Friday File: Two Buys, Two Stop Loss Triggers, and earnings updates

by Travis Johnson, Stock Gumshoe | November 3, 2017 7:00 pm

Checking in on the real money portfolio -- one sell and two buys, plus comments on CRTO, OHI, GOOG, FB, AAPL, DLPH, BABA, DSEEX, SHOP, FFH.TO, MPW and SWKS. Phew!

Today I’ll start by stating the obvious: One of the great problems with being an investor is that you can’t know for sure beforehand what’s a dip and a buying opportunity, and what’s the beginning of a long-term decline or a crash.

That’s what sticks in my craw about mechanical stop-loss trading, because it doesn’t make any sense if you’ve done your research, understand the prospects for the business, and are committed to the long-term value of a company or an asset and want that exposure in your portfolio… but it does make you feel good, and it does help to avoid many catastrophic investments, even as it presents you with another challenge: When or what to buy with that money? Being out of the market entirely for long periods of time, or even heavily in cash, is a huge drag on a portfolio — mostly because a huge portion of the market’s gains tend to come in very brief periods of time, and at times when investors are feeling fairly uncertain.

You’ve probably heard some of the stats on this, but one example is that a “buy and hold” investment in the market in the beginning of 1995 would have returned almost 10% a year if held until the end of 2014, 20 years. If you take out just the ten best days of market performance from those 20 years, that average annual return drops to 6.1%… and a lot of those “best days” happened pretty close to some of the worst days, sometimes as a bounce-back after a steep decline, so if you happened to sell after the market drop on a stop loss, you would likely have been too gun-shy to buy right back in to capture the possible recovery. That’s why buy and hold performs better than the average investor, because most of us have a tendency to sell low (get out of the market after a scary fall) and buy high (only get back into the market after it has recovered and it feels better).

We would all like to believe that we’re not “most people,” of course — just like most drivers consider themselves to be above average… but most of us fall prey to the same psychological bugaboos. It’s really hard to sell a stock that made you feel smart when you bought it. It’s hard to change your base assumptions about a company after you’ve invested. And it’s really, really hard to buy a stock back at a higher price after you sold it on a “stop loss.”

But even if I don’t feel comfortable automatically following any trading signal, can we use stop losses as a way to force some discipline when it comes to individual stocks? The most important benefit of a stop loss order, I think, is that it keeps you from misjudging a declining company for years and years as it fades into irrelevance — a psychological check against hubris, because once you’ve researched and committed to a stock and feel you understand the prospects (and probabilities of success) well, it’s very easy to become stubborn and put on blinders so you miss real underlying problems that let you ride a stock down for years.

Both long-term declines for individual stocks, and crashes and bear markets that hit almost all stocks, happen with some regularity in the stock market, despite the fact that “buy the dips” has been the safest strategy of all for the past few years (at least for “growth” stocks).

So what do I do? I don’t mechanically follow stop losses for all of my positions, though I do give them a lot of weight when it comes to stocks that are trading on momentum and don’t have underlying fundamentals that I can think of as a foundation for the shares. So I do watch the stop loss triggers, and I share those “Smart Stop” levels from Tradestops with the Irregulars in the Real Money Portfolio… but instead of automatically following the price trigger with a sale, I take them as signals that I need to reassess the investment, see if I have good reason to believe that the market is overreacting… and let it stop out if the position is not one I’m committed to or would buy at these levels, or if the story or my understanding of it has changed.

Why do I bring that up again this week? Well, a couple more stop losses have triggered in my portfolio — Criteo (CRTO) and Omega Healthcare Investors (OHI), both following their earnings reports that disappointed in some way. So what have I done?

Well, I’ve sold out of Criteo (CRTO). This is a position I reduced earlier in the year as risk rose, and now that they have quantified the impact of Apple’s anti-tracking initiatives (though they do say they have some ways to get around them for some data), the growth doesn’t seem likely to re-accelerate for Criteo.

They are profitable, they do have a strong core customer base, but they don’t seem to be able to move beyond that — and they have not attracted a takeover, despite the rumors along those lines over the past couple years, so I’ll follow the trigger alert and sell. My reason for buying in the first place in the high $20s, and holding over the years (with some trading in and out), was that the stock was more profitable and reasonably valued than most in the ad-tech space, particularly among the smaller players.

