-current liabilities $0.60
Other Discontinued Ops $2.82
  subtotal liabilities $15.30
shareholder equity -$1.61
Disputed A/P $5.77
Nexsan Promissory Note $5.04
Reduction in other liabilities (50%) $0.95
Discontinued Ops (50%) $0.84
subtotal before equity $12.59

At the end of the 3rd Quarter 2016 Imation financials showed shareholder equity of about -$3 million. I estimate that Nexsan had a maximum of about $5 million in shareholder equity, leaving the balance of the company with about an $8 million equity deficit.  Pro forma, then we might expect Glassbridge to have an equity deficit of about $1.60 per share post reverse share split and Nexsan spinoff IF NOTHING ELSE HAPPENED IN THE 4TH QUARTER (which of course it did, but we’re not yet privy to this yet, so this is all a bit fictitious). Where’s the value then? It’s both in the potential balance sheet upsides listed above as well as the value of the ongoing asset management business and the equity interest in the new Nexsan. Right, the above analysis gives no value to the 50% interest in the new Nexsan entity nor does it ascribe value to what Clinton Group contributed for the 1.25 million shares it received.

Clearly from a balance sheet perspective we max out at an asset value of $10/share or so, and that’s not considering that Glassbridge will be using some of its cash to build a staff for its new asset management business. In other words don’t count on that cash being returned to shareholders or even invested in passive investments (private or public equity) for the benefit of shareholders; A liquidation valuation really isn’t of interest here as Glassbridge is set to be an ongoing business and I can see an operating cash bleed for 3-5 years depending on how long it takes the company to attract enough AUM to cover operating (read staffing) costs.

What makes this an interesting potential investment then? I think it’s because management and major institutional shareholder interests are aligned with the interests of us little shareholders. Yes, Clinton Group gets a ‘free’ equity ride for contributing its expertise; it’s a low-cost way to launch an alternative asset manager that will be valued in the stock market, but they have every incentive to make it work. After all, their name is attached to it! And to make it work they need to have some good initial investments. That’s why I think getting in early could have advantages. But it’s not to say that the share price will not go lower. Yes, I’d rather buy $10/share worth of company for $4 rather than the current $6. And the market may not recognize the potential for this asset manager until its results are proven so we do run that risk that shares could tank from here until the market sees results. That said, I do think this is an interesting investment opportunity for anyone looking at a publicly traded alternative manager (and there aren’t many out there).

Note that the above is simply my very approximate analysis of Glassbridge; asset managers are not really in my field of competence, so I would be quite happy if someone more knoweldgeable weighed in on this and pointed out where I am mistaken. Thanks!

Disclosure: I own a small position and may add to it if the share price drops further.

Regency Affiliates (RAFI)

I’ve recently picked up a small position in Regency Affiliates (RAFI), not an easy thing to do at the price I wanted to pay as the liquidity is almost zilch.

I first read about RAFI in a 2013 post over at OTC Adventures. At the time I remember thinking that the company looked interesting but the potential value recognition catalyst appeared to be about 5 years away, so I took a pass and put it on my ‘potential’ list that I file away (sometimes only mentally). As it happens, a few weeks ago I was browsing through Barrons weekly list of new annual highs and lows and I recognized the name Regency Affiliates (on the ‘new lows’ list of course, I rarely peruse the new highs). So I took a jog over to their website to see if there was any news that might have caused the stock to drop. I didn’t immediately see any, but that didn’t surprise me; illiquid stocks like Regency can make significant price swings on just a small amount of volume. Then I thought I might check to see if they had published any recent financials. Regency is a ‘dark’ company (no financials filed with the SEC) and so I didn’t expect to find much. But just when you least expect it! Yes, the company participated at a microcap conference in October of last year and made a presentation that was available on the website!

Basically the presentation was a valuation of the company. And while I found the presentation interesting, more interesting to me was why a CEO who owns almost 50% of a company would be making a presentation showing the company to be significantly undervalued by the market. But lets leave that till later.

