Mark Twain, Market Strategist

I was reading over the Bain and Company Private Equity report over the weekend, and there was a key line that stood out for me. The report mentioned that “Resilient PE markets have provided a floor on sellers’ price expectations. Acquisition multiples reached record or near-record highs across the US and Europe, at more than ten times EBITDA in both regions at the start of 2016. In a recent Preqin survey, buyout GPs overwhelmingly cited deal pricing as the biggest challenge facing the industry.” Assets are getting expensive, and it is tough to get deals done at a reasonable price.”

Bain analysts added “And there’s a new wrinkle: Every month brings us closer to what many consider an inevitable next recession. Assumptions that GPs now build into any deal model for market beta—future multiple expansion, GDP expansion, leverage—have turned more bearish. GPs find it increasingly difficult to pencil out how assets bought at prices today will achieve targeted returns.” It is going to be tough to get money to work at prices that will allow private equity firms to get the returns their Limited Partners expect.

The report goes on to outline way firms may search for deals that offer adequate returns but the truth it is going to be difficult to get large sums of money to work. PE firms continue dot do a lot of selling in 2016. While not quite up to the record setting pace of 4014-2015 2016 was still one of the biggest years in PE exits with about $300 billion of assets sold in one form or another. Combine this with strong fundraising in a return starved world and cash is piling up at PE firms. There is currently about $1.47 trillion in dry powder waiting to be invested. $534 billion of that is earmarked for traditional buyout funds.

Private equity fund managers are going to have to cut back on their expectations or begin to look for riskier deals with higher potential returns The Bain reports notes that “As a result, GPs who aspire to generate the strong returns that a “2-and-20” model demands will have to take on more risk or get more creative in putting money to work. The standard formula for GPs cannot accommodate the prices paid in the middle of the fairway. PE funds are getting pushed into the rough and the sand traps, where the higher-risk deals live.” The private equity firms that reach too far will fare poorly in my opinion. Those who sit on their cash and wait for their deal at their price will do very well, but patience is a difficult chore in a world dominated by short-term thinking.

The tone of the report is optimistic about the PE industry but suggests that high valuation will make it harder to find deals that yield the returns investors have come to expect from private equity funds. PE funds are selling a lot of assets and cash is piling up as they wait for better pricing to deploy the money.

Compare the cautious tone of the private equity folks to this weekend’s front page headline in the Weekend WSJ. Just above the fold was an article titled Small Investors Run to ETFs. $124 billion has gone into ETFs so far in 2017, and retail investors have accounted for about 85% of that volume at Blackrock according to the article. Nine years after the market bottom investors are finally getting excited about stocks. A lot of the money has gone onto S&P 500 ETFs but here has been a lot of buying in sectors investors think will fare well under President Trump. The Financial Select Sector SPDR ETF has attracted more than $8 billion in assets since the election. Given that the fund has about $26 billion in assets that is a huge asset build.

When retail investors are rushing to throw money at the market, it is a good time to rethink your portfolio. As Mark Twain since suggested, “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

Last week I put hedges in place for the first time in 8 years.

More Banks, Baseball and Books

I had a chance earlier this week to sit down and chat with Robert Hendershott of Context BH Capital. Context is a fund the employs an event-driven, long/short investment strategy focused on the community and regional banking sectors. They invest in banks that are acquisition targets of aggressive consolidators and capturing takeover premiums in advance of acquisition announcement and select merger arbitrage transactions post-acquisition announcement.

This firm was built from academia, not Wall Street. Mr. Hendershott was a professor at Santa Clara University where he wrote several papers about the likelihood of banking consolidation once interstate banking regulations were relaxed. He realized that there was money to be made here and in 1998 he became an advisor to a hedge fund and eventually struck out on his own. In 2010 he started managing individual separate accounts and started the fund in 2012.

Mr. Hendershott pointed out that consolidation has been going on for a long time. When all this started in the late 1980s and early 1990s, there were over 16,000 banks in the United States. Today we are down to just about 6,000. He also noted that the number of publicly traded banks has stayed about the same over this time. The banks that have disappeared via M&A have been small private banks for the most part. He thinks that the thousands of smaller banks in the US are an endangered species right now.

