The equity market has had a great run, currently up around 24% for the year (S&P500). Tempting as it is to assess the risk of a reversal as high, we tend to avoid market calls like that. But two stocks that recently reported earnings provide an interesting contrast.

Netflix (NFLX) last night reported quarterly revenues of $1.1 Billion (up 22% year-on-year) and EPS of 52 cents (versus 13 cents a year ago). At $360 a share it’s currently trading at 106X next year’s forecast EPS of $3.41, or 4X next year’s forecast revenues. CEO Reed Hastings was moved to comment on the “euphoria” surrounding the stock. We don’t own NFLX, sadly, since it has rallied around 275% so far this year. It obviously was very cheap a year ago, but doesn’t fit our investing model of companies with reasonable earnings visibility and a persistent competitive edge. They have a great product though.

IBM reported last week and disappointed analysts with revenues of $23.7 Billion, about $1 Billion less than expected. IBM will probably earn around $16 in EPS this year, close to $18 next year and remains on target for management’s goal of $20 in operating earnings in 2015. It currently trades for less than 10X 2014 EPS. IBM is down about 10% this year, around half of which came as a result of their disappointing 3Q13 earnings last week. IBM’s revenues have been flat for years. In 2008 they generated $103 Billion in sales. They’ll probably do $101 Billion this year and somewhere between 100 and 104 in 2014. IBM is not a company with revenue growth. However, their EPS in 2008 was $8.93 and their operating margin has improved from 15.2% to around 20%. Over six years they’ve doubled profits on flat sales by operating more efficiently and providing customers what they want. They’ve also reduced their sharecount by 18% through buybacks, further supporting the growth in EPS. They will keep doing all of these things.

We own IBM. The contrasting stock performance of IBM and NFLX don’t mean the market is expensive, but at current valuations we would only ever own the former and not the latter.

Quarterly Outlook

As is so often the case, the near term outlook for financial markets hinges on the two channels through which the government influences economic activity: monetary and fiscal policy. The Fed’s decision to continue Quantitative Easing via its $85 billion a month buying program showed how difficult it is to communicate the subtle shifts in the precise level of monetary stimulus being provided. The subsequent drop in bond yields demonstrated a communication breakdown between the market, which had expected a reduction in the Fed’s purchases, and the Fed, who thought they’d been clear all along. No wonder Larry Lindsay, a former Fed governor, commented that less openness might well be better.

Personally, I found $10 billion per month more or less of bond purchases not as striking as the answer Bernanke gave to a question about when the Fed might allow short term rates to “normalize” back to the 4% rate that their website posits as the equilibrium level. Bernanke noted what is already public, that the majority of FOMC members expect to begin tightening short term rates around 2016, but then suggested that it might be another two or three years after that before rates reach 4%. Of course Bernanke has only a few months left at the Fed, but his reflection of the FOMC’s views suggests that one consequence of the 2008 financial crisis will be more than a decade of stimulative interest rate policies. So far such policies have worked better than many expected so there’s limited tangible evidence that they’re flawed. The FOMC’s current forecast for short term rates is on their website. On this basis, bond investors face many more years of unattractively low rates that will ever so slowly rise to the point of fair compensation. A ten year security bought at a 3% yield will approximately return zero if over the subsequent year its yield rises to 3.4%, since the drop in price will offset the interest income. Even after the “non-taper” bond rally, corporate bonds have returned -3%. Why, hedge funds have done better!

At the time of writing we are entering another period of brinkmanship in Washington over funding the government and raising the debt ceiling. It’s not the sort of thing that alters our investment posture, though we despair at the dysfunction in D.C. just like everyone else. The sight of Texas Senator Ted Cruz reading from Dr. Seuss’s “Oh, the Places You’ll Go!”  during his marathon monologue may not be the deliberative legislative process at its best, but then other countries’ elected officials have even been known to get into fistfights (for example, Kiev, Ukraine on March 19, 2013). The competition for legislative comedy champion is fierce. Although government policies can affect almost any company, we focus on those that we believe are less sensitive to variables we can’t predict.

