Marek's 11 Things to Worry about... Revisited

On January 4, 2011, I sent out a document titled, “Marek’s 11 Things to Worry about in 2011.” It was a list I created for myself of what to consider while investing, and I wanted to share it with friends and colleagues. Over the course of the past year, while the awareness of the issues has heightened significantly, the actual list itself hasn’t changed much for 2012. Below is the original document with today’s commentary (in bold). I think this year it’s important to remain mindful of the risks, but also identify opportunities driven by other investors’ fear.

Marek’s 11 Things to Worry about in 2011

1. Europe – Greece and Ireland are struggling. Portugal, Spain, and Italy are next. The problem is solvency, not liquidity. More bailouts? Restructuring? Changes in the Euro-zone? This, of course, ended up dominating the headlines for most of the year and continues to be a major concern.

2. Commodity Prices – Many commodities have appreciated tremendously in 2010, including corn, oil, and sugar. This will have its effect on the global economy eventually. They didn’t get many headlines, but commodities were one of the worst performing assets classes in 2011. While oil and gold performed well, the Dow Jones-UBS Commodities Index was down 13%. As for the impact on the world economy, it must be a factor but I haven’t seen much data on the details.

3. US Government Balance Sheet – Federal debt is high and continues to grow despite rock bottom interest rates, while taxes are being cut. Many municipalities, states, and cities are struggling to remain solvent due to high debt and declining tax rolls. At some point this irresponsible behavior will catch up to the US. Federal balance sheet and budget problems surfaced on several occasions and will continue to do so- this problem isn’t going away anytime soon. On the other hand, municipalities held up much better than many had prognosticated, including Meredith Whitney who had a well-publicized blunder.

4. US Unemployment – Unemployment remains stubbornly high and there is little sign of material improvements coming anytime soon. This impacts consumer spending, economic growth, and government benefit spending. Unemployment stayed over 9% for the majority of the year, and only very recently dipped a bit. The labor participation rate, the number of people employed relative to the population, and other related metrics, all show a population that is shifting towards permanent unemployment (which isn’t captured in the headline rate).

5. China – People are in awe of China, its growth, and its prospects. But historically China has had its booms and busts, and it hasn’t always delivered on its potential. The biggest concerns are a possible real estate bubble and inflation. “Housing prices in the U.S. peaked at 6.4 times average annual earnings this decade. In Beijing, the figure is 22 times.”*. Given the recent global focus on China, a major correction in its real estate market will likely be felt by investors everywhere. Inflation is soaring and the government is raising interest rates, but will likely need to take more drastic action. China was one of the worst performing equity markets in the world last year, down around 20%. Economic challenges are getting more attention and 2012 will tell whether the government can engineer a "soft landing."

6. Japan – Japanese debt now stands at 200% of GDP**. Japan has an aging population, and growth is nonexistent. Judgment day is coming.

7. Interest Rates – They have nowhere to go but up. It is unclear how the markets and the economy will respond once the process of raising rates begins. Investors have piled into government, corporate, and high yield bonds in 2010 and enjoyed substantial gains. These gains will be pressured when rates start to rise, which will likely impact other markets. I was blatantly wrong on this one. Rates went down and then down some more on treasuries and mortgages. I’ll go out on a limb and repeat my assertion that rates have nowhere to go but up at this point.

8. US Housing – Mortgage rates are rising (most recently from 4.2% to 4.8%), foreclosure inventory is high and rising, prices are dropping (1.3% in October alone), unemployment is high, and many homeowners are underwater. Nothing good to say here other than some markets are starting to look cheap. Last year was a difficult year in housing and several of the major builders are under heavy debt. However, things are starting to turn in the market and this may be one of the big positive surprises in 2012.

9. Economic Growth – Troubles in Europe and cuts in government spending will negatively impact European growth, which will in turn hurt the rest of the world. This one held true, in retrospect was obvious, and will continue.

