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My $25,000 Bet against Buffett, One Year Later

Written by Nicholas Vardy, CFA.

SNAG Program-0809

There's no point in putting lipstick on a pig: March 2014 was a lousy time to bet on U.S. small caps.

It was exactly a year ago today that I bet investment manager David Rolfe that U.S. small caps would beat Berkshire Hathaway stock over the next 10 years.

Sure enough, the day we placed the bet, Berkshire leapt out of the starting gates.

Over the next nine months or so, Berkshire looked like a nimble Olympic sprinter competing against a sadly outclassed wannabe.

Berkshire — also a long-time recommendation in my newsletter The Alpha Investor Letter — went on to have a monster year in 2014 during which it absolutely crushed U.S. small caps. Chock full of large-cap names, as well as a slew of private investments, Berkshire soared 26.6% last year.

In contrast, U.S. small-cap stocks lagged badly, with the Vanguard Russell 2000 ETF eking out a 5.01% gain for all of 2014.

Even more impressively, Berkshire delivered its strong performance despite highly publicized flops in Tesco (TSCO) and IBM (IBM), as well as equally uninspiring performances in long-time stalwarts like The Coca-Cola Company (KO) and Exxon Mobil Corporation (XOM).

Looking for a Better 2015

2014 was not a typical year, neither for Berkshire nor for U.S. small caps.

Relative to the S&P 500, this was Berkshire's strongest year since 2007.

Relative to U.S. large caps, U.S. small caps actually performed worse than they did even at the height of the 2008 financial crisis.

But extreme trends inevitably revert to the mean. And the more extreme the trend, the more pronounced the reversion.

In last week's edition of the Global Guru, I pointed out why I expect U.S. small caps to soar in 2015.

First, after a year of nearly record-breaking underperformance, U.S. small caps now trade at far more attractive relative valuations than the large caps that populate Berkshire's portfolio. The Russell 2000 trades at 19.82 times forward 2015 earnings. That's well below the 84.68 level of a year ago.

In contrast, U.S. large-cap stocks have rarely been this expensive, especially when viewed through the lens of the long-term Cyclically Adjusted Price-Earnings (CAPE) ratio. In fact, the last times U.S. stocks were this expensive were in 1928 and 2007. And we all know what happened the following years.

Second, U.S. small caps are purely domestic businesses, which have few, if any, international operations. In contrast, large caps face the headwind of the stronger U.S. dollar. A stronger dollar has already hit the revenue of 70% of the top 50 companies in the S&P 500 — including several of Berkshire's holdings.

Third, in 2015, U.S. small caps offer investors far better revenue growth prospects than their large-cap rivals. According to Bloomberg, sales per share are estimated to increase 6.6% this year for the small-cap stocks in the S&P 600. In contrast, Bank of America Merrill Lynch forecasts overall S&P 500 earnings growth to be flat in 2015.

Why I'm Not Eating Crow, Just Quite Yet

There are several more reasons why I am not ready to eat crow, even after such a lousy start to my long-term bet.

First, U.S. small caps' volatile performance cuts both ways. One out of three years, small caps tend to have a lousy year, and 2014 was clearly one of those. But as with many asset classes, lousy years are often followed by blow-out ones. That's also why I've been increasing my own personal exposure to U.S. small caps.

Indeed, U.S. small caps already are clawing their way back. Over the past three months — admittedly a short period — small caps have outperformed Berkshire by an impressive three-to-one, gaining 6.61% versus 2.02% for Berkshire.

In fact, Berkshire is actually in the red this year, even as major market indices are hitting record highs.

Second, Berkshire's track record over the past decade is nowhere near 2014's market-busting performance. No matter how you slice and dice it, Berkshire's returns have been waning over the past decade and a half. Up until the year 2000, Buffett's average annual return approached a remarkable 30%. Since then, these returns have shrunk to an annual average of 10.4%.

Size — that is, huge investments in large-cap stocks — is becoming Berkshire's enemy. Recall that during a five-year period, year-end 2008 to year-end 2013, the S&P 500 beat Berkshire's gain in book value per share. That was the first such period in Berkshire's history.

No wonder Buffett himself has advised his own heirs to invest in a low-cost S&P 500 Index Fund, rather than keep the money in Berkshire itself.

That's not exactly betting against yourself. But it is pretty close.

Despite 2014's strong performance, I don't expect that trend to improve over the next nine years.

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In 2015, Little Is the New Big

Written by Nicholas Vardy, CFA.

SNAG Program-0807

When it comes to stocks, "big" is sometimes little — and "little" is sometimes big.

Here I'm referring here to the recent performance of small-cap stocks versus large-cap stocks.