MLPs

Master Limited Partnerships (MLPs) had quite a tumultuous month, buffeted both by moves in interest rates and also by critical research from a small firm in Connecticut called Hedgeye. MLPs are bought by yield-seeking investors, and although unlike bonds their distributions generally grow each year, monthly fund flows are sensitive to movements in other traditional income generating sectors. Over a three day period recently MLPs  rallied more than 4%, driven both by the drop in bond yields following the Fed’s “non-taper” and a reaction to the sell-off precipitated by Hedgeye (on which more below).

On September 18^th Rich Kinder, founder of eponymous Kinder Morgan (referred to hereafter as KM since there are multiple entities), sounded every bit the angry billionaire as he defended his company on a conference call to investors. Hedgeye’s research analyst Kevin Kaiser had issued a research report suggesting inadequate upkeep of KM’s infrastructure and questioning their non-GAAP accounting for “maintenance capex” (“capex” is shorthand for capital expenditure). Before releasing the report Kevin Kaiser referred to Kinder Morgan as “…a house of cards on the verge of collapse.”  Apparently, Hedgeye’s marketing strategy is to announce an impending report so as to attract new subscribers drawn by the stock’s sell off in anticipation. They evidently have too few paid up subscribers to justify providing them the report in time to act on it (i.e. before the stock has fallen). This need not reflect on the quality of their research, but is nonetheless worth noting.

KM consists of four publicly listed entities: Kinder Morgan Partners (KMP), Kinder Morgan Management (KMR), Kinder Morgan Inc (KMI) and El Paso Pipeline Partners (EPB) with a combined enterprise value of $105 billion. It is the largest MLP, and although we doubt Hedgeye’s Kevin Kaiser has spent much time with Rich Kinder, the former certainly got the attention of the latter.

The crux of Hedgeye’s report concerned Kinder Morgan’s definition of “maintenance capex”. An MLPs Distributable Cash Flow (DCF), the money available to pay distributions to investors, is calculated after the cost of maintaining their assets. A pipeline that costs less to repair means more money paid out to LPs. Hedgeye’s report argued that KM spends too little on maintenance, artificially boosting its returns, and subsequently makes up for it by replacing a pipeline and counting all of the cost as a capital investment.

Following price weakness induced in part by Hedgeye’s report, Rich Kinder’s initial response was to buy 500,000 shares of KMI to add to the 230 million he already owns (worth $8.3 billion). This was followed up a few days later with the September 18^th conference call during which the company provided some detail around its maintenance capex to show the weakness in Hedgeye’s analysis and conclusions. As they noted, energy infrastructure is a highly regulated business and operators have limited ability to skimp on maintenance.  Accounting treatments vary, particularly for non-GAAP measures like DCF, and where one company may attribute maintenance expense to operating costs another may allocate it to recurring capex making a more comprehensive analysis of the financials prudent before sounding the alarms. A quick look a KM’s record of spills and other accidents, the kind of thing that might point to such under spending, is at least comparable to the industry average. Furthermore, KM’s distributions have been growing reliably for 17 years. So although KM doesn’t quite rise to the “death and taxes” level of certainty, it still looks to us like a pretty good investment.

Although we didn’t find Kaiser’s analysis compelling, he did correctly note the substantial power General Partners (GPs) have over the Limited Partners (LPs) in many MLPs. The traditional MLP structure consists of a GP that owns 2% of the equity and is entitled to an increasing share of the Distributable Cashflows in the form of Incentive Distribution Rights (IDRs) before the LPs are paid. The GP’s “cut” of these can reach 50%, as it has in the case of KMP. GPs also exercise substantial operating control over MLPs, far more than is the case with businesses organized as corporations. GPs benefit whenever an MLP issues equity through a secondary offering, since the cash raised is typically invested in a new project that increases the funds to pay IDRs without enduring the dilution suffered by the LPs. In fact an MLP GP’s position is analogous to that of a hedge fund manager. KMI (which owns the GPs of KMP and EPB) owns a 2% GP interest in KMP and receives an almost 50% incentive fee on distributions paid rendering the ubiquitous “2 & 20” of the hedge fund industry almost frugal by comparison.