That’s still true, but being “reasonable” in this space is not enough to thrive, not when Alphabet (GOOG) and Facebook (FB) are growing ad revenue at a faster rate despite their massively larger businesses — you need growth, and preferably accelerating growth if you’re a small company like Criteo. Criteo has held the benefit of the doubt for me for some time, mostly because it’s profitable, but the revenue growth has failed to recover over the past two years. Partly that’s because of currency effects, but not entirely… there is some indication that the growth is plateauing, and with analyst downgrades and the company’s own reduced guidance because of Apple’s changes, it’s quite possible that the stock could fall meaningfully further.

There is still opportunity to grow for Criteo, their customer relationships are strong and their technology works, but they haven’t been able to accelerate themselves out of their strongest niches, and security and tracking and privacy changes favor the larger players (they say they have workarounds, but only for some of that business… and if it becomes a game of chess between Criteo and Apple or Google when it comes to tracking and privacy rules in their browsers and mobile operating systems, Criteo loses), so I’ve let this stop loss sale go through and my multi-year position in CRTO ends up being thoroughly “blah” — I didn’t lose money on Criteo, but my investment in that stock certainly underperformed the broader market even if you credit the profits I’ve taken over the years.

The other big stop-loss trigger this week was in Omega Healthcare Investors (OHI), and that’s a tougher one to assess. The company has regulatory risk, as has always been the case — this is a REIT that owns skilled nursing and assisted living facilities for senior citizen care, whose operators are both focused on the need for capacity growth in the near future (the demographics are obviously appealing for this segment of the market as the baby boom generation heads into retirement years), and very much dependent on government insurance programs for a large portion of their revenue (and, therefore, in position to have their fortunes whipsawed when the rules for that insurance coverage change).

It’s not regulatory risk that’s hitting them right now, though, it’s counterparty risk — one of their major tenants is in financial distress, and that’s cutting into their forecasts for revenue and funds from operations (FFO) this year (and may reduce earnings from those facilities in the future, if they negotiate lower rents — as seems likely).

But on the flip side, OHI is also a strong dividend payer, and the drop that brings us to our stop loss trigger also bumps the dividend yield up above 9% — with no indication from the company that they are going to be unable to keep paying the dividend (or even keep growing the dividend — they’ve raised it by a penny each quarter for the past five years, including this quarter). They do not have a huge amount of leeway with the dividend, but that’s been true for a long time (and it’s one reason the stock has usually traded at an above-average dividend yield for the healthcare REIT segment — though the biggest reason is the concentration in skilled nursing facilities and the inherent regulatory risk).

Part of what appealed to me about Omega back in early 2016, when I first bought the shares, was the fact that it was crushed for reasons that didn’t have much to do with their ongoing business prospects. The stock fell because one of their competitors had a problem with one of its major tenants, which helped everyone to overreact to the risk in pretty much all of the healthcare REITs in February of 2016, and it dropped down to an unusually cheap valuation for a dividend growth REIT, with the dividend yield briefly popping above 8%.

Now, the dividend is above 9% for the first time since Omega started its “raise the dividend by a penny each quarter” trend five years ago… so it’s similar now to the yield it traded at back in the 2009 and 2011 drops. Dividend growth has slowed gradually over the past few years, since a four-cent annual increase in 2012 was about a 4.5% dividend growth rate but a four cent increase now, from these higher levels, is more like a 1.5% growth rate. So now we’ve got a company that yields 9%, is expected to grow that dividend at a rate that’s slightly slower than inflation, and it has hit a stop loss. What do we do?

With a dividend stock, for me it’s primarily a question of whether the dividend is sustainable and whether they can grow the payout. I am generally reluctant to sell a compounding dividend stock just because of a temporary disappointment, since they are such powerful investments over time if you let those small disappointments smooth out and those dividends compound into more dividends, but I do sell them sometimes. Retail Opportunity Investment Corp (ROIC), for example, was one I sold just recently, after a stop loss trigger, because dividend growth was slowing, the yield was insufficient if growth slowed, and there were real reasons to believe that their risk level had increased… and in the health care REIT space, Physicians Realty Trust (DOC) was also a sell back in June, because I determined that they weren’t really getting any per-share improvement in their financials, despite lots of acquisitions, and would likely be unable to become a “dividend growth” REIT in the foreseeable future.