Small caps include stocks with a market capitalization of between $300 million and $2 billion. The bulk of these companies are ones you probably have never heard of.

Large-cap stocks consist of stocks with a market cap of more than $10 billion. These stocks make up a huge chunk of the S&P 500 and include all of the household names you know.

Diverging Performance

Large-cap and small-cap stocks differ not only in size, but also in terms of performance.

In 2014, large-cap stocks meant big returns, with the SPDR S&P 500 ETF (SPY) posting double-digit percentage gains of nearly 12%.

By way of comparison, returns to the small caps were indeed little, as stocks in the small-cap SPDR S&P 600 Small Cap ETF (SLY) eked out a mere 1.3% gain for the calendar year.

No wonder investors withdrew $31.5 billion from small-cap stocks over the past 14 months, according to research firm EPFR.

So far in 2015, the playing field for both big and little stocks has been far more level.

The S&P 500 has pushed its way to a 2.75% gain so far this year, while both the S&P 600 and the iShares Russell 2000 (IWM) are up 2.4% year to date.

While these two market segments are running neck and neck so far in 2015, I expect small caps to overtake their large-cap rivals between now and the end of the year.

And I'm not alone.

The latest weekly data from EPFR showed that investors increased inflows into small-caps by $31 million — a trickle that I expect will turn into a flood before the year is out.

The Small-Cap Tailwinds

In 2015, small-cap stocks have the wind at their backs.

First, after a year of underperformance, small caps now trade at far more attractive relative valuations than their big-cap brethren. The S&P 600 now trades at roughly 20.3X forward 2015 earnings. That's much lower than the trailing 20-year average, and well below their level at the start of 2014. In contrast, large-cap stocks have rarely been this expensive.

Second, there's the relative strength in the U.S. economy. Growth in the U.S. economy — whether measured by gross domestic product (GDP), employment numbers, manufacturing PMIs — is a boon for small-cap companies.

The reason here is quite simple. Most small-cap companies are purely domestic businesses whose fate is closely tied to the U.S. economy. U.S. small caps have few, if any, international operations.

That means small caps are immune to the drama playing out with Greece and the European Union, the tenuous ceasefire between Russia and Ukraine and the attempt by the European Central Bank to reflate its sagging economy via the Old World version of quantitative easing.

It is the big guys — the large-cap multinationals — that make up the S&P 500 and sell much of their goods to Europe and the Far East, which are suffering from these challenging developments.

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Why I Expect Global Value Stocks to Beat the S&P 500 in 2015

Written by Nicholas Vardy, CFA.

SNAG Program-0806

Yale University Professor and Nobel Laureate Robert Shiller was back in the news last week, warning that the U.S. stock market is bordering on bubble territory. Trading at a cyclically adjusted price-to-earnings (CAPE) ratio of 27.8 compared to a long-term average of around 16, by this measure, the U.S. stock market is overvalued by over 70%.

For the uninitiated, CAPE is a variation of the traditional price/earnings ratio (P/E). Rather than simply looking at the most recent year's earnings, CAPE values the stock market using a trailing 10-year average of inflation-adjusted earnings. Taking a 10-year average of the price-earnings (P/E) ratio smooths out the extremes of the business cycle.

Despite its recent popularity, CAPE is not the "Holy Grail" of investing. In fact, rival academic stock market guru Jeremy Siegel at the University of Pennsylvania's Wharton School has argued that CAPE makes stocks seem more expensive than they actually are due to changes in accounting standards in the 1990s.

Nevertheless, a look at global stock markets ranked according to CAPE is revealing.

The U.S. stock market is, by a wide margin, the most expensive major stock market in the world. Only tiny Denmark trades at higher valuations.

This is not surprising, as both the United States and Denmark have been among the top-performing stock markets since the financial markets bottomed in March 2009.

That should give you pause...

Even as the U.S. markets hit record highs, the U.S. bull market is getting long in the tooth. Thanks in large part to collapsing earnings in the energy sector, some analysts are predicting the S&P 500 will see no earnings growth at all in Q1 of 2015. That would make it the worst quarter for S&P 500 earnings since Q3 of 2009, not long after the United States emerged from its recession.

So, what's the antidote to buying expensive U.S stocks with stagnating earnings?

Just do the opposite...

Buy global stocks. And buy value.

Taking CAPE Global

Cambria Investments decided to examine whether Shiller's approach applies in global stock markets.

Sure enough, Cambria's research confirmed that the value investor's strategy of selling what's expensive and buying what's cheap works on a global playing field as well. Put another way, stock market returns are lower when starting valuations are high, and future returns are higher when starting valuations are low.