10. Banks – Unclear whether the banking crisis is really over. Financial results of the banks are lackluster, and every time things look up there is a new issue, like the mortgage “robo-signing”. Financials were one of the worst performing sectors in the US and abroad last year. This also might be an area of positive surprise in 2012. I believe the US banks are much better positioned than anytime in the past decade with leverage ratios the lowest in 20 years*** and very conservative lending criteria. In addition, financial stocks are very cheap, mostly trading at a large discount to tangible book value. On the other hand, European banks might continue to suffer for a while. Nevertheless, as you may have read, Catalus recently announced expansion to the Continent.

11. War – The Koreas aren’t playing nice. Iran is a wildcard. Russia has been aggressive in places like Georgia. Any decent sized war or attack will have its implications globally. Nothing major in 2011, but rumblings in the Middle East are growing and the risks remain.

Bonus! The Unknown – Who knew that AIG was selling naked CDS en-mass in the 2000’s? I didn’t, I thought it was an insurance company. You don’t know what you don’t know. We’ll see what we don’t know in 2011. My favorite!

* Wall Street Journal, ** Central Intelligence Agency (CIA), *** Goldman Sachs

More on Europe

I recently read an investor letter discussing the historical correlation between global mobility of capital and the propensity of banking crises.  It concluded the easier it is for money to move (physically or electronically), the more likely a financial crisis.  As soon as people think their institution or country is in danger, they move their money elsewhere and the problem is exacerbated.

This is currently happening in Europe.  Capital is fleeing the already insolvent peripheral countries (Greece, Portugal, etc.) to the core countries (Germany, Switzerland, UK) in a flight to safety.  In actuality, this trend is worsening their stance and banking systems.  A hedge fund manager framed it nicely saying, “Greece is like a business whose revenue base is declining (GDP), who generates revenue through receivables (taxes), who collects only a fraction of those receivables, and who has a huge fixed expense base that it can’t cut without enraging customers (the voters).  This is not sustainable, and definitely not a business you want to lend money to.”

At some point in history most countries have been overly optimistic, borrowed too much, got carried away, and weren’t ready when things deteriorated.  However, there is one risk specifically unique to Europe scaring many investors, including myself: redenomination risk.  What happens if the Euro falls apart?  What if certain countries leave and not others?  What currency will your investment be denominated in?  What will that currency be worth relative to the dollar?  Is there a way to hedge this?

Redenomination is scary, possible, and maybe even probable.  So what's an investor to do?  My best advice is to 1) study the language of each legal document to understand the ramifications of a currency change and 2) be careful when crafting new documents.  As detailed in my previous post, Catalus is now actively seeking European investments.  We are working to understand and mitigate redenomination risk, rather than letting it eliminate potential excellent opportunities.  I’ve included some articles below on the topic.

Banks Ponder Scenarios if Countries Drop Euro

Banks Struggle With Euro Contingencies

An EU Currency Breakup Would Be Unlike Any Other
Banks Prep for Life After Euro
Time to Think the Unthinkable on the Euro

Also, to review interesting investor letters like the one I refer to at the beginning of this post, visit the Neo-Alpha Blog.  

Entering Europe against the Grain

Like the entire financial community, Catalus has been watching European developments with horror and skepticism.  Unlike most of the financial community, we believe that where there is uncertainty there is also opportunity.  It appears that most European banks have restricted or discontinued lending until stability is restored, which means that our type of capital could start to play a larger role in financing growth, acquisitions, and recapitalizations.

Catalus, of course, differentiates between the Continent's countries.  We view the UK and Germany as the most desirable, with Greece and Eastern nations trailing further behind.  For us, the specific company, opportunity, and deal structure is far more critical than the "bucket" within which it falls.  Our focus will remain on existing cash flow and/or hard assets.  In a newly originated deal, our minimum investment will be $10 million (~7.5 million Euro), however it could be less for traded bonds or loans.

