Finding Safe Investments In A Dangerous Market

Hello everybody, thanks for joining us today. I'm going to focus on helping you as our clients, friends, followers protect yourself in what is a very challenging market. I think the current market conditions are more than a little bit shocking for people who are not doing the kind of risk management that they ought to do. Maybe even a little bit surprising. I think a lot of experts have been calling for this for a long time. We hope that unlike a lot of investors, you're not looking for fundamental research when it's already too late. We think fundamental research is part of fulfilling fiduciary responsibilities to your clients, to yourself. We think it's important to risk management. We think it's central. We think it's critical. Look, even if you want to focus on momentum strategies, technical strategies, at least know how much risk you're taking on a fundamental basis. If you're going to invest in some of these stocks that we've had on our Danger Zone, like Qlik or Demandware, which are in some ways— it's hard for me to even say— a joke when it comes to how overvalued they are and how poor their business models are. At least know how much risk you're taking. A stock like Netflix is another great example. You may want to play that game. You may want to play that price momentum game. And look, let me tell you, I've been on CNBC talking about Netflix, more on the bearish side than the bullish side, and the guy on the bullish side literally said to me when I talked about how overvalued the stock is specifically, right, the current stock price implies— I think Kyle did an update for us recently. The current stock price implies that they're going to have something like 4 billion customers for the next 20 years or so, right? That's unique customers. That assumes no sharing of Netflix accounts, which we all know a lot of people do. I mean, I know people that have like 2, 3, 4, 5, and they allow up to what, 5 or 6 streaming at one time? Anyway, the guy on the other side said profits don't matter, okay? He said it live and on CNBC. I think it was a pretty major firm, Cowen or something like that. I don't think it was Cowen. It was somebody else. But it's real. It happens. And so, look, I understand those are strategies. I understand that this guy's really compelling. He makes money when the market goes up. He makes money when there's a lot of people involved in the market. His incentive is to keep you engaged, keep you trading. All right, but the fact of the matter is his recommendations and Wall Street recommendations are not as good as you think. Wall Street's not even in the business of really doing recommendations, right? I know sell-side analysts, people that are still on the sell side. Let me tell you, there's not many left. All my friends that were over there when I was on the sell side have long gone. And, you know, as the Financial Times pointed out, Ratings don't even matter to these guys. They'll tell you, they don't get paid for ratings. They don't get paid for doing fundamental research either, right? 20% of CFOs say earnings are fudged by as much as 10%, and the sell-side analysts don't actively detect it. All right, usually. I would say most of the time. Anyway, some of you have heard this before. The point is, look, you've got to do your diligence. And let me tell you, I know that diligence is difficult. That's why I created a company to focus on it. I think that now it's going to be really important, as important as ever. I think that, look, many experts have said the markets have been overvalued for a long time. Interest rates have been artificially low for a long time. What does loose money do? It props up asset prices, pure and simple. I think it's very hard to argue that we are Not closer to the end of the bull market than we are to the beginning. And as some really smart clients of mine pointed out, back when I was sort of early to proclaim a lot of stocks were overvalued and the market was overvalued, they flat out said, listen, overvaluation doesn't matter. The only thing that's going to precipitate Reconciliation is a meaningful reduction in liquidity. And we're getting that in China, big time. We're getting that in that on the margin, there is no more easing left. Everybody around the world is easing as much as they possibly can and have been for a long time, to the point where even in the United States, we're tightening. So on the margin, liquidity is drying up. And when you have that happen, there's nothing else to fill the void when you see growth start to drop off, as we're seeing in China big time. An analyst this morning on CNBC talked about the $7 trillion contribution that China made to profits and growth around the world for companies. That's declining. So there's not any— the Fed is out of bullets effectively. So what does that mean? Diligence is all the more important. What is diligence? For those that are new, I'm going to quickly go through a couple of key high points. Diligence is reading the entire 10-K or annual report, understanding the footnotes, because there's a big disconnect between reported earnings and accounting earnings. A lot of that's because accounting rules are complex. The sell-side guys, the Wall Street research guys, they don't get paid to fix accounting earnings. Right. They get paid for other things than research. They get paid for sitting in meetings with management, and they get paid for providing quote-unquote incremental information that their buy-side