In OHI’s case, the yield is obviously not insufficient… and a 9% yield makes up for the fact that they are not growing the dividend as fast as they used to. Interest rates are rising in general, which further pressures all income investments, but they are not going to rise so fast that a 9% yield that grows even at a very slow pace should be unattractive (after all, people are buying high-risk junk bonds that yield only 3-4% now). So the question is, has the risk level risen enough that I should follow the stop loss trigger? Is there a reason to believe they will stop paying this 9% dividend?

Omega’s Adjusted FFO came in at 79 cents per share in the last quarter, but that “adjustment” takes away the big concern — Orianna Health, one of their clients, is in trouble and they recorded $195 million in impairments on those Orianna leases during the quarter. The CEO’s comments indicate that they think they’ll end up dropping their revenue from those Orianna facilities by 20-25% (about $10 million a year, total) once those facilities are reorganized, likely under new operators (some have already transitioned to new operators)… but it’s also noteworthy that the reason for Orianna’s troubles is not a huge one-time issue, so that’s a little “red light” indicator of the tight margins in the business and the lack of room for error: Orianna’s occupancy rate dropped from 92% to 89%, and they grew revenue only 2% while expenses grew 6% over the past three years. It wasn’t a one-time regulatory change, it wasn’t a scandal or a crisis, it was just a business that teetered too far over into unprofitability for a relatively short period of time. I don’t know to what extent those problems were things that Orianna could have controlled better, whether they were the victims of outside circumstances or just victims of management that wasn’t quite good enough.

When it comes to Adjusted FFO, which is the metric OHI prefers to use, the numbers look like this:

Q317 .79 – dividend .65 – payout ratio 82%
Q217 .87 – dividend .64 – payout ratio 74%
Q117 .86 – dividend .63 – payout ratio 73%
Q416 .88 – dividend .62 – payout ratio 70%
Q316 .83 – dividend .61 – payout ratio 73%
Q216 .87 – dividend .60 – payout ratio 69%
Q116 .83 – dividend .58 – payout ratio 70%
Q415 .81 – dividend .57 – payout ratio 70%

So even without that “Adjustment” for the Orianna impairment, things are looking a little tough for Omega right now… but not desperate. The FFO guidance range for 2017 had been $3.40 for FFO, $3.42 for AFFO, and now it is $3.27 per share for AFFO, almost entirely because they won’t be recognizing revenue from the Orianna facilities until the actual cash rents are paid, probably in six months or so once the reorganization or transfer to new operators happens.

OHI also uses another cash accounting term that they call “Funds Avaialable for Distribution” (FAD), and that excludes non-cash revenues and capitalized interest to further clarify just how much cash the business is generating for the owners — and that comes in closer to flat year over year, at $150 million for the quarter versus $152 million last year (and $472 million YTD, versus $455 million for last year’s first three quarters). So on that front things are not getting markedly better… but they’re also not getting worse in a fundamental way.

OHI is also still profiting from the fact that their interest expenses are declining — each time they’ve refinanced a bond or gotten new debt financing for expansion, the rate has been lower. Revenues are more or less flat year over year, mostly because they didn’t get that $15 million or so in lease revenue from Orianna in the quarter that was expected. And they’re still signing deals with new tenants that often have cash rent returns of 9-12% a year on their investment, so there is clearly still both return potential and risk within this little REIT sub-sector as operators struggle with whatever changes come to the reimbursement models for assisted living and skilled nursing facilities.

So with all that, I remain on the fence — but even without Orianna, that $3.27 per share in AFFO for 2017 is more than enough to cover the dividend and keep it growing at this rate… so that’s worth holding for me, and I will keep my OHI shares despite the stop-loss trigger. I think the most likely explanation for the current share price weakness is that investors have overreacted to short-term bad news, something that is an almost universal tendency in the market. That said, it’s important to be mindful of risks and I wouldn’t be upset with you if you made a different decision — their closest competitors, like Sabra (SBRA), are also struggling right now (SBRA “missed” on their quarter this week, too, and is down about twice as much as OHI this year to date — mostly because they bought Care Capital (CCP), yet another skilled nursing REIT).