The presentation confirmed the basic outline of OTC Adventure’s post. The only update was that between then and now the company made a rights offering (to qualified investors only… a bit of a caveat here that management can be self-serving) raising about $9 million last Spring and investing those funds in a self-storage facility in PA. This means the company now has 4 assets; Cash, a 50% interest in a Maryland property currently under lease to the Social Security Administration, a 50% interest in a co-generation plant serving a Kimberly Clarke manufacturing plant in Alabama and the new investment in a Pennsylvania self-storage facility. Per management’s calculation the shares are undervalued some 35-60% (upside of 60-135%). Take a look at their calculations. They don’t seem unreasonable. The two main risks are that the Social Security Administration doesn’t renew their lease in 2018, which I think is very unlikely, and that Kimberly Clark doesn’t renew their co-generation contract for the Alabama power plant, which I also view as somewhat unlikely. The other risk of course is that management does something stupid with the free cash flow or makes some self-serving investment. This is entirely possible because apparently in the early 2000s they did something similar, but more recently they have been using cash flow more judiciously, paying down borrowings in each of their investments.

The real question here is what is management’s game plan and is there an exit strategy. The CEO owns close to 50% of the equity and is 60 years old, i.e. heading towards retirement at some point in the next decade. This is not a company that is likely to be bought out given the diversity of the assets. Potentially, the assets could be sold off individually. But if that was management’s intent then why buy a the storage facility just 9 months ago? So I have to conclude that management’s short-term strategy is to opportunistically buy undervalued assets that will accrue in value over the long-term, but that their long-term game plan and/or exit strategy is still unclear, or possibly even unformulated. The question is why suddenly participate in a micro-cap conference? The most obvious response would be that Management is trying to boost the stock price. But if the stock price is so undervalued why doesn’t management simply buy more and eventually buy out all the public shareholders?  That would provide the most upside. Perhaps they don’t have the means. More likely is that they might want to use equity, combined with funds from refinancing the MD property (once the lease is renewed), to potentially make a large acquisition. If this is the case, then the current undervaluation of the shares is merited as there is some risk that the funds might not be effectively invested. For shareholders looking to close the value gap the best outcome, of course, would be for management to return any cash from a refinancing in the form of a dividend or share buyback . Ironically, returning the cash from a refinancing would probably do more than anything else to get the company’s share price up and the company’s market value closer to its intrinsic value.

For me, despite the risks, the shares represent an attractive investment in a basket of undervalued assets with the potential of a value-enhancing catalyst happening within the next two years. Yes, the attractiveness, is somewhat limited by the risk that management could poorly allocate future free cash flows, but, given the asset value, I see limited downside and I like investing alongside management where they have significant skin in the game. My hope is that the cash freed from refinancing the MD property will, at worst, highlight value of the company to the investment community and at best be returned to us patient shareholders.

DryShips (DRYS): The wild west of share trading

Does anyone know what’s going on with DryShips (DRYS) stock? Shares have lost over 80% of their value since the first of the year and over 99% of their value in the past 12 months. Last Thursday alone the shares traded down 36% to $1.01 per share with 73 million shares changing hands. As of Friday there were 107.8 million shares, of which less than 34 million in public hands. As of Monday, January 23, DryShips management implemented an 8 for 1 reverse split (the 3rd or 4th int he last 12 months), and once again the shares traded down another 33% on Monday.  Less than 4.2 million post-split shares are in public hands (the balance belonging to Kalani Investments, but more about that later) and Monday’s volume was over 12 million. Rather strange, no?  So what’s really happening?

This is a real question to which I don’t have the answer. I’m hoping some reader will jump in here and give me something better than my humble speculations below.

