Apologies for the delay in sending out this month’s letter. My goals is to always get it out in the first week of the month, however I’ve been extremely busy on a number of items. One of these directly affects you, my readers. This is the revamp of the website. Special thanks to FatAlpha follower Christina for her amazing website design feedback. Check it out at www.fatalpha.com. It is still being updated but you will find that it has changed significantly. Comments and suggestions are welcome. There is much more information on the strategy and statistics that are of interest. In addition, I’ve added a new blog section where I tend to provide updates throughout the month. Posts will include interest articles that I’m reading, brief comments on some of the stocks I’m looking it, as well as some of the trades that you see here in the monthlies (eg. see my trade on XRX: http://goo.gl/xkyU2Q). I invite you to engage in conversation on any of the posts via the comment section that is available under each post.
I’ve also been busy with other work items such as meetings, new tools to help assist me, and a lot of research. Many don’t realize how much work goes on behind the scenes. For example, when the market was recently closed for a holiday my wife asked me what I was going to do with my day off. I replied I was going to work. She didn’t realized how much preparation is needed. So I further replied to my wife, who is a high school teacher, “Before you go to class to teach, don’t you prepare, don’t you have any work to do before you teach that class?”
Before I discuss performance, note that I have changed the benchmark for the S&P 500. Until now, I used the SPX Index from Bloomberg and then the ^GSPC from Yahoo Finance as the S&P 500 benchmark. I have changed this to the SPY which is the S&P 500 ETF. This is a better comparison, as the SPY is something an investor can buy as a passive portfolio vs the active value investing strategy I run. In the benchmark calculation, I now assume reinvestment of after tax dividends.
This is a better benchmark which as a result will be a better judge of the FatAlpha strategy. (It should be note that this change resulted in a slight increase in the return of the benchmark both historically and this month). Regarding April’s performance, the portfolio experienced the perfect storm. Earnings season was the worst for FatAlpha since I’ve started running this strategy in 2012. Either good or bad, the market found a reason sell. It was a miss in either sales or EPS or both, it as a change in guidance, it was the strong dollar (where exactly was the surprise here?), it was oil, etc, etc, etc. According to FactSet, the blended earnings growth is 0.1%, the lowest since the third quarter of 2012! Furthermore, “This week marks the first time since January in which earnings for the first quarter reflect a year-over-year increase.” As a result, during April, the portfolio was down -4.80% vs 1.35% for the S&P benchmark. Therefore the 2015 return has been reduced to 1.42% vs 2.26% for the S&P.
The main reason for the poor performance was the drop in the portfolio’s two largest positions: Trinity Industries (TRN) and Sanmina (SANM) which together were about 14% of the NAV. TRN (which has been reduced and is no longer the largest position – See “Trades” Section) lost -24% while SANM dropped -16% for the month. Sanmina reported both higher sales and operating profit but missed Wall Street expectations. Furthermore guidance was stated below what the street estimated. There are some related industry concerns, however the stock still remains cheap. It was unfortunate that I increased the position a few days earlier on a decline following a downgrade by a broker. This resulted in a bigger negative impact. With hindsight some ammunition could have been held back. On Trinity, the story is a lot more complicated. After I took some profit last month, the stock sold off following a Bloomberg article regarding rumours of a Department of Justice investigation into an investigation into the Federal Highway Administration for favourable treatment of Trinity regarding its guardrail product. Once this rumour was confirmed and that TRN was co-operating with the DoJ, the stock further sold off. This was announced at the conference call after a monster positive earnings release. So instead of a rally, it fell further. As noted under “Trades” I bought more on this. The way I see it is that this whole issue has been exaggerated. Firstly, the company’s guardrail business is absolutely tiny compared to the rest of the business. Specifically the guardrail product is under the construction products group. The ENTIRE constructions products group makes less than 7% of revenues. So is it worth the company’s time? I don’t think so. One could argue that Trinity could have compensated the Federal Highway Administration into supporting them so that they ensure they don’t get hit with the 700-800m ruling that was appealed (see previous monthly letters). That amount is still less than 1 year’s operating profit. Would Trinity management engage in illegal activities even for this amount? Again I don’t think so. It is still manageable. Much larger companies (think banks) with much better connections and much more at risk didn’t try paying off the government. So if we assume that Trinity did nothing, then the DoJ has no case. They can’t really to tell the Federal Highway Administration that their view of the guardrail is wrong. Hence I think this issue has been exaggerated.
To make matters worse, the WSJ reported that demand for railway cars has declined (see “Trades” section). If the investigation is not an issue, then this is. A fellow investor and FatAlpha follower noted to me that perhaps the drop was not due to the investigation but due to the decline in car demand due to the slowdown in the oil industry. Thanks Kevin for the view! Kevin could be right and the DoJ investigation is a coincidence or more likely it is the combination of the two that has result in this heavy selling. Following the WSJ article I reduced the position in order to better manage the risk. So while the investigation is an exaggeration, this news is negative fundamentally. On the bright side, there is a great deal of discussion and commotion regarding safety and the upgrade of railcars. If this plays out then they will need replacement which will be a huge positive for TRN.
With a concentrated portfolio you always run the risk of having such volatility pop into the returns from time to time, but only with a concentrated portfolio can you truly outperform. As Warren Buffett correctly put it “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” I have been bless with a phenomenal performance so far. But all investment strategies run into speed bumps. This is one of them and I wouldn’t be surprised if there were more. It’s natural in the financial markets. Good discipline dictates that we stick to a solid strategy and patience will pay us.
Taking a step back and looking at the market, I can to stress that I am a bit worried. The valuations look extended and the activity I’ve seen is getting quite emotional. Huge volatility in both value and growth stocks. Look at TWTR and LNKD moves. Growth investors in particular should worry as the market is starting to punish these stocks. If earnings continue to disappoint these stocks will be hit the hardest. From a technical perspective it appears that we could be running out of steam. The chart below (scroll down) shows the pit session S&P continuous futures contract on a weekly basis. If we look at the rotations taking place we see there are overlapping rotations which get closer and closer. A strong trending market pushes higher and higher. This is not the case as shown. So fundamentals and technical are not looking attractive. Having said that, we need more evidence. The bull still needs to show some excess on the highs. An excess with a selling in tail is still nowhere to be seen, and I believe we will see one before this market turns over. So I remain net long but keep all of this at the back of my head.
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