I don’t want OHI to be a huge part of my portfolio of healthcare REITs, but it is the highest yielder in the bunch (the others I own are Ventas (VTR), which I think of as a more diversified blue-chip healthcare REIT, and hospital owner Medical Properties Trust (MPW), which went through its own counterparty issues in recent years but came out well and saw its stock price recover nicely).

I also don’t want to add to my position here, which would be the ultimate vote of confidence, but I will let it ride as we see whether the Orianna issue is a resolvable and specific problem or an indicator of larger concerns in the sector. The stop loss I’ve used on OHI is the suggested volatility quotient stop of about 18% from TradeStops, which was hit at $28.90 or so — if you wanted to give it more room and use a 25% stop loss, that would be about $25.80… and my adjusted cost basis (including those reinvested dividends) is about $26.80, so that’s also a level that will catch my eye if we keep falling and this turns into an actual loss in my portfolio. For now, I think this is an overreaction, given the obvious need for more of the facilities that Omega operates and the relatively flexible balance sheet that they maintain… we’ll see if that thinking comes back to bite me.

Now that the uglier stuff is out of the way… how about the good stuff?

Apple (AAPL) released earnings last night, as you might have noticed. There won’t be any lack of coverage, of course, given that Apple for a long time has been the most popular and widely-held stock in the market, and remains the largest publicly traded company on earth by a pretty wide margin (it’s just about at the $900 billion mark now for market capitalization).

The world was in a tizzy in recent months about the iPhone X being late, and about orders not coming in for the third quarter because there was only a week of iPhone 8 sales in that quarter… but they still had their best revenue growth in years, and, while it remains truly an iPhone-dependent company, they are still growing those other revenue streams — the iPad recovered a bit after being left for dead, Mac sales were strong, and their services revenue (Apple music and iTunes, iCloud storage, etc) for all those locked-into-the-Apple-universe iPhone lovers is now becoming meaningful, and that helped, on the margin, to make up for the fact that iPhone sales are being pushed a little later into the Fall than usual.

I don’t know whether they’ll end up with a real breakthrough augmented reality device over the next couple years to take the baton from the iPhone, as we talked some about when I looked at Jason Stutman’s latest ad yesterday[1], but they don’t need it right now — the iPhone X, given its price and “differentness” (meaning it’s not just a slight update, as the 7 and 8 arguably were), could easily end up being the best-selling iPhone ever… which, given the late release date and slower rampup of sales this Fall, would mean that the next couple quarters for Apple could also show really substantial year-over-year growth.

Yes, Apple’s stock might come back down a bit from this latest surge, I have no idea (one guy was getting attention on CNBC yesterday for calling it a “screaming sell,” since “middle of the road” comments don’t get you any airtime)… but I’m certainly happy to hold here (I did take profits on a little over 10% of my position back in May). In a world of overpriced growth and consumer stocks, Apple is an underpriced blue chip stock — it’s underpriced primarily because of its size, I think, and perhaps a bit because of the concentration of risk in a single product, both of which are legitimate reasons to discount the stock a bit… so it might remain underpriced even as they do more share buybacks and raise the dividend, but they’ve also shown that they can still grow faster than expected sometimes and surprise the dozens of analysts who follow the stock. An easy hold here, though I’m not buying more — and it’s also a stock you don’t really have to fret about whether to buy or not to buy, since everyone with a diversified portfolio in index or mutual funds probably has close to 4% of their portfolio in Apple anyway… no one should have “fear of missing out” with Apple at this point.

Facebook (FB) reported another fantastic quarter, too, showing yet more dramatic revenue and earnings growth and continuing increases to the user base and to engagement… and more progress monetizing Instagram effectively, but, as has become habit over the past year or so, they also bummed investors out a bit with some Debbie Downer commentary about the massive investments they’ll be making in oversight and security following the Russian “hacking” and election interference scandals.