First, a bit of background. DryShips owns dry bulk carriers, 20 Panamax ships as far as I can see, and some other oil service vessels. But times are not good. Bulk carrier rates are low, as is demand in the offshore oil service sector, and the company is highly operationally leveraged as its vessels are not under long-term contract; thus the company has been bleeding cash profusely for the past couple of years. The company was able to sell some convertible preferred stock with warrants for further convertible preferred stock last November, raising up to $100 million to at least partially offset the cash drain. In December the company announced a private equity offering for an additional $200 million. Kalani Investments, an apparently very private buyer, however extracted blood for the infusion. They agreed to a $200 million equity purchase but at a  price to be determined by market trading with the price being set by the closing stock price each day. In the past 3 weeks Kalani has purchased 9.2 million shares at an average price of $14.20 per post-split share. They still have almost $70 million more to invest under their $200 million equity purchase agreement.

So who has the most to gain from a falling stock price? Certainly short sellers gain. But the person with most to gain is Kalani. As the share price tumbles they can purchase more and more of the stock at lower and lower prices. Basically as the share price falls they are able to increase their percentage ownership of the company to the detriment of existing common shareholders AND owners of the preferred convertible; the preferred have a conversion floor of $12.00 per share ($1.50 pre split). So I ask myself, is it possible that Kalani or a proxy is shorting the shares in an attempt (very successful to this point) of gaining the majority of the equity at the least price? In theory they could short sell shares over the trading day, then purchase the shares at the closing price under their equity purchase agreement, delivering those shares to the purchasers and making a profit (day-end prices have almost always been at the lows). To be clear, I have no information whatsoever to assert that Kalani (whoever may be lurking behind its corporate shield) is in any way involved in pressuring the share price. But the incentives speak for themselves.

So where will this end up? Well, as I said Kalani has only $70 million more to invest so at the current rate of purchases ($40 million a week over the past 3 weeks) this should be over in a week or two. At that point the pre-equity infusion shareholders will be diluted down to 10% or less of the company’s equity when all the common shares have been issued under the two equity infusion agreements. So for $300 million the two parties will have purchased 90% or more of DryShips and they have $300 million to invest in the new LNG tanker fleet (if they can stem the operational bleed). Is this a good deal? Sorry, I don’t really know. It’s out of my sphere of competence.

Is there any way for us mere mortals to profit from this? Well, I guess if I had understood the dynamics some 3 weeks ago and if I was able to borrow shares I could possibly have profited by shorting the shares. But there are 2 too many ‘ifs’ in that sentence. And besides, I try not to speculate. What about now? Perhaps once Kalani has purchased its entire $200 million of equity the downward pressure on the share price will abate. Then might be a good time to invest but we’ll have to look at what a common shareholder gets for his/her share and that we’ll know only after its announced at what price Kalani was able to purchase shares.

For now its just an exciting spectator sport.

“Short and Stupid”, or “God I’m Short!”

Yes, that could be a description of me, physically and mentally! (not really, I’m on the tall side, but for the sake of poetic license…)  I rarely ever take a short position. The only times I have, the outcome has more often than not been disappointing. In general, I think shorting is a loser’s game. To play it right you have to have a very different emotional mindset than the average long investor, and I really don’t think I have that mindset. But here goes anyway. I’ve shorted Netflix. I know. I know. Everyone will now think I’m either stupid or crazy, or both! Netflix is one of the biggest success story of the past decade both as a company and as a stock.