Launched in March 2014, The Cambria Global Value ETF (GVAL), a current recommendation in my investment service, The Alpha Investor Letter, uses an approach similar to Schiller's, but applies the CAPE methodology to 45 major world markets.

Using CAPE as an initial screen, and after narrowing the markets down to the cheapest 25% in the world and which also have market caps larger than $200 million while avoiding overconcentration in any single country, Cambria generates — and invests in — a portfolio of 100 global value stocks.

Why I Expect Global Value to Work

First, global stock markets have been out of favor for so long that they are far overdue for a monster rally. And in my experience, once global stock markets take off, the best-performing markets can double and triple in relatively short order.

I just don't see the same kind of upside in the U.S. stock market over the same time frame.

Second, the Cambria Global Value ETF invests in the cheapest markets in the world. So when global markets do rebound, I expect the bounce in these markets to be the sharpest and quickest.

Third, stock markets eventually revert to the mean. Stock markets that are overvalued — such as the United States — tend to stagnate, and undervalued markets do tend to recover over time. Given the valuation gap between the United States and the rest of the world, the case for global value has rarely been more compelling.

Finally, most global value stocks are small- and mid-cap stocks. All other things being equal, small-cap stocks generate higher returns over the long term. While this insight was developed and tested as it applies to the U.S. stock market, further research has confirmed that this applies to global stock markets as well.

The Psychological Challenges of Value Investing

The idea of applying the tenets of value investing to global stock markets is not new.

After all, assembling a portfolio of global value stocks was the secret behind the long-term investment success of the father of modern global investing, the late Sir John Templeton.

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Investing in the ‘Internet of Everything’

Written by Nicholas Vardy, CFA.

SNAG Program-0803

If you're reading this, you're on the Internet — but are you on the "Internet of Everything?"

If you think this sounds like another buzzword that tech-savvy Silicon Valley-types throw around to sound sophisticated... well, you're right.

That said, the Internet of Everything is a game-changing phenomenon that is already becoming a disruptive force in the marketplace.

It is also a trend that can make you big money as an investor.

So, what exactly is the "Internet of Everything?"

Often referred to simply as the "IoE," the Internet of Everything is the connection of people, data and objects to the Internet, as well as to other smaller, more local networks.

Already, millions of "intelligent" devices are being designed to link up to the IoE.

This allows the end user a higher-quality, more integrated experience with countless devices that today you'd never expect to be part of the IoE.

A Megatrend That Won't Be Denied

Today, you likely have an Internet connection via a DSL/cable modem or corporate router. That's the traditional way to connect to e-commerce websites like Amazon.com (AMZN) or eBay (EBAY), video streaming services such as Netflix (NFLX) or music streaming/downloading services such as Pandora Media (P) or iTunes from Apple (AAPL).

Yet, thanks to the burgeoning growth of smartphones and a plethora of other devices now connected to the Internet, the number of devices that are part of the IoE in your household is set to explode.

Within a few years, home appliances, medical devices, gaming consoles, industrial machinery, home entertainment systems, smart meters and security systems all are set to become what are called "non-traditional wireless access points."

And this is a megatrend that won't be denied. Just ask Internet pioneer and Cisco Systems (CSCO) CEO John Chambers.

Chambers estimates the IoE could soon become a $19 trillion market. To put that number in perspective, that's about $2 trillion more than the current size of the U.S. economy.

Chambers says IoE will be the biggest single trend in high tech in the coming decade. And, the best part is that we are barely out of the starting gate.

According to a Swedish telecom provider, the average user accesses data on her smartphone 151 times per day. Swedish handset maker Ericsson (ERIC) also estimates the total number of devices subscribed to mobile networks will reach 9.3 billion by 2019, of which about 60%, or 5.6 billion, will be smartphones.

As it turns out, smartphones will end up being only a small part of the total number of connected devices. In 2012, only 8.7 billion devices (including smartphones) were connected to the Internet. By 2020, Morgan Stanley (MS) estimates that number will rise to more than 70 billion.

That's 10 connected devices for every man, woman and child on planet earth.

And the IoE Winner Is...

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GLOBAL GURU CAPITAL – MONTHLY UPDATE

Written by Nicholas Vardy, CFA.

GLOBAL GURU CAPITAL – MONTHLY UPDATE


January 2015

The "Ivy Plus" Investment Program gained 0.30% for the month.
The "Global Gains" Investment Program rose 0.11% for the month.
The "Double Your Dividends" Investment Program added 0.43% for the month.
The "American Alpha" Investment Program lost 3.42% for the month.
The “Masters of the Universe” Investment Program rose 0.02% for the month.