He is cautiously optimistic about community banks in 201. If all the expectations of lowered regulations and tax cuts coupled with a growing economy and higher net interest margins today’s prices will be an excellent entry point. He is worried about the timing and form of all these changes and exactly who changes are made to banking regulations and tax code. I have said for since the election that if it all comes to pass it will be a community bank bonanza. Given that we are dealing with politicians and the legislative process there is a lot that can go wrong along the way.

He said several times that it is just not a lot of fun to run a bank these days and that provides an incentive to merge. The burden and cost of running a small bank today are enormous, and many bankers are suffering from what I have called exhausted board syndrome. They are tired, and the current improved pricing may spur some to ring the bell and sell the bank.

I share Mr. Henderhott’s views pretty much down the line. We will continue to see M&A activity and it will go on for years. We have too many banks, and consolidation has to continue no matter what happens in Washington this year. I worry about current valuations in the sector, but among the smaller banks, I can still find some banks to buy at bargain prices. The Trade of the decade continues and will for some time still to come.

SnapChat priced today, and I am supposed to have an opinion as a responsible observer of the financial markets. I have no idea what the stock will do, but my opinion is that this is a piece of crap. The valuation is ridiculously high, and corporate governance is non-existent as investors will be buying shares with no voting right. As near as I can tell the app exists so millennials and teenager can trade Boobie pics and has little to no practical purposes. I confess that I am very suspicious of parents who teens have the app on their phones and there is no chance in hell the youngest will ever have it while I pay for the phone. The stock will be priced at 60 times revenue at the IPO price. The corporate governance issues alone would keep me from buying the stock but the valuation ad some very real questions about exactly why we even need a company like this further my deep aversion and dislike for the stock and the company.

The market hit 21,000 on the Dow this week in a rapid fire move up from the 20,000 level it hit earlier this year. Wall Street is in love with this new President and his agenda but as Mr. Hendershott observed when discussing the bank there is a long way to go. He is the President to be sure, but he is not the Emperor. The key provisions of his plans have to be legislated, and it is clear from the behavior of the Democrats during Tuesday night’s speech they have no intention if playing along or cooperating in any form. They refuse to even agree with him when he agrees with their ideas. Tax and Regulatory reform are still a long way off, and stocks are priced as if it all starts to hit the bottom line tomorrow morning. If you are not cautious here, you are not thinking things all the way through in my opinion. Cautious optimism and a strict adherence to valuation with an increased emphasis on margin of safety seem to be the best course of action.

On a happier note, I got a look at the new book release schedule for March and its pretty exciting. Randy Wayne White, Greg Iles, Clive Cussler, Robert Crais, Paul Levine, Ken Follett, Janet Evanovich, Stuart Woods and some other favorites will be out this month. Since I am spending a week at the beach in Texas in March while visiting my in-laws, I intend to do a lot of recreational reading this month.

That is when I am not watching baseball. The MLB app that allows me to watch games on my phone is one of my very favorite inventions of all time. In addition to the Spring Training games, I can and will be watching the World Baseball Classic as well this spring. The AL East is shaping up to be a dogfight this year, and I see a lot of books and baseball in my future. Reading a good book while watching the ballgame over the top of the page is one of my favorite ways to spend an evening and the new release list, and Spring Training results so far appear to offer some great opportunities to do just that for the next several months.

I am starting to work on my baseball predictions for the 2017 season and will have that around the third week of the month for you. We had a good year last year predicting division winners and had the easy prediction of the Cubs winning it all. There have been a lot of offseason moves and some good young talent that will make their MLB debut this year, so it is going to be a bit tougher to get it right, but I think I am up for the challenge.

Everyone is pretty excited about the markets right now. At such times I like to recall Mark Twain’s suggestion that “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

Have a great week

Tim

Let’s be careful out there, so we don’t end up shedding