rga investment advisors q3 2013 commentary

7/27/2019 RGA Investment Advisors Q3 2013 Commentary

http://slidepdf.com/reader/full/rga-investment-advisors-q3-2013-commentary 1/10

October4,2013

Beware of Mistaking a Symptom for the Cause

“Ifyoucanhealthesymptoms,butnotaffectthecause,it’squiteabitliketryingtohealagunshot

woundwithgauze.”–TreyAnastasio,Phish

Reflectionson5YearsPast

ThemonthofSeptembermarked thefive-yearanniversaryof theLehmanBrothers bankruptcy. Formany,especiallythose infinancial circles,September15,2008 is“a day thatwill live ininfamy”for

bringing to the fore the fragility ofour financial system. Yet herewe are five years later, and the

anniversaryoftheeventitselfisconvincingproofthatweasasocietyhavenotlearnedtheappropriate

lessons.Nearlyeverymainstreamnewsoutletfeatureda “5YearsAftertheFinancialCrisis”headline

(WashingtonPost1,FoxBusiness

2,BloombergBusinessweek

3,Forbes

4),insinuatingthatthecrisisstarted

punctuallyuponLehman’scollapse.Whilenoteveryoutletsharedthesamemessage,theyallmadethe

samecrucialmistake:thecollapseofLehmanBrothersabsolutely,positivelydidnotcausethefinancial

crisis;itwasasymptomofacrisissetinmotionseveralyearsprior.

InFooledbyRandomness,NassimNicholasTalebtaughtusthatoftenwhatseemsatightconnection

ismerely coincidental,withtherandomnessmislabeleduntilit’stoolate.5LehmanBrotherswasn’t

eventhefirstcasualtyofthefinancialcrisis(NorthernRockfellbeforeBearStearns),sohowcouldit

possiblybethecause?SomemightarguehadLehmansurvivedthatfatefulweekend,thecrisiswould

havebeenlessbad,thoughwecautionthatsuchaclaimisimpossibletoprove.Moreover,withthe

placementofFreddieMacandFannieMaeintoconservatorship,thegovernmentandFederalReserve

Bank’sinterventioninAIG,MerrillLynch’ssaletoBankofAmericaandtheaccompanyingstockmarket

panicallwouldhavetakenplacewithorwithoutLehman’sfailure.

Infact,evenatthetime,andinhindsight,oneofthemostshockingfactsoftheLehmanfailurewashow

muchofaslow-motiontrainwreckitallways.ThefailureofLehmanseemedinevitablethemoment

BearStearnswritinghitthewall,withtheonly“out”beingasaleofthecompany,somethingCEODick

1http://www.washingtonsblog.com/2013/09/5-years-after-the-financial-crisis-the-big-banks-are-committing-more-crimes-than-ever.html 2http://www.foxbusiness.com/personal-finance/2013/09/16/5-years-after-financial-crisis-meet-new-consumer/ 3http://www.businessweek.com/features/financial-crisis-anniversary-2013/ 4http://www.forbes.com/sites/greatspeculations/2013/09/29/debt-still-bedevils-economy-five-years-after-financial-crisis/ 5http://www.amazon.com/Fooled-Randomness-Hidden-Chance-Markets/dp/0812975219



Fuldviewedasunfathomable.Itismaddeningandfrustratingtoheartalkto thecontraryandforthe

crisisnarrativetoshifttowherethesefiveyearsofeconomicstagnationwouldnothavehappenedwere

it not for Lehman. This new narrative is designed purely to suit the political desires of certain

constituenciesandWallStreetinterestswhoseownmessagesandbusinessmodelswouldfacesevere

disruptionwerewetoacknowledgethetruenatureofourfinancialsystem’sproblems.

Lehman’scollapsewasduetotheexcessivebuildupofleverageinoureconomy,andthefinancialsector

inparticular.Householdsalsotookonleverage,butitwastheconcentrationofleverageinfinancial

institutionsthatreallyblewthingsapart.Inchartform,thisismostclearonboththewayup,andthewaydown:

Thebluelinerepresentstotaldebtinthefinancialsector,theredlinerepresentshouseholddebt,and

thegreenlinenon-financialcorporationdebt.Wecanclearlyseethatthebluelinehasthesteepest

trajectoryonboth theway upand theway down,yetit stillremainsthedominant domicileforthe

concentration of debt in our private economy. Since the onset of the crisis,we can also see that

householdshavedeleveraged(pleasenote:thedeleveragingofbothfinancialsandhouseholdswouldbe



morepronouncedshownasapercentageofGDP,wearelookingmerelyatgrossvalues),mostlybyflat

lining in terms of total liabilities outstanding. Non-financial corporations have been the biggest

beneficiariesofthelowinterestrateenvironmentbyissuingincreasingamountsofdebt.