So why am I short? First let me say that my position is relatively small and I have set a limit on my potential losses. That said, I have a very simple thesis. Netflix earned $.15/share during the 4th quarter of 2016. It is trading at $140. That makes the annualized PE something like 230. What stock trades for a normalized PE of 230??? OK, so you think Netflix deserves that PE due to its blazing earnings growth? Not really. Check the figures, earnings are down over the past couple of years. They’re in subscriber acquisition mode. They’ve been reinvesting most of the incremental dollars from those incremental subscribers in what? marketing and programming! “Great!”, you say, “they are building a library that will increase their asset value”. You’re right, but the asset value is not growing as fast as they are burning cash. One of the problems is they are on a growth trajectory, driving subscriber growth by investing in original programming and marketing. It is unclear what will happen when they begin to reach subscriber saturation (acquisition costs increase for incremental subs) and they cut back on marketing. Will the subs stay? Will they stay if Netflix cuts back on new original programming? Will Netflix be able to bump up subscription costs enough to finance additional original programming AND incremental profits for owners? I do believe last year’s price increase saw some consumer resistance, and it really wasn’t that big an increase. Will new players come into the market (Amazon, Apple) and force Netflix to INCREASE their programming budget in the face of low, no or even diminishing subscriber growth? Will new technologies make Netflix’s streaming technology obsolete, just as Netflix is making linear cable program delivery obsolete? None of this is clear. However, it seems to me beyond common sense to pay 230x earnings (or even 50x earnings) for a company whose future is so uncertain. There you have it.

The sticky part of my thesis is that I could be 100% right and lose my shirt; its is not clear that the thousands of enthusiastic Netflix share owners will ever agree with me. They may be content to hold their shares when Netflix shares trade at 500x earnings i.e. at twice today’s stock price! There is no real catalyst to bring the share price down into the stratosphere, not to speak of to earth.

This is a calculated bet on my part. The market is priced relatively high right now. I think we could see a pullback sometime during the next year, and I think the Netflix share price will prove extremely vulnerable during any pullback. However, my strategy is full of giant holes. I’m ready to call it a day and eat my losses if Netflix shares continue their upward trajectory and hit $160/share. Yup, its like going to the casino floor and taking only $100 with you for ‘entertainment’. You leave your credit cards in the room and tell yourself that you won’t go back and get them. That’s why I’m writing this post… so I can’t ‘go back to my room and get my credit cards’. I’ll let you know how this works out…If I have mud on my face, so be it.

Luck, Skill and the Human Condition

It’s funny how those who are successful most often attribute their success to their own skill and those who are less so attribute their misfortunes to bad luck. The truth is it’s very hard to determine what is luck and what is skill. Especially a posteriori. This is particularly so in the investment world. Let’s say you decide to purchase a stock and it immediately goes up. You pat yourself on the back and say “Good job! You were really smart to purchase stock in XYZ company when you did.” Of course that’s absurd! First of all you probably didn’t purchase the stock thinking that it would go up right away (otherwise you’re not an investor but a speculator!). So why are you patting yourself on the back? I think the answer is, being right makes us feel good. And making money while being right even more so. So we really like to ‘be right’ about an investment. It’s fulfilling. We convince ourselves that ‘we were right to pick that stock’, rather than ‘Oh how lucky that the stock went up after I bought it’. Being lucky doesn’t exactly produce the same high.

The truth is, one can almost never be sure whether skill is involved in picking a certain stock. Yes, we can be more certain that skill is involved as the sample size gets larger, i.e. more picks. But still, we know that you can be right calling a coin flip 10 times in a row and you’re still just lucky. 100 times in a row and you’re just luckier. (That is, I think so, as no one has yet been able to call a coin flip a million times in a row. But is it ever really knowable?) The same can be said of picking stocks. Picking 10 winners over a year might easily be just luck. 100 winners over 10 years begins to look less like luck, but in fact it could be just luckier. After all, if you have enough stock pickers, one is bound to get it right! Its just math (or probability, in this case). But experience tells us that in most instances its true what they print on mutual fund prospectuses; ‘Past performance is no indication of future returns’ or some such. So how can we be sure that we are adding value, ‘skill’, in our investment practice? If we can’t be sure about adding value, and thus skill,  shouldn’t we just resign ourselves to investing in low-cost index funds?