FB reported $1.32 in earnings per share on the quarter, substantially more than analysts had expected, and they also again reduced their forecasts for capital spending — which has been a trend all year, they first scared everyone by promising to spend huge amounts of money, and each quarter they “surprise” us by spending a bit less and reducing the spending forecast, and making more money.

The need for oversight is real — Facebook needs to help users sort fact from fiction, and they need more people (and continuing improvements to their AI) to make sure that ugly stuff like the Russian propaganda campaigns don’t make it through… though we also have to take some personal responsibility and get a lot smarter as human beings and learn to recognize propaganda and manipulative crap (I’m not holding my breath on that front)… it’s shocking how many people still have to be told that no, everything on the internet is not true, and “seeing both sides” doesn’t mean giving equal weight to evidence and innuendo.

But I digress. Facebook is probably going to talk up their investment in safety and security aggressively over the next few months, if for no other reason than that they’re trying to give Congress an excuse to let them self-regulate. If Congress has a bunch of hearings and yells at Mark Zuckerberg and Facebook’s lawyers and gets it off their chest without actually forcing any real (expensive) regulatory oversight for Facebook and their competitors, that’s great news for Facebook. And, frankly, if they put social media in a little bit of a chokehold that’s probably also good for Facebook on a relative basis — more regulation and more stringent requirements almost always cement the position of the incumbent and make the strong stronger.

I wouldn’t be surprised to see Facebook dip a few percent in the weeks to come as they continue to talk about spending more and focusing on users and privacy and security… and it’s possible that some analysts will start to bring down their forecasts given those new spending expectations — but I expect they’ll also have a record-breaking fourth quarter in their advertising businesses, as their big commercial customers are really just now getting used to relying on Facebook for massive branding campaigns and video ads, and advertising spending this quarter, with the economy in relatively good shape almost everywhere in the world, is going to be epically huge.

Any meaningful dip in Facebook remains a buying opportunity, I think, though it’s currently my largest position and I’m not willing to go further into “overweight” on the shares myself. The shares are trading at about 27X next year’s earnings estimates, and should grow earnings by 25-30% next year — it’s terrifying to think that a company this big can grow this fast, but that was also true when Facebook was a $200 billion company (it’s over $500 billion now). Great companies that are hugely scalable can grow faster than the market, even when they seem like they’re “too big to grow.”

And speaking of “giants that keep growing,” Alibaba (BABA) kept growing its pants off this quarter as well… with, again, no sign of a reason to think that growth will stop. I don’t hold BABA directly, but that certainly makes my long-term LEAP options look a bit better this week… and, as I’ve noted a few times, I think the options market continues to underestimate the continuing growth potential of the big Chinese tech companies — I want meaningful upside exposure to that growth, but want my risk to be clear and manageable, so I’ve been doing it with options.

BABA is really a half dozen large companies, and they seem to be all doing well — with Alibaba, like competitors Tencent and Baidu, also quite clearly dedicated to emulating Amazon and Alphabet and other big US tech firms as they spend massive amounts on R&D to push forward with artificial intelligence and other next-generation initiatives (and, in the case of Alibaba and ecommerce competitor, spending huge on real infrastructure to strengthen their fulfillment infrastructure). There’s risk in China, to be sure, particularly if there’s a real debt implosion from the scary banking sector or the real estate market, so there’s always the potential that Chinese stocks could fall by 30% in any given month if sentiment shifts… but I think we’re still not appreciating the growth potential of a bunch of the big China tech names at this point.

Skyworks (SWKS) reports after the market closes on Monday, and I am upping my SWKS position by a little bit going into earnings — assuming that the iPhome volumes are really going to pick up at Apple, Skyworks should show a really strong quarter and will probably issue optimistic guidance. The price has been sliding upward, but the stock is still very fairly valued for a growing supplier in a growing industry (and yes, as expected they’re still in the Apple watch as well as the iPhone 8 and iPhone X, per the X teardown released today[2]). My position in SWKS is now about 20% larger, we’ll see if my guess on earnings is right but I think the long-term prospects look good regardless of how the quarter reads.