THE "IVY PLUS" INVESTMENT PROGRAM
BIG MONTH FOR REAL ASSETS


The "Ivy Plus" Investment Program gained 0.30% for the month. The program is up 0.30% year-to-date, through January 31.

With all U.S. stock market strategies ending the month in the red, it was the positive performance of international stocks- both in developed and emerging markets- that steadied the performance of the “Ivy Plus” Investment Program in January.

Alongside Developed Markets Large Cap and Developed Market Small Cap stocks, it was two specialist emerging markets strategies- Emerging Markets Small Cap and Emerging Markets Low Volatility – that eked out gains in January.

But it was the “real assets” portion of the Ivy Plus investment Program that were the month’s strong performers. US Real Estate soared 6.85%,  and International Real Estate jumped 2.65%. Long underperforming timber and agriculture also recorded gains of 2.30% and 1.37% respectively. Managed futures- no doubt benefiting form the strong trends in global currency markets- also managed a gain of 1.49%.

The “Ivy Plus” investment program positions performed as follows:

 

Monthly Gain

YTD Gain

Equities

 

 

 

 

 

US Large Cap

-2.74%

-2.74%

US Mid Cap

-2.01%

-2.01%

US Small Cap

-2.14%

-2.14%

Developed Large Cap

0.71%

0.71%

Developed Small Cap

0.28%

0.28%

Emerging Markets

-0.20%

-0.20%

Emerging Markets Small Cap

0.72%

0.72%

Emerging Markets – Low Volatility

1.18%

1.18%

Private Equity

-0.55%

-0.55%

Business Development Companies (BDCs)

-0.77%

-0.77%

S&P 500 Equal Weight

-2.92%

-2.92%

S&P 500 Dividend Payers

-2.75%

-2.75%

Initial Public Offerings (IPOs)

-2.27%

-2.27%

Corporate Spin-offs

-1.07%

-1.07%

 

 

 

Fixed Income

 

 

 

 

 

US Treasuries

2.40%

2.40%

Foreign Bonds

-1.57%

-1.57%

Inflation Protected

3.23%

3.23%

High Yield Bonds

0.09%

0.09%

 

 

 

Real Assets

 

 

 

 

 

US Real Estate

6.85%

6.85%

International Real Estate

2.65%

2.65%

Timber

2.30%

2.30%

Agriculture

1.37%

1.37%

 

 

 

Hedge Funds

 

 

 

 

 

Global Macro

-0.11%

-0.11%

Hedge Fund Long/Short

-1.70%

-1.70%

Managed Futures

1.49%

1.49%

Hedge Fund Managers

-5.69%

-5.69%

THE "GLOBAL GAINS" INVESTMENT PROGRAM
GLOBAL STOCK MARKETS: BETTER THAN THEY LOOK


The "Global Gains" Investment Program rose 0.11% for the month. The program is up 0.11% year-to-date, through January 31.

Global markets had a slightly positive month with emerging markets leading the way.  Developed market strategies were not far behind. Frontier markets had the worst month, as they were hit by the continuing drop in oil prices.

Global stock markets are much stronger than their performance in January would suggest.  That’s because global markets are facing the headwind of a rapidly appreciating U.S. dollar. Some developed markets in Europe actually gained close to double digits in January in Euro terms. Those gains almost evaporated once they were translated back into U.S. dollars.

Once the sharp moves in currencies abates, as it inevitably will, I believe global stock markets will generate larger and more sustained gains for U.S. dollar investors in the months ahead.

The “Global Gains” investment program positions performed as follows:

 

Monthly Gain

YTD Gain

 

 

 

Emerging Markets Low Volatility

1.18%

1.18%

Emerging Markets Small Cap

-0.74%

-0.74%

Frontier Markets

-2.95%

-2.95%

International Markets – High Quality

1.10%

1.10%

International Dividends

1.30%

1.30%

Non-US Developed Markets

0.85%

0.85%

Global Emerging Markets

-0.02%

-0.02%

Non-US Developed Small & Mid Caps

-0.12%

-0.12%

Non-US Developed Large Cap

0.03%

0.03%

Non-US Small Cap

0.28%

0.28%

Global Guru Capital tracks 46 global markets on a monthly basis, tracking opportunities across the globe.

The top three markets in January- Egypt, Philippines and India continued their strength from 2014.

The top five performing global stock markets for the month were:

 

Monthly Gain

YTD Gain

 

 

 

Egypt

7.68%

7.68%

Philippines

6.88%

6.88%

India

6.35%

6.35%

Hong Kong

5.50%

5.50%

South Africa

4.26%

4.26%

The Greek market tumbled as a radical left wing party was elected to head the government, and put the current terms of Greece’s bailout at risk. Nigeria also suffered it own crisis as the price of oil continued to tumble.