I’m not sure I can provide an unbiased answer to that question. Perhaps its illogical but there’s something in me that says there must be a way to produce superior returns. So when I see studies showing that value investing produces market-beating returns I feel immediately relieved. I like that answer to the active vs. passive investing conundrum. So am I being biased in accepting those studies as proof? I’m not sure. The indexers have a point. You just put your money in an index fund and let it sit there. It produces good returns over the long-term. Most of the time better than the active managers collectively. But then there’s this little voice inside my head saying it’s not all about cut and dry returns; you have to consider human emotions (especially your own). Why is it that the average investor’s return in a mutual fund is far inferior to the mutual fund’s long-term performance? The answer is simple; most investors pull money out at the bottom of the market and put money in at the top. I want to avoid that at all costs; that’s the kiss of death for investment returns. So I’ve tried to adopt a strategy that embraces value investing but addresses the emotional aspect of investing. My strategy is a kind of value approach where I only invest when I’m confident that I’m buying a dollar’s worth of a company for less than  dollar and leaving whatever’s left of my investment funds in cash, as a kind of countermeasure to the emotional side of investing. Take this moment in the market for example. I’m less than 50% invested in equities. I just can’t find the kind of value I want for the prices being offered at the current ‘risk’ level. It’s been that way for over a year, so I’ve missed much of the market appreciation over that time. But I sleep well at night. I know that if the market falls 50% I’ll have cash to load up on shares; I have my wish list ready. I’m not really worried about not catching that 10% upside. I want to be emotionally ready when the market drops 50% to put my money at risk. Just ask yourself, if you have 95% of your savings invested in equities and the value of your portfolio dropped 50% would you be in the appropriate emotional state to invest the remaining 5%? or even to leverage up on margin? knowing that you have a mortgage to pay, a family to feed, health bills to pay… and your job security is becoming more and more tenuous as the overall business outlook dims? I know I wouldn’t! So I’d rather forsake the certainty of index investing for the relative emotional calm of my value investing strategy. It’s funny, the secret of success with both strategies is the same, patience, but one requires more emotional resilience, a resilience I’m not sure I have.

The Big Picture

OK, so the end of 2016 has rolled around, and its time to reflect on ‘The Big Picture’. Where are we? Where are we going? Broad questions but let’s restrict the subject to the equity markets, in particular the US market; What’s really been happening in the US stock market and where is it going in 2017? Even more important (for me that is), what have I been doing with my investments and what am I going to do in the new year?

First of all, let me say I have absolutely no idea where the markets will go in 2017, just as I had no idea where they were going in 2016 at the end of 2015, and so on and so forth. The only thing that I COULD have correctly predicted at the beginning of last year was that I WOULDN’T be able to predict what was going to happen. And that’s exactly what came to pass! We had the energy-induced market swoon at the end of 2015/beginning of 2016, then the Brexit swoon in June then the Trump post-election rally. Who wudda thunk?? The only thing I can say for sure is that market valuations are at the high-end of historical averages… they were last year at this time and they are, even more so, this year. So I can unequivocally state that the market will go down at some future point in time and, most likely, regress to the mean. In my lifetime?? who knows. Lets just say that I think forecasting the next move in the market is a waste of time.

So if forecasting the direction of the markets in 2017 is out, I can at least try to understand what happened to the markets in 2016. My observation on this is simply that ‘the market is a fickle creature’; it goes down when it should go up and up when it should go down, or so at least it seems so to me. With oil prices going down, the equity markets should have gone up; lower energy costs should mean lower industrial production and transportation costs and thus higher corporate profit margins, lower heating and transportation costs for consumers and thus more disposable income to be spent. But no, that’s not how it went. Lower oil prices dragged DOWN the US equity markets! (well, we can’t really be sure that’s what dragged down the markets, but the markets did go down around that time, so it’s not unreasonable to assume….). Then we had the Brexit vote that nobody anticipated and the ensuing downdraft in markets across the pond had a dampening effect on US markets. Totally unexpected! And now we’ve had this wild post-election Trump rally! Before the election pundits were saying the market would fall off a cliff if Trump was elected.. but on the day after the election a strange thing happened; the market went up. So the market forecasters changed their tune and affirmed that the Trump election was GOOD for the economy and thus the market because he is a businessman and will reduce regulation, increase military spending, increase infrastructure spending, reduce taxes, etc. I’m not so sure they were right before, or are right now for that matter. I don’t see how a heavily indebted nation is going to both cut taxes and increase military and infrastructure spending; even deep cuts in entitlement programs (social security? Medicare? welfare?) could hardly be large enough to counterbalance that increased spending. Then there is the issue of the impending impact of increasing interest rates on our national debt… But who am I to judge forecast?