Ourpointhereisrathersimple: leveragehadgottenextremeinourfinancialsector,Lehmanwasone

ofthemoreleveredfinancialinstitutions,andassuch,itsfailurewasmerelyabyproductofadeeper

systemicproblem.Tomakemattersworse,leveragewassimplytoohighthroughoutourprivatesector

oftheeconomyandhadtobebroughtdown(withthegovernmentsteppingin tofillthegap,though

thisisadiscussionforanothertime).

Lessonslearnedforinvestors

Thisdistinctionbetweensymptomandcauseisanimportantone,forhowcanwelearnanylessonif

cause and effect are reversed? In markets, the relationship between causation and correlation is

inherentlytrickybusiness.Onefactisclear:evenwiththecrash,thosewhofocusedoninvestingin

soundbusinessesperformed farbetter than thosewhoreliedon tradingormarket timingstrategies.

Evenpeoplewhoinvestedinindexeshaveonceagainearnedapositivereturnfromthepre-dawnofthe

crisisuptotoday,whilemanywhoanticipatedandsoldbeforethecrashhavemissedoutonmoregains

than losses saved. It was those who invested with leverage, or those who could not handle the

behavioralelementthatisaprerequisiteforriskingcapitalinfinancialmarketswhosufferedtheworst

fates.

Inour January2013 InvestmentCommentary6 wehighlightedtheconceptof “myopic loss aversion”

wherebyinvestorscostthemselvesasignificantportionoftheirlong-termreturnbycheckingstockstoo

frequentlyandreactingtooemotionallytovolatility.WhileoneofthecorefoundationsoftheEfficient

MarketTheoryholdsthatvolatilityisrisk,inactuality,thehumanresponsetovolatilityiswhatmakes

for risk, not the volatility itself . One of the easiestways tomitigate this risk is by separating our

analysisofabusinessfromtheideaofthe“stockmarket”itself.Wewillspeaktothispointdirectly

below, but first it’s important to digress and ask ourselves,what exactly the existential purpose of

marketsis?Inabroadersense,weallknowthatmarketsareabouttheallocationofscarceresources.

Insofarasthestockmarketsareconcerned,theanswerisfarmorenuancedandmanymaydisagree;

howevertoustheanswerisabundantlyclear.Stockmarketsareheretoprovidecompaniesameans

throughwhichtoraisecapitalinordertoinvestintheirbusinesses,andinvestorstoallocatecapitalin

6http://www.rgaia.com/january-2013-investment-commentary-high-yield-corporate-debt-markets/



order to generate a return. Many argue that markets are a “zero-sum game” meaning that one

participant’sgains(loss)isanother’sloss(gain).Inessence,thisissimplynottrue.Whencompaniesuse

marketstoraisecapital,theycan(andshould)benefittheirexistinginvestorsandnewinvestorsalike.It

isonlyinthemoreabstractworldofshort-termismandtradingthatmarketsarezero-sum.

In thedecade leadingup to Lehman’scollapse, theproliferation of trading-based strategies became

completelydistortedandabstractedfromthebasicpurposeofmarketsthemselves.Manyweremaking

more money trading spreads and leveraging minimally profitable strategies while appearing to

generateenormouslysafereturnswithouteveracknowledgingthattheformerwasmerelysupposedtobealubricantforinvestment,nottobemistakenwithinvestmentitself,andthelatterwasmerely

themagnifiedeffectofleverage.Wespeakofthesetwointhesamesentence,becausethingswent

most wrongwhere thetwo phenomenonof tradingand leveragewere combined, like in Long-Term

Capitalinthelate1990s,andLehmanBrothersamerefiveyearsago.

Theexistentialquestionisaparticularlyimportantonebecausemarketshavemovedso farpasttheir

intended purpose that most fail to even acknowledge the role of boring, old-fashioned business

investment.That’spreciselywhatwe’reherefor.

WherewestandintheLongRun

Herewemusttakeaseconddigressionbeforegettingtotherealquestionofwhatitmeanstoinvestin

businesses as separate and distinct from the stock market. In our 2012 Investment Outlook, we

highlighted how the Dow Jones Industrial Average’s long-term total return since 1925, even when

counting both theGreatDepressionandtheGreatFinancial crisiswas6.58% annualized. Since that

time,theDow’sannualizedreturnfrom1925totodayhas improvedto6.74%. Thereisanimportant

connectiontomakebetweenthemarket’saverageP/Eof15overthelongrun,andthemarket’slong

runreturn.AnotherwaytothinkaboutaP/Eratioisasanearningsyield,(wecalculatethisbytaking

theinverseofthenumber,i.e.E/P,orinthiscase,1/15).Itjustsohappensthattheinverseofthe

market’slong-runP/Eratiois6.67%,amazinglyclosetothe6.74%longrunreturnexperiencedsince

1925.