Delphi (DLPH) had a “beat and raise” quarterly report this week as well, but they didn’t raise the fourth quarter forecasts as much as analysts had expected — perhaps partly because they want to be fairly conservative going into the spinoff that will happen early next year. The midpoint guidance for full year earnings for DLPH is now $6.75 per share, so the stock is trading at about 14X current-year earnings… and I continue to think that investors are not appropriately valuing the growth potential (and the possible higher valuation) we’ll see when Delphi’s electronic drivetrain and self-driving/car automation divisions are split from the traditional autoparts/drivetrain business. Sentiment about “peak auto” continues to push DLPH down, but I think they’ll outperform the sector pretty handily over the next year or two… I’ve also added slightly to my DLPH shares on the post-earnings dip.

Medical Properties Trust (MPW) beat by a little bit on both the top and bottom line, and continues to look relatively strong within the healthcare REIT space with a decent valuation and a strong 7% yield — though we haven’t yet heard whether they’ll be raising the dividend to close out this year, which would probably help investor confidence. This has been a stock to buy on pullbacks, not when things are looking rosy, so I’d hold back and wait until one of their hospital tenants gets in financial distress, or for a day when interest rates are climbing sharply, but I think this company is performing well and did a good job working through their latest tenant problem (hopefully that success will rub off on OHI, though the sub-sector is quite different).

Fairfax Financial (FFH.TO, FRFHF) reported[3] a really strong quarter, given the huge hit from the hurricanes. Mostly that’s because their sale of part of ICICI Lombard made up for the hurricane losses and boosted their earnings and book value, but the end result is that they posted a nice profit in the quarter and became a more valuable company again.

The underwriting performance was, as expected, very weak in the quarter — that will be true of all property and casualty insurers, since the hurricanes (and fires, and earthquakes) will certainly overwhelm their incoming premiums for the quarter… Fairfax overall reported a combined ratio of about 130 for the quarter, which is better than most that I’ve seen (Markel was at 134, Axis over 150, Berkshire should report tonight but probably had a very bad insurance quarter as well).

The book value per share now stands at about $415, up from $378 last quarter… and, as I’ve noted before, as soon as their next transaction goes through with Mitsui-Sumitomo, that will result in another $33 per share boost to book value (the deal is expected to close sometime in the next five months, but they await regulatory approvals). So after that deal closes, Fairfax, all else being equal in the interim, will have a book value per share of about $448. Paying up to 1.25X book value is pretty easy in this environment, particularly given the much higher valuation that most strong insurers trade at and the likelihood (or possibility, at least) that the insurance market will “harden” and underwriting discipline tighten (meaning prices go up) in the year to come… that would be about $560. The stock hasn’t traded that high since last year, and the all-time high is about $590, so there’s ample reason to keep nibbling on Fairfax if you can handle the volatility and risk brought by Prem Watsa’s big equity (and sometimes macro) bets. The stock dipped a bit on the news, down a couple percent today, so is below 1.2X book again… if it stays in this range or falls some more, I’m likely to keep adding (but haven’t done so this week — I last added shares at about US$516 a month ago).

Shopify (SHOP) finally had their earnings report, on Halloween — with no real surprises on the financial side, and no aggressive or specific defense of their affiliate marketing practices on the “responding to Citron” side.

At this point, even if they are doing something ugly on the affiliate side and not screening their affiliate marketers well enough (part of the Citron complaint is that Shopify is effectively using affiliates to sell their service as a “get rich quick” scheme), my sense is that it’s pretty minor. I’m satisfied that this perception is a focus of the company now, and I’m comfortable with the fact that SHOP’s client base will remain very long-tail… a few customers will become large and use SHOP’s highest level of service, most will be small, and a lot will go out of business eventually. That was true five years ago as well, but SHOP’s user base overall keeps climbing as they fight to maintain momentum and keep the edge on the (many) competitors. Sometimes you just have to trust the overall numbers… and the user base keeps growing, so unless there’s a “churn” number that hides some really terrible behavior (they don’t release churn rates), there’s no real red flag for me.

But yes, the stock is still overvalued. It will look overvalued as long as it’s growing fast, and it’s certainly still growing fast — the actual earnings report was excellent, as we’ve grown accustomed to from SHOP, and I don’t see anything else to worry about beyond the high valuation. I’ll let a stop loss trigger handle the overvaluation, since an overvalued stock can always grow dramatically more overvalued and this position is not large enough that I feel compelled to reduce my risk exposure or take profits at this point. SHOP stays a hold here.