No one knows how things will end up in Europe.  It is probable that it will struggle for a number of years to come and possible dramatic changes will be made to how the Euro zone is structured and governed.  Certainly there are countless risks.  Nevertheless, as of today we are updating our website and online profiles to include European investments.  Although we may be getting in a bit too early, we believe in the end Europe will prevail and emerge as a stronger global competitor.

Catalus will start an online campaign to generate European deal flow.  We will be actively searching for companies looking to borrow money and for intermediaries (investment bankers, deal brokers, lawyers, accountants, and others) that can help make an introduction.  If you are in the market, we would love to hear from you at marek@cataluscapital.com.

A Quick View into the Shark Tank

A good friend of mine who is a trader on Wall Street sent me an email saying, “Have you seen Shark Tank?  It is exactly how the public sees private investors.”  I figured I should check it out.  The show is almost like an American Idol... for investing... complete with all the drama akin to Mr. Trump’s “You’re Fired”.  A story is told about an (innocent and naïve) entrepreneur raising funding for his or her next “big thing,” who then pitches the idea to a panel of five (aggressive and merciless) investors.  The high level deal terms are negotiated right there on the spot and the venture is either funded or not.

Granted this is reality television I'm writing about, as someone who goes to work everyday as a private investor I have to vent.  The whole concept of the show is completely at odds with what I believe to be the most important aspects of investing.  These investors listen to a five to ten minute pitch about the company raising capital, couple it with the same amount of time for Q&A, and their decision is made.  (I won’t even get into the fact that this show focuses on start-ups, perhaps the riskiest investments of all.)  How can someone make an informed decision about an industry and business they know little to nothing about after a brief conversation? What happened to everything that makes investing difficult? My reality day in and day out consists of extensive industry-specific research, meticulous diligence on financial prospects, investigation of a management team’s track record, and competitive analysis.

So, going back to my friend's email.  If the public views private investors as they are portrayed on Shark Tank, then that’s quite a shame.  What makes me more worried, though, is that based on some of my daily interactions with investors and capital raisers, maybe Shark Tank isn’t too far from reality at all…

The Forgotten Middle

At Catalus our focus is investing in middle market companies.  These are loosely defined as businesses with revenue between $10 million and $1 billion.  I'm not an economist so I won't recite the statistics, but, according to an opinion piece in the WSJ, the middle market produces 40% of our nation’s GDP and employs 32 million people. At Catalus we believe this market is full of potential.  It is the glue that keeps the US economy together and spurs innovation.  It is where tomorrow's leaders are born and how America stays competitive globally.  The general public, the government, and most investors, however, do not share this same outlook.  Most favor larger and public companies.  This makes running a middle market business, raising money for one, or investing in one a challenge to say the least.

So why are things so difficult in the middle market?  First of all, because of the generally luke-warm attitude, it just doesn't have the access to capital it deserves.  This, combined with less sophisticated financial and operational reporting, substantially constrains growth.  I find it odd that venture capitalists have money to burn when it comes to start-ups with huge losses, but when approached by a profitable, consistent, and stable company, there is limited equity capital available.  

Further complicating the situation are the dynamics inherent in the middle market investment community.  The arena is fragmented, highly inefficient, and deal flow is based on networking, word of mouth, and personal contacts.  The result?  Deals delayed or not funded at all because they never crossed the right person's desk.  In recent years, numerous websites have launched attempting to correct this problem by connecting investors and businesses in an open forum.  Catalus supports these sites, but unfortunately most are focused on M&A, not the minority capital raises and lending situations that need it most.

Finally, the WSJ article above discusses the middle market regulatory landscape problem.  In short, it is fickle, contradictory, and constantly changing, making it near impossible for companies and investors to feel confident about the future. 

Despite its difficulties, Catalus remains excited about the middle market and will continue to invest growth capital.  While we are well aware of the challenges, we see even more opportunity and talent.  