With the market passing favorable judgement on the yet-to-be-installed new administration and the first rate hike in years, bank stock prices have climbed precipitously. A bit too fast in my opinion so I have finally sold my Bank of America warrants as they have tripled in price since last summer. After this sale my overall exposure to the market is less than 50%, i.e. cash is greater than 50%, even with the several small additions to my portfolio this Fall. This is not so say that I am taking a macro view and structuring my portfolio accordingly. No, it’s just that I haven’t spent much time trying to uncover undervalued shares, and what time I have spent has been anything but successful. Sometimes the best thing to do is just sit on your thumbs if you aren’t quite sure… But, if I could find some interesting net-nets or even low P/E and P/B opportunities I wouldn’t really care about overall market valuations. The point is, I just can’t find much of interest to purchase. In September/October I did add a small position in New York REIT (NYRT) when the shares were trading toward the bottom of their annual range. This is a liquidation situation where both the upside and downside are limited; it is more of a parking place for funds for which I can find no better opportunity. More recently I picked up a small starter position in (SPRT) as a special ‘turnaround’ situation (thank you, Shadow Stocks!). No slam dunk, mind you. but enough overall positive characteristics to make it a small position in a diversified portfolio (which mine is not at the moment).

So the first part of my New Year’s resolution is to spend more time focused on stock analysis, and, given the overvaluations in the market, focus on small cap special situations. Perhaps I can uncover some gems for the portfolio despite whatever gyrations the market may take. The second part is to get more invested because market timing just doesn’t work; YOU JUST DON’T KNOW WHAT CRAZY MR. MARKET WILL DO.

In addition to the relatively high valuations in the market I do have another concern; the growth of index funds and their impact on the overall market. The fellows of Horizon Kinetics have written about this more at length and with greater insight than I ever could.  I just wonder if this won’t be the catalyst to nudge the market into regressing back to the mean. Taking the current index fund growth trend to its (il)logical extreme, if 95%, 97% or even 99% of US equities were held through index funds, who would be determining the value of individual stocks and thus the composition and level of the indexes? that 5% or 3% or 1% that actually owned the individual company shares? So isn’t the real US equity market getting smaller and smaller, rather than larger and larger? And isn’t market size the single most important factor in making pricing efficient? Index funds re-weight in response to changes in market capitalization of the components of the index they mimic. Thus if shares of GM go down more than the overall market, index funds have to sell some portion of their GM holdings. So all it takes is one guy deciding he needs money for a new truck and selling a million GM shares in a low market-volume context to send the GM share price down. Well, of course, its more likely that some rogue trading system sells 100 million shares, but that’s just an extension of this argument. Furthermore, index funds that use heuristics (using a subset of stocks to mimic an index) create more imbalance as share price movements are magnified or demagnified based on the relationship between the subset and the true index.

Could it be like the proverbial butterfly flapping its wings off the coast of Africa and starting a hurricane in the Caribbean? Prices changes magnified because so much of trading will be program trading? It’s not just black-box program trading that destabilizes the equity markets, as we have seen, but perhaps even more, index fund ‘program trading’ as retail investors move more and more into index funds.

Is there any kind of investment opportunity created by this? I don’t really know. The only thing I can think of is focusing on stocks not in the indexes (micro and small caps), focusing on situations indexers don’t participate in (spinoffs, exchange offers, etc), and simply not being afraid to hold cash. Perhaps we’ll see if this is even a factor when the next big selloff finally comes.

note: edited 1/2/17