Wefindthemarket’searningsyieldparticularlyimportant,asitisthebestproxyforconceptualizinga

stockinvestmentlikeonewouldabond.The6.67%earningsyieldisanalogoustoacoupononabond,

andgiventhisrelationship,astheearningsyieldandlong-runreturnarestrikinglyclose,itseemsclear

thatthebond-likeelementofstocksisthegeneratoroflong-runreturns,notcapitalappreciation(aka

theriseinshareprices)asmanywouldsuspect.



Interestingly, despite periods of deflation and inflation, the market itself has generated a fairly

consistentannualizedyieldforinvestors.While6.74%isthelong-runreturn,therehavebeenyearswith

returnsfarinexcessofthemean(thisbeingoneofthem)andyearsthatnotonlyfallshort,butdestroy

significantamountsofcapitalifnothandledappropriately(like2008).Investingforthelongrunisthe

greatesthedgeagainstabadyear,foraconvictioninyourtimeframeaffordstheopportunitytocapture

the easy part of the return the market has tooffer. Meanwhile,within all of these years, there is

substantiallywidedispersionbetweenstocksthemselves,andnotallstocksriseandfallinunison,tothe

pointwhereprudentbusinessanalysiscanmakeabigdifferenceinmitigatingthedepthsofdownturns

andenhancingtherewardsthatgoodtimeshavetooffer.

GettingMicro

Onefactwe feel is significantly underemphasized is thecapacity of sound businesses (thought ofas

separateanddistinctfromthemarket)togeneratemeaningfullybetterreturnsthanthemarketitself.

Overthepastdecade,whichcoversthetailendofthedot.combustandthefullextentoftheGreat

FinancialCrisis,455stocksintheRussell2000havereturnedatleast15%annualized.Thatmeansthat

nearly1in4stocksinourbroadestmarketindexhaveoverdoubledthemarket’sannualizedlong-run

return.Whileitwouldtakeasignificantstrokeofluckandatleastmodestskilltohaveaportfoliofullof

only15%annualizedreturners,wedothinkit’spossibleforaportfoliotobeheavilyweightedtowardsthebiggainersandwethinkthereisatriedandtruemethodtodoingso.

Tothatend,weneverthinkofourselvesasbuying“stocks,”ratherwethinkit’sourjobtoanalyzeand

buyfractionalinterestsinbusinesses.Thisrequiresfarmoreanalysis,diligenceandpatiencethandoes

investinginstrategiesthattryandcapitalizeonfluctuationsandspeculationsinthemarket.Itinvolvesa

holisticanalysisintothedriversofabusiness,its industrysituation, relationshipswithconsumersand

suppliers, management’s incentive structure and the price that financial markets are offering us

comparedtoarationalintrinsicvalue.

Noteveryinvestmentineverycompanywillworkaccordingtoplan,andthatiswherethebenefitsof

buildingadiversifiedportfolioofbusinessesplaysaroleinmitigatingrisk.Wepurposelyseektobuilda

basket of businesses, each exposed to disparate risk factors and unique reward catalysts, operating

globallyand ingeographicniches,with short and long durations. Our favoritebusinessesare those

with a solid valuation,with the consistentability to compoundcapital, and the addedchance for

somethingtogoasymmetricallyright.Thisaddedideaofasymmetricopportunitiesisimportant,forit

iswhatoverthelongruncansetapartagreatportfoliofromadecentone.



Wearenotaloneinthispursuit,andourphilosophyisfoundedontheprinciplesofinvestmentgreats

likeBenjaminGraham,WarrenBuffett,PhillipFisher,andmore,thoughweareconstantlysurprisedby

how many would rather base investment decisions guesses on policy direction inWashington, and

presumptionsaboutwhereotherspeculatorswillmovetheirmoneynext.Tothatend,whenwewant

toknowhowourcompaniesareperforming,wenevercheckthepriceofasharefirst;rather,wecheck

theresultsofthebusinessitselfagainstourinvestmentthesis.Iftheresultsaresoundandreflectiveof

ourthesis,thoughthemarketitselfhasnotmovedhigher,ourconvictionincreasesasthepricetobuyis

moreattractive;whilealternativelyifthemarketpriceofourstockrisesandthefundamentalshavenot

followedourexpectations,ourconvictiondiminishesandwearelikelytosell. Thepointhereagainis

quite simple: when we follow a business, we first and foremost follow the performance of the

businessasanownerwould,andonlysecondarilylookatthestock’schart.