clients can't get anywhere else, which is very difficult to do in a post-Reg FD environment. And for those that aren't familiar with what Reg FD is, that's the rule that was created in 2000, the year 2000, that said it is illegal for analysts to convey information to their big buy-side clients Or for companies to convey information to analysts before conveying it to everybody else. That's right. It's now illegal to front-run, or to make money on inside information by talking directly to companies. Thank goodness we put that in in the year 2000. If that doesn't give you confidence about the stock market, or lack thereof, I don't know what does. And just so you know, I'm not just blowing off a lot of hot air. We have a lot of major clients and partners who rely on us to get the numbers right. to protect trillions of dollars in assets. Why do they do it? Because nobody goes through the same diligence we do. Nobody's going through the MD&A and identifying hidden items that distort income statement results. Nobody's going through the notes to find out all the write-downs that highly distort balance sheets. Nobody's putting data together like the fact that Eastman Kodak was an obvious short call in the beginning Of 2011 just by looking at the numbers because they had to milk their pension plan to the tune of over 2% of revenues, several hundred percent of earnings, even though that pension plan was underfunded by almost $2.6 billion or 3 times the market cap. They showed increasing accounting earnings by milking an underfunded pension plan and the stock price implied 10% compounded annual growth rate in net operating profit after tax for 11 years. It's a no-brainer, right? If this is what you focus on. So what I'm here to talk about with new constructs is fundamental research matters to risk management. It matters to protecting your portfolio, right? And I also want you to know that, look, there is no quick panacea here. A lot of what I'm going to spend some time talking about is— I'm going to give you examples of good fundamental research, but I'll also talk to you about how hard it is. I started this company 12 years ago to build automation and technology around allowing our clients to do the kind of fundamental research they would want to do in a perfect world, but don't have the time or patience for. And this is a view of my platform. We have automatic technology. I realize automatic technology is kind of redundant. We have technology that sources data directly from the SEC to scrape financial statements and footnotes. via proprietary extraction system that my analysts use to go through the filings more quickly and more intelligently. We've been using this for 12 years, been through over 70,000 filings, 75,000 filings, right? And we in turn use the information gleaned from the system recording everything my analysts parse to parse more things automatically, right? If the system sees that our analysts, who are very highly trained, Highly intelligent, highly educated folks. If they've parsed the same item and the system catches that they— or does it catch everything? The system sees they've parsed the same item 20,000 times, out of 20,000 times in the same way. Every time they've seen it in the 20,000 times it's appeared in filings, it's been treated the same way. We don't need humans to do it anymore. It's that attitude and that approach that has helped us build speed and accuracy and intelligence around how to get through these 200-page-plus filings to get you the real numbers. And what does it mean? Well, it means that we've got good ideas. A recent update on the performance of our most attractive, most dangerous stocks, and those are our model portfolios, pretty good since inception. This is January 2005 to the end of 2015. This is our long-short portfolio, looking at our long stocks as most of the most attractive stocks as long and the most dangerous stocks as short. Did pretty well last year. A lot better than the market. I think the stats are here. Last year, our long-short was up 16%. Versus the risk-free rate, which is basically flat. And the S&P, I think last year was— I'll have to look that one up. I don't have that at the top of my head. I think the S&P was basically flat last year. Anyway, you get the idea. And that's the long-short version. That's the large cap. The small cap did extremely well. And then on the long-only side, See, the S&P was down 1.8% last year, right? Our large-cap stocks underperformed. Overall, we were about the same, you know, large-cap versus small-cap on the long-only side. So, the small-cap stocks did really well, especially versus the Russell 2000, right? If you're long the Russell 2000, you were down 7%. If you were long our small-cap attractive stocks, you were up 10%. 