Stein's Law

Herbert Stein, Chairman of the Council of Economic Advisers under the Nixon and Ford administrations, came up with a principle many years ago that has guided me over several decades of professional investing. Stein’s Law, as it is now known, is simply this: “If something cannot go on forever, it will stop.” In other words, unsustainable trends are unsustainable. 

Let it (the Investing Herd) Go

It never ceases to amaze me how time and time again so many investors fail to heed this basic rule of the universe. Respect for the cyclical nature of just about everything gets chucked out the window as trends of the day gather more and more followers (and investment dollars). I’m not complaining, because this works to our advantage. Let me explain.

I believe that one reason FIM Group has succeeded over the years is this: We’ve refused to follow the herd during times when it throws Stein’s Law to the wind. For example, during the late ’90s Internet boom, we generally said “no thank you” to the highly popular and ridiculously expensive dot-com stocks. Many felt that these stocks were on a straight-line path to the moon, but our rational analysis suggested otherwise. And in the ’08-’09 Global Financial Crisis, when the crowd panicked and priced even the highest-quality companies as if they would go “poof,” what did we do? We held our ground and stayed invested as others chose to cash out at incredibly (and temporarily) depressed prices. 

2015: The Year of Cyclical Forgetfulness?

Last year was interesting for many reasons, but a standout for me was the “cyclical forgetfulness” that plagued investors in two very different areas of the market. On one hand, we witnessed a late-’90s-like wave of investor euphoria for “new economy” stocks. Think Amazon, which posted a 117% total return for the year, and Netflix up even more at 134%. Yes, these companies are seeing significant business success at the moment, but will they continue to grow at a pace that justifies market valuations of more than 400 times last year’s earnings? Maybe. But so far this year (as of February 12), both stocks have lost a quarter of their value. Those who loaded up on shares after last year’s stellar results are discovering Stein’s Law the hard way.

On the other hand, 2015 saw a second year of massive declines in the price of oil. After dropping 45% in 2014, West Texas Intermediate Crude Oil (WTI) dumped another 30% in 2015. And just five weeks into 2016, WTI plunged another 25%. Putting this extraordinary move in dollar terms, WTI went from $107/barrel in the summer of 2014 to sub-$30 today. Will this trend continue right on down to zero? 

Stein’s Law, and common sense, would suggest not. Are oil markets temporarily oversupplied? Absolutely. Will oil prices below the cost of production persist forever? No way. Yet segments of global financial markets today are reacting as if the new normal will be one where oil companies can somehow figure out a way to sell their product below cost forever.

Oilmageddon Dislocations

As our team highlighted during our February Investment Team Webinar (posted at www.fimg.net), we have identified several investments offering compelling value that are currently being impacted by the “oil price heading to zero” mentality in markets today. I’ll add a few comments to one specific example here, with Immofinanz. Suzanne writes about another area of markets where prices seem to reflect too much Oilmaggedon thinking: senior loan funds. 

Half-Off European Real Estate Sale

Immofinanz (Schwab ticker: IMMZF) is a leading Austria-based property company that combines property rental (roughly 80% of earnings) with property development (20%) across 391 European office and retail properties. Its net asset value per share (assets minus liabilities) is around EUR4.10 and its share price (February 12) is EUR1.72.

So why so cheap and what does European property have to do with the oil price slump? One answer to both questions can be found in the fact that about 25% of the Immofinanz property portfolio is located in Russia. The company’s five standing investments there are all large retail properties like the one pictured, and these are feeling the brunt of Russia’s current recession. Oil is a huge part of the Russian economy, and its price slump has coincided with a big drop in the ruble, double-digit inflation for consumers and slumping wages (see Wages Contract chart below). 

For Immofinanz, the Russian economic funk has several temporary ramifications. First, it has been offering short-term rent reductions to keep its tenants in place (these properties are now around 85% occupied). Second, it has written off some rent receivables for tenants who went belly up. Third, it has marked down its property values to reflect the current weakness in rents.

Management must also keep focusing on the other 75% of its business outside of Russia and continue to build long-term shareholder value. We think it’s doing a pretty good job of that despite these tough conditions and that several initiatives underway this year will bring the company back onto the radar of oil-spooked investors. These initiatives include disposing of its legacy holdings in logistics and residential properties and re-establishing a sustainable dividend policy.

In short, we believe that Immofinanz trades at a market price far disconnected from the underlying value of its income-producing properties. The negative stigma currently attached to its Russian assets seems to be the primary culprit for this disconnect. Simply trading back to levels in line with the average Austrian property company (10% discount to NAV), would provide us significant upside given Immofinanz’s more than 50% discount today. Add the resumption of a 3%+ dividend stream this year and the potential for longer-term normalization of operating conditions in Russia, and you can see why we remain excited about this holding.

16Mar-wages1.png

Staying Level-Headed

There is no doubt that today’s global economy gives us plenty to worry about as your investment managers. Trillions of dollars of negative interest rate government bonds outstanding, relentless terrorism, refugee crises, potential currency wars, a sure-to-be divisive U.S. election season and the list goes on. What I know is that Stein’s Law is pretty darn robust and that we will continue to let it guide our broad thinking. This will help keep us level-headed when the herd gets overly exuberant about trends of the day and well-prepared to seize opportunities when this exuberance shifts to panic and drives bargains our way.