Whatdoweown?

Withthe3rdquarterinthehistorybooks,it’stimetocontinueourglimpseintoyourportfoliobylooking

attheleadersandlaggardsduringthequarter,andhowtheirrespectivestockperformancesstackupto

ourfundamentalthesis.

TheLeaders:

GivenImagingLtd.(NASDAQ:GIVN)+37.16%

After buying Giventowardstheend of the second quarter, the stockwastednotimeimpactingour

portfoliosin apositivewaywiththreeexcellentcatalysts. Givenmakesa swallowablecapsule (called

the PillCam)designed to take images of the gastrointestinal tract in amore comfortable, minimally

invasivemethodforpatientsthantraditionalprocesses.ThefirstcatalystwasapprovalforthePillCam’s

useforcolonoscopiesinJapan,thesecondlargestmarketforcolonscopiesintheworld,followedby

betterthanexpectedearnings,andlastly,bytheapprovalofa newergenerationof thePillCaminUS

marketsthatshouldofferimprovedandexpandedfunctionalityfordoctors.

Givenembodiesthe type of companydiscussedabovewith a solid valuationandthe potential for

asymmetricalreturns. Thevaluationis justifiedbasedonitsexistingstatusasthefirst-linetreatment

for diagnosing GI bleeding, and its asymmetry comes from the potential to reinvest earnings into

improvingthetechnologywiththeaimof completelydisruptingthecolonoscopy.Whilethiswilltake

time, this quarter, the company demonstrated tangible steps towards making the asymmetrical

possibilityareality.



INGGroep(NYSE:ING)+24.86%

INGwasoneofthelaggardsinourfirstinstallmentof“Whatdoweown”fromthefirstquarter.7Since

thattime,INGhasrecoupedallofitslossesandthensome.Thisquarter’sstrongperformancewason

theheelsofanimprovingmacro-environmentintheEurozone(seelastmonth’scommentaryonone

year since our foray into European investments8), on improving earnings at ING itself, and on the

successfulevolutionofING’splantorestructurearoundcoreEuropeanoperationsinordertopayback

thebailoutmoneyprovidedbytheDutchgovernment.

Duringthequarter,INGcompletedthespin-offofitsU.S.-basedassetmanagementbusiness,INGU.S.

(NYSE:VOYA).Thecompanytookinnearly$550millionincashproceedsthatwillbeusedtoshoreup

its balance sheet and buildupa stash torepay the Dutchgovernment. AsVOYAshares have risen

steadilysincetheIPO(up52.8%to-date), INGhasdivesteditselfofyetmoreshares,bringing itstotal

ownership interestto71%. By theendof2014,INGwillsellyetmoreshares,targetinganownership

stakeoflessthan50%,atwhichtime,thecompanywillalsohaverepaidthefullextentofitsbailout.

Oncethisisdone,INGshouldbeabletoreinstateadividendandcommencebuybacks,offeringfurther

opportunityforupside.

SiemensAG(NYSE:SI)+21.92%

SiemenswasanotherlaggardinourQ1reportwhohasbeenaleaderoflate.Whilealsoabeneficiaryof

Europe’sresurgence,Siemensdidhavesomenewsofitsown.Duringthequarter,thecompanywarned

onitsannualprofitandmargingoals,thenproceededtofireCEOPeterLoescherbeforereplacinghim

withCFOJoeKaeser.KaeserhasalonghistorywithSiemensandthusfarhasbeenperceivedbythe

marketas therightpersonto restoremanyofSiemensoperatingsegmentstoindustryaverageprofit

margins. While only timewill tell whether this judgment by the market is correct, should Kaeser

succeed,thecompanywillbeworthwellinexcessofourpresentfairvaluetargets.

Siemensisadiversifiedconglomerate,whichunderKaeserwillcontinueitsfocusonsheddingnon-core

andnon-performingdivisions.Inthepastquarter,thecompanyspunoffitslightingdivision—Osram—and sold its joint venture interest in Nokia SeimensNetworks. Both initiatives took loss-generating

divisions out of the company’s responsibility, and should help a focus on improving operational

efficienciesintheremainderofthecompany.

7http://www.rgaia.com/march-2013-investment-commentary-what-do-we-own/8http://www.rgaia.com/july-2012-investment-commentary-europe-one-year-later-our-conviction-remains/



WelovetheroleastocklikeSiemensplaysinourportfolio.Thecompanyhasareallystablenon-cyclical

business that is a stellar sector in andof itself (healthcare), a well-positioned, butunderperforming

cyclicalbusinesses(CitiesandInfrastructure),andalthoughthereissubstantialEuropeanexposure,the

companyhasaglobalrevenuebase.