8.6%. Large cap, not so much. Over time, you can see the charts. Long has outperformed the market. And then on the most dangerous side, this is where we saw a lot of outperformance. And this is where it's important to point out that, look, New Constructs is not just about giving you good ideas. We're about protecting you too, right? And we're going to be doing— we do a lot of research. That's been published recently around how to do good fundamental research. Like, a great example is when somebody creates a high-quality ETF, how do you know that that's high quality? How do you know that's high quality? By the way, feel free to go ahead and start sending in some questions. I know a bunch of you already have. I've got 10+ here already queued up. If you're new to this, I love questions. I love emails. I love Twitter. David.Trainer@NewConstructs.com. Our Twitter handle is @NewConstructs. We're on Facebook as well. You can talk to us on the blog. But here's the big point. When someone says they're creating a high-quality ETF, how do you know it's high quality? How do you know their definition of high quality is the same as your definition of high quality? I'm telling you that there's a lot of jargon thrown around to sell stock, to sell attention, to sell commercials. they call something high quality, you don't know if it's high quality. And look, the way you can tell, right, just to jump to the point, is how transparent people are, right? So for example, this is our website, and if you're a subscriber to us, you can have your portfolio in here, and we've got tracking on all this. We'll let you know. For example, we suspended the rating of Apple because we think there's a changing the outlook on the fundamental front, despite the fact that they've got super high returns on capital. But it's the level of detail people are willing to provide, right? Here's the detail behind our rating, and this is not so impressive in and of itself. Where it gets impressive is you start looking at adjustments that we make to the income statement. Look, we're transparent about it, right? And you want to see how transparent we really are? Well, here's my model. I'll show you my model. How many of you have ever seen a model from another research firm? How many analysts are actually willing to show you a model? You know, one thing I know they're not willing to show you is what we'll show you. And how about the filing from which the data came? Because you know what? There's no other research firm that sources their own data, right? They're getting data from a data feed, which means it's dirty. I created new constructs because I knew I could not trust any of the other data feeds out there. I needed to create my own proprietary data feed. Well, I didn't want it to be proprietary, but since no one had created a parsing system before, it had to be proprietary. It wasn't my choice to be proprietary, it just needed to be because no one had ever thought of— well, I'm sure plenty of people thought of it. No one had actually been willing to endure the pain that I've endured over the last 12 years to create a system that works like this. Trust me, it's not that much fun. It's a lot of hard work going through a lot of filings and painstakingly tagging and identifying and detailing exactly how every little thing needs to be treated for the machine, seeing it. The machine records the value, the text, the location. Anyway, probably getting boring you, but it's tough. It's tough. A question about coverage. We cover 3,000 stocks. 400 ETFs and 7,000 mutual funds, and the rating system is consistent. So for example, you saw my rating system, you know, here's my rating detail for Boeing, right? Neutral. Quality of earnings looks good, valuation looks a little bit expensive even after the recent decline. We also cover ETFs. Look at that, similar rating system. An ETF and mutual fund is just a collection of stocks. We cover enough stocks that we can actually cover the funds that hold stocks because we've built the system. We have this highly reliable, highly sophisticated engine that again is relied upon by some of the biggest and most trusted names in the business. Right. I think our mutual fund and ETF reports are amazing because they actually break the portfolio down. It's a pie chart showing you how much of the fund is allocated to very dangerous, dangerous, neutral, attractive, They have very attractive sites. Nobody else is doing work like that. This is awesome. Like to go through and look at how the fund breaks down in terms of what the management team is doing and how they allocate. This is extremely valuable to all kinds of institutions. Think about endowments. Across all the money managers they have, for someone to actually go through and identify where the endowment is at the most risk because you got a guy who's putting Too much money in biotech. Biotech, if there was ever a ticking time bomb, it's biotech, for goodness' sakes. How did the most attractive, most dangerous stocks perform in the last downturn? That goes back to this chart here. You can see '08 and '09, most dangerous did very well, large and small cap. Large cap did very well. as did small cap. I think the proof is in the pudding more on the long side though. What I want to point out here in terms of the most attractive stocks, look, when you have a correction like that, everybody is throwing the baby out with the bathwater for a little amount of time. We did as poorly as the market, not worse than the market, but when things got better, that is where we took off because we are focused on quality. Everyone is going to get crushed in the beginning. This market may be a little bit more different because it's— I don't think we're going to see such a huge drastic hardcore decline. It's going to be more of a slow downward grind. So it's going to be more selective. I think that's the end of the day. Look, when you don't have loose money, when you don't have too much money to throw at stuff, what do you do? You're more selective about what you buy. It's natural human nature. Yeah, I agree. Right? If you've got money coming out of your ears and you go to buy a car, well, you know what? You're probably not going to bargain as much. You're not going to shop as much. You're not going to compare