How to Invest During the European Crisis, US Slowdown, Fiscal Irresponsibility, and Stock Market Chaos

There is a lot to be worried about in the world today.  If you’re intellectually curious enough to read this blog, then you’re probably well informed of the problems we face:

• One by one, Europe’s nations are failing.  The only country seemingly not at risk is Germany, whose ingrained culture of discipline kept it fiscally and economically prudent while its neighbors did the opposite.  Germany will have to decide whether to bailout Europe and save the Euro or break up the union (read Michael Lewis’s controversial take on it here). 

• US economic growth has stalled, unemployment is up, housing is sputtering, and the Fed is running short on its magic bullets.  

• Over 65% of US government spending is payments to individuals (see WSJ chart), which creates an illogical dynamic where the government’s #1 job is to subsidize peoples’ lives.  The downgrade of the US as a creditor is probably the beginning of a series of negative events, not the end.  

• There is a panicked feel in the financial markets, best reflected by the VIX volatility “fear” index reaching historical highs last week.

These are structural issues that will be around for years (with the probable exception of the notoriously volatile, volatility index).  They affect our decisions and our finances, but there isn’t anything we can do to change them.  Instead, we can incorporate these issues into our decision-making process and take advantage of the opportunities created.  We’ve all heard the many variations of, “buy when people are panicking, sell when they are exuberant”.  It sounds pretty simple, but it's difficult to execute when the headlines are blaring the world is about to end.  It requires a high level of discipline, an avoidance of greed, and the ability to confront fear. 

No matter what is going on in the world today, one thing remains the same: the importance of investing in quality businesses.  Potential return, deal structure, and everything else are all secondary to quality.  A strong business will perform in all economic cycles, and more importantly, will be around after this cycle is over to fight another day.  These are companies that offer a highly desirable product or service that customers value and would not easily substitute.  These businesses strive for integrity and excellence in all of their endeavors, and have shown repeatedly that they can win.

It is crucial to remain prudent and cautious at all times, good or bad.  During times of excessive optimism, don’t forget that challenges are just around the corner.  When the problems do come, don’t let them render you immobile.  Times like today can offer the greatest opportunity.  Apply the same rigorous analysis and diligence that you always do, while following the principles of integrity, diligence, and discipline.  You might surprise yourself. 

What's More Important: Growth or Return on Investment?

Investors are obsessed with growth.  Articles and investor reports constantly hold a microscope to growth rates and how they are changing.  The attention seems to be on revenue, rather than gross profits, EBITDA, and net income.  Why does everyone marvel at growth analysis when investor returns can be equal or better from steady, repeatable cash flow?

The companies I like generate relatively consistent levels of EBITDA and cash flow from year to year (in other words, they are boring).  They may grow a little or fall a little (gasp) but they have healthy profit margins, strong balance sheets, and have created a niche in their market.  Historical growth and future prospects are important, but don’t get my attention like sustainability of the existing revenue stream.  Will the business keep its historic revenue and profitability for many years to come?  If so, it’s a quality company offering a service/product that people want and growth will take care of itself.

I think growth is generally overvalued.  For example, in the early stage tech sector, barely-profitable businesses are being valued at many billions of dollars, with astronomical multiples.  The only way investors are making outsized returns is unprecedented growth or the “greater fool theory” (investors manage to sell their holdings to another round of even more bullish investors).  Meanwhile, the blue chip tech companies like Microsoft, Intel, and others are very modestly valued.

Maybe people focus on growth because they think it’s the only way to make outsized returns.  I don’t buy it (pun intended).  A pretty simple analysis can prove my point.  Say an investor buys a middle market business that has been around for 20 years making relatively steady results.  He pays 4x EBITDA, keeps this identical profitability for 5 years, and then sells it for the original purchase price.  The result is a 20%+ annual compounded return from dividends.  If moderate leverage is used (provided by Catalus of course) it becomes 30%+.  Add some normal business growth and the return accelerates further.  The assumptions can vary, but the opportunity to make substantial returns remains.