TheLaggards:

CreeInc.(NASDAQ:CREE)-5.70%

SomecontextisnecessaryinCree’splaceasa“laggard,”forthestockisup77.13%ontheyear,andwas

ourtopleaderinthefirstquarter’sLeadersandLaggards.Thereislittlenewtoaddtoourpointsmade

onthecompanyinthepast.Wesimplyneedtoreiteratethatthefundamentalsinthisstockcontinueto

moveintherightdirection,thoughit’sclearthatintheshort-termthestock’spricehadaccelerated

aheadofthegrowthinintrinsicvalue.Thisisnotacompanywewouldcall“downrightcheap,”thoughit

isonethatisaworthwhileholdforpositionsestablishedinthe20sand30s.Allalongwehavebeen

anticipating2014 as theyear foracceleration in LEDdemand, andCree’s technological prowess has

pulledforwardsomeofthisdemandinto2013.Thisisagreatthing,forwhenwediscountcashflows,

moneyearned todayisworthmore thanmoneyoneyearhenceand 2014remainson track tobea

breakthroughyearfortheLEDlightingindustry.

BerkshireHathawayInc.(NYSE:BRK.B)-3.70%

Berkshirehasbeenaslowandsteadygainerforus.Duringthequarter,wetooktheopportunitytotrim

fromahighconviction5%positionincoreaccountstoa3%normalsizedallocation.Thiswassimplydue

tothestock’sappreciationtowardsourestimationoffairvalue.WeareallfamiliarwithBerkshire,and

of course, its Chairman and CEO, Warren Buffett. We view Berkshire as one of the penultimate

collectionsofsupremelyhighqualitybusinesses,acrossdiversesectorsoftheU.S.economyandexpect

thecompany’scultureto drivecontinuedcompoundingof shareholdercapitalregardlessofwhenold

agecatchesupwithMr.Buffett.Inthemeantime,wewillremainpatientwiththestockasanormal-

sized,coreposition.

TevaPharmaceuticalIndustries(NASDAQ:TEVA)-3.62%

ThisisTeva’sfirstappearanceinthelaggard’ssection,thoughontheyear,ithasbeenoursinglemost

disappointinginvestments.Thepharmaceuticalsectorhasenjoyedaquietresurgence,whileTevahas

beenleftbehind.Despitethis,ourconvictionhasnotwaveredonthecompanyandweviewthisstock

asaformoftimearbitrage,whereweareessentiallypaidtowait.Tevahasanearningsyieldonits



equityofgreaterthan10%andwillusehalfofthatmoneytoreturncapitaltoshareholdersintheform

ofdividendsandsharerepurchases.

Thecompany’ssharescontinuetosufferunderthepressureofreplacingitsleadproduct—Copaxone—

onceitspatentexpires.Wethinkthemarketisoverlypunitiveinitsestimationofthelossofearnings

fromCopaxone.Moreover,Tevaremainsthelargestglobalmanufacturerofgenericproducts,andinthe

handsofnewCEODr.JeremyLevin,wethinkthepossibilitiesforimprovedresultsaretremendous.Dr.

Levin is one of pharma’s premier capital allocators and is one of the key reasons why his former

companies,Novartis andBristol-MyersSquibbfind themselvesbetterpositioned thanother large-cappharmaceuticalsinthefaceofthedreaded“patentcliff.”Dr.Levin’sexperienceasadoctor,abusiness-

modelinnovatorinpipelinedevelopmentandasaprivateequity-basedbiotechinvestormakehimthe

perfectguide forTeva’s transition froma growth company toa value-based stewardof shareholder

capital.

Thankyouforyourtrustandconfidence,andforselectingustobeyouradvisorofchoice.Pleasecallus

directlytodiscussthiscommentaryinmoredetail.YoucanreachJasonorElliotdirectlyat516-665-

7800.Alternatively,we’veincludedourdirectdialnumberswithournames,below.

Warmpersonalregards,

Jason Gilbert, CPA/PFS, CFFManaging DirectorM: (917) [email protected]

Elliot Turner, Esq.Managing DirectorM: (516) [email protected]



[This page is intentionally left blank]

Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment

Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any

responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These

views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth

above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio.

Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented

herein, RGA shall furnish to any person upon request a tabular presentation of: (i) The total number of shares or other units of

the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors,

trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as

maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or

range of dates during which the securities listed in response to item (i) were purchased .

rga investment advisors q3 2013 commentary

Documents