as much. You're going to just do what's more convenient. Unfortunately, too many people take that perspective when it comes to investing. It means they don't adequately adjust and manage for risk. Here's a question that looks interesting. Financial advisor told me for 2016 either A, hold Dividend Aristocrats as major holding and hedge with options and inverse ETFs, or B, hold cash and bond ETFs, supplement with small, select small caps. What do you think about that? Thank you. You know, I think that all that sounds great, but the devil's in the details, my friend. Dividend Aristocrats, I would run that through my system because you know what? Just because it's a big popular company doesn't mean people have done their diligence on it. I'm telling you, I had a meeting last week with a major sell-side analyst. Flat out admitted, oh, we don't do fundamental research. You know what the truth is? No one does fundamental research anymore, almost nobody except for us. The reason is because it just doesn't pay. It's too much work. You've got to compete against all the noise coming out of the marketplace. Are you kidding me? Do you have time to spend 6 to 8 hours minimum for 1 year? No. To build a model and read a 200+ page 10-K? Yes. Yes, we do offer trial subscriptions. We have a refund policy at any time, so if you sign up and you cancel within the first 30 days, you know, go for it. If you want to know what our subscription stuff looks like, or how it looks, just go to this page, or get access. Right, there's free, so you get a little bit here, access to some research. But look, you know, for $49, so you can sleep better at night, I think that's a pretty good deal. Now granted, it's only for 25 tickers a quarter, but hey, what can I say? It's still a really good deal. All right, for, uh, you know, if we gave you one ticker a quarter, I think you'd be happy to trade 8 hours— really, if you're doing years of history for a model, you're talking probably at least 40 hours to really do proper diligence, financial, fundamental diligence on a company. $50 is probably worth your time. So to get to the key point, how do you manage risk? How do you protect your portfolio? That's what this webinar is about. I'm telling you, You need to go through and you need to read the entire annual report. You need to build a model that adjusts for accounting distortion, accounting loopholes, accounting idiosyncrasies from sector to sector, you know, and make sure that you do proper diligence. You can take a look at our most attractive stocks as a way to quickly get an idea of what's good out there. Here's the most attractive stocks for January. I can't leave it on the screen for too long, right? Otherwise, I'm giving it all away for free. But you can see there's a lot of good ideas here. They're cheap. It doesn't mean they're not going to get cheaper, but when the market comes back, right, you're going to be in the right spot because that's what matters. The market will come back, right? But I do think that we are in for a world now where there's less money out there. People are going to be more discriminate with their investments. And therefore, you're not going to be able to get away with playing stocks like Netflix, playing stocks like Twitter, playing stocks like Qlik, playing stocks like Splunk, playing stocks like Demandware, playing stocks like Lance, playing stocks like Men's Warehouse. Those days are over. Do we see any positive areas of the market at this moment? Selectively, yes. But you never know, right? If the market's going to be getting crushed the way it has, as I said, in the near term, they'll throw the baby out with the bathwater. How do you get access to the most attractive, most dangerous stocks? Sign up, right? Our Gold subscription gives you access to that. You know, that's— you know, look, we used to sell this thing at $250 Right? And now you can get it for $50 and get all this other information too. Thanks for all the great questions, guys. Non-GAAP earnings. Oh, okay. Let's talk about non-GAAP earnings. We've done a lot of good work on this. And I think this is part of the fundamental research offering. And this is all for free. Okay? So in terms of you want to get free advice, free details on fundamental research, Here's where to do it. We've got a bunch of our fun stuff coming out, but finding safe investments in a dangerous market, we're talking about that. Here's our outperformance. You can get our danger zone highlights, right? Here's some stocks that we did that we think are still pretty bad, probably— not probably, but are still bad that did well last year, and you can get detailed write-ups On how we identified what was bad. Here's a detailed paper on why accounting book value is not a good metric for you to use. Another detailed paper on why ROE is not a useful metric, not as useful as it seems. Newell— the Newell Rubbermaid, details on the Newell Rubbermaid and Jarden. Click in the Danger Zone. These are all things that are free on our website to get you up to speed on what fundamental research ought to really look like. True value investing still works. Details on that. How about what did well in the last crash? The common thread between stocks that outperformed in the last crash, right? Guess what it was? High returns on invested capital. What does high returns on invested capital mean? It means high-quality earnings. Yeah, we just got another question. Is this webinar going to be recorded and available for later viewing? Yes, it will be. Absolutely. So