Finally, I also had a small profit-taking trade in the real money portfolio — I sold a portion of my Intel (INTC) LEAP call options, in a trade similar to many I’ve made in the past… those options soared in value as INTC was rerated following its last earnings release (I expected the soaring, I didn’t expect it to happen immediately), so I sold enough to guarantee a decent-sized profit on the full investment and will let the rest ride to see if Intel really resumes some sort of growth trajectory. It’s a cautious move, not as aggressive as those who would always “let winners run”, but I’ve seen profits disappear quickly in options positions with a minor change in sentiment, so it usually makes sense to me to book a little profit so I can tolerate a big loss, if need be, in the remaining position.

And, as usual, that’s all reflected in the Real Money Portfolio[4] I’ve updated for this week. If you’ve got questions or suggestions, please send them along… and speaking of questions:

I got a question this week about one of the mutual funds I’ve written about, here’s what a reader sent in…

“What are your current thoughts on DoubleLine Shiller Enhanced CAPE? Since you spoke of it in August it has underperformed the S&P.”

Which is true. This DoubleLine fund (DSEEX) is essentially a “smart beta” fund — they try to use the Shiller CAPE to identify undervalued sectors, and rotate funds into those sectors each month… and since this is DoubleLine, which is primarily a bond management shop, they do so using derivatives and use their collateral to invest in bonds to try to juice the returns a little bit. You can see that August commentary he mentions here[5], though I first wrote about DSEEX in the Summer of 2016[6].

The third quarter report for DSEEX does illustrate that they have trailed the S&P 500 since June — and the underperformance has been worse since the end of the September quarter, frankly, so it could be that the massive outperformance that jumped out for our attention at the end of the June quarter was as strong as it was going to get, I have no idea. The differential between DSEEX and the S&P 500 has narrowed considerably now, though, whatever the reason, and the year-to-date total return is very similar to the S&P (17.13% for DSEEX, 16.88% for the SPY ETF). The three-year performance gap was built mostly during 2016, and there have been other periods during the short life of this fund that it has underperformed relative to the broader market.

The quarterly report from DoubleLine indicates that the bond portfolio contributed to returns in the quarter, but the quarterly performance was also actually fine, in line with the S&P, until mid-September. And mid-September is also when interest rates really jumped higher, with the 10-year rate going up by almost 20% from trough to peak, which likely had some impact on the NAV of the bond portfolio in the fund. In my examination of past periods of rising rates I didn’t see any indication that they should really harm DSEEX returns, but I bet that was a big part of the reason for the recent underperformance. When it comes to the actual Shiller CAPE sector rotation strategy, that has held up well for a long period of time and rarely underperformed the S&P for meaningful periods, so I’m pretty confident that has a chance to beat the market… and though DoubleLine will undoubtedly have periods of time when they’re caught flat-footed when it comes to interest rate changes, I expect they’ll be better than most at profiting from rising rates… and if rates do actually rise meaningfully, then the bond portfolio could be a meaningful ballast for the equity exposure and reduce downside risk somewhat if rising rates hurt the stock market.

So I’m not particularly worried, and I keep putting more money gradually into both DSEEX and the similar European fund DSEUX — DSEUX is less than a year old and has not yet demonstrated a tendency to beat the market — it trails the Vanguard FTSE Europe index ETF this year to date, 25% to 21% (and relies on a similar bond portfolio, and has also particularly underperformed since early September — probably not a coincidence). I don’t expect them to be dramatic outperformers over time, but I continue to think that DSEEX has a decent chance of long-term outperformance, particularly in weaker markets, and that this logic should carry over to Europe and DSEUx as well… I’ll try to remember to let you know in five years whether or not I was right.

And that’s where I’ll leave it for you today, dear Irregular. More to come in the week that awaits, I’m sure.

  1. I looked at Jason Stutman’s latest ad yesterday:
  2. X teardown released today:
  3. reported:
  4. Real Money Portfolio:
  5. August commentary he mentions here:
  6. wrote about DSEEX in the Summer of 2016:

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