Just as the business of managing a hedge fund beats being a client, so it is with MLPs as well. Not all GPs can be bought on the public markets, but not all MLPs have a GP in their structure either. We have long recognized the similarity between hedge fund managers and the MLP GPs, and so around 60% of our MLP strategy is invested in MLPs with no GP, or in GPs themselves. We hold KMI in our MLP strategy and raised it to large position in our Deep Value strategy. We also run a variation of our MLP strategy for those investors who dislike K-1s. It is invested in C-corps that own GPs, and is designed to provide similar returns to the MLP benchmarks but with 1099s for tax reporting. As such it also represents a way for non-U.S. investors to access the underlying asset class.

In what will hopefully become the new normal for websites, the Huffington Post last week announced they would no longer be allowing anonymous comments on their website. This is a completely sensible move and one that will add civility (their main objective) as well as raise the quality of comments that are made. How is anyone supposed to properly evaluate a comment or opinion if it’s expressed without disclosing the commenter’s identity? It’s a basic element of public discourse and debate that who is saying something is relevant to what they are saying. The individual’s qualifications to hold an opinion as well as any potential for conflict of interest or inconsistency with past statements are all valid information for the reader. Many argue (always anonymously) that they are prevented from posting their identity because of restrictions imposed by their employer (in which case maybe they should just respect those restrictions). Others claim fear of harassment of some form. But an opinion uttered anonymously is not worth the time it takes to read. Anonymous comments are simply an indulgence to the commenter. I always ignore anonymous comments on anything I write, and only respond to those with a true identity attached. This is the standard that should prevail in the civilized areas of the internet. If you disagree, please don’t bother commenting anonymously.

In recent weeks much has been written and said about who President Obama should select as the next Fed Chairman. Supporters of Larry Summers and Janet Yellen are said to be each pressing the case for their candidate from behind the scenes. For a position that is supposed to float above politics, it is surprisingly political.

So without regurgitating what’s already been said, let me offer a couple of observations. Larry Summers is routinely praised for his intellect. CNBC this morning described him as a “brilliant economist”, a breathless term that many might regard as an oxymoron or at least not wholly complimentary. Although I’ve never met Larry Summers, his high IQ is so often cited by others that one is left with the uneasy feeling that he uses every interaction with people to make sure his brilliance is on display and not missed. Modesty is an adjective rarely in the same zip code as Mr. Summers. That may not disqualify him, since politics and business are both full of people unburdened by much self doubt. Nonetheless, the future is generally uncertain and the next captain of monetary policy might be expected to retain some humility with respect to the brilliance of their own views.

Janet Yellen’s qualifications are that she’s already Vice Chair of the Fed’s Board of Governors. Since 2008 the Fed has been engaged in the most enormous monetary experiment labeled QE and the purchase of more than $3 trillion of bonds. Curiously, CNBC labeled Dr. Yellen’s “ownership” of current policy as a negative. Since the Fed will presumably be navigating an exit from QE during the term of the next Fed chairman, it would seem less disruptive to have the steering performed by someone who helped get us in there in the first place. You can almost hear Fed Chairman Larry Summers, at the first sign of market trouble, proclaiming that had he been in the job since 2008 his intellect would have kept us out of the current situation.

As with many ideas in investing, while we all have opinions on what should be, more interesting is assessing how they will probably be and investing accordingly. My views on the next Fed chairman won’t alter the outcome of that decision. However, exiting QE will represent an enormous communication challenge for either of these candidates. Janet Yellen will be inevitably labeled a dove on monetary policy, and bond investors will likely assume a tightening of short term rates is even farther away than the approximate date of 2015 indicated by the FOMC’s blue dots. The Fed will be either late or very late in restoring rates to neutral. It’s a long time ago now, but I remember in 1987 how the incoming Fed chairman Alan Greenspan was immediately faced with a bond buyers’ strike. Yields rose as investors fretted that nobody could adequately fill the shoes of Paul Volcker, the vanquisher of the inflation dragon. Greenspan was felt to be a poor second act.

As Fed chairman, Larry Summers will be unpredictable. No doubt his prodigious intellect will at some point lead the less intellectually gifted ROTW (Rest of the World) to misinterpret his statements. In either outcome, bond investors will be grappling with less certainty than they were used to. The role of Fed chairman changed in 1975, 1987 and 2006. We’ll soon get only the fourth change in 39 years. It’ll be a big deal. Bond investors probably deserve a little more risk premium in the yields they accept as we head into the next transfer of power.