the common thread, high returns on invested capital. Hmm, doesn't that make sense? Right, like, okay, number one, I want to be in companies that are super profitable. That's helpful because when there's blood in the streets, when there's blood in the markets, you know, what's the one thing that really can protect you? What's the one thing the market's going to come back to? Real cash flow. Right, and that's best measured by return on invested capital, right? It also means the company is competitively strong. You don't get to be profitable by chance. You can grow non-GAAP earnings by chance because you can control what goes into non-GAAP earnings. Truthfully, I think non-GAAP earnings are probably going to be made illegal in the not too distant future because they are highly misleading. It's a joke. It's a joke. If you're looking at non-GAAP earnings, please be careful. Please be careful because it is effectively a tool for companies to mislead you about what their profitability is. So the key is these high return on capital companies are the ones that perform best. What do you think is going to do best in the current market downturn? How do you stay safe? You stay safe by focusing on quality of earnings. That's what our rating system is about. When we're looking at individual stocks and ETFs and mutual funds, we're focused on how do the real economic earnings compare to the GAAP earnings, right? Is it better? Is it worse? What's the return on invested capital of the business? How does it stack against the entire market in terms of its overall profitability? And then valuation. For me to think a stock is attractive, it's got to be really profitable and seeing an increase in profits, and then have a cheap valuation. Cheap valuations lower your risk profile. When you have valuations on stocks like— oh, what's a good one, man? Let's go with Qlik. It's my whipping boy recently. Right? I mean, the valuation on the stock is absurd. I go to the model. What do I have to put in here? All right, so let's just create a forecast right here for Qlik to get a sense of what's baked into a $28 stock price. Let's call it optimistic scenario. Let's say that they grow at 20% for the next 10 years. Trail off, and they've got margins as high as they were when they— back in 2012 before all the competition came in and started making the market for data visualization a lot more challenging. So let's see what that means about valuation. Oh my gosh, still need more than 100 years. That's the yellow scenario, the optimistic scenario I just put in there for you guys. Right. We still can't get much above— we can't get to $20. All right, let's try this again. Let's say 20% going out for 15 years. 20% compounded annually for 15 years. That's a big number. That's a big number. I recommend if you're not sure what that means, put that into a little spreadsheet and look at what $10 looks like after 20 years at 20% compounded annually. Whoa, we still can't get there. In a 100-year DCF, we still can't get to a value that equals the current stock price. So let's jack margins up a little bit more. Let's say margins get up to 10%, which is as high as Oracle and those guys, right? So they're going to be as profitable It's not going to happen overnight, you know, obviously, because they're negative right now. Let's just say within the next 5 years they get to 10%. I think that's extremely optimistic while also growing, right? Because, you know, their whole business, the whole bear or bull argument is, oh well, they're going to be profitable at some point, so, you know, Let's just go ahead and be as unprofitable as we need to be in order to get to the number of customers that will make us profitable. So they've got to get to the best margins ever, or 10% margins about as good as Oracle, some of these other really profitable big companies, and grow revenues by nearly 20% compounded annually for 17 years, right? You know, on average have a return on capital versus cost of capital spread of 48%. Which in the history of the company they have never had. Anyway, expectations are ridiculous for a business that doesn't make sense, and guess what? As you'll see in our Danger Zone article on these guys, they have a big problem, in my opinion, in that their executive compensation— I'm sorry, David, I'm sorry, I'm sorry. Big red flag. A lot of their executive comp is based on non-GAAP earnings. This is a big red flag, folks, because you're paying executives for performance that is not aligned with your best interest. Managers are supposed to be agents of capital. Agents of capital means that they are there to make more money with the capital you give them. When they are getting paid on non-GAAP earnings, they are getting paid not to do that. They're not getting paid to destroy value necessarily. They are getting paid to do things that are not in your best interest. They are getting paid to meet performance targets that do not correlate with value creation. In fact, a lot of times it does correlate, or is really more like value destruction. When you are getting paid to grow top-line numbers, whether it's earnings or revenue or adjusted earnings, with no attention to how much capital goes into acquiring that revenue or earnings, you are in big trouble. All right, that's all we have today. If you want to follow up with more questions, feel free to email. And thank you for your time. Feel free to email, hit us on Twitter, and be sure to come back and check out our next webinar. Thank you very much. Thank you.