KEN HEEBNER: GREAT CONTRARIAN INVESTOR

April 18, 2014

Consuelo Mack: This week on WealthTrack, legendary investor Ken Heebner is known for his stock picking abilities and trading prowess but what does he think of high frequency trading. Is the market now rigged? Great Investor Ken Heebner on market fairness, risks and opportunities is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Is the stock market rigged? Have so called high frequency trading programs taken over the market? Are they taking unfair advantage of both individual and traditional institutional investors? Well that is the allegation by bestselling author Michael Lewis in his new book Flash Boys. Like other Lewis financial tales, such as The Big Short and Liar’s Poker, Flash Boys provides a fascinating inside look at otherwise hidden, arcane and significant Wall Street activities. In this case his focus is high frequency, or high speed trading which is just that. The computer driven buying, selling and sometimes just ordering and cancelling thousands of trades in milliseconds. We are talking about close to the speed of light here. According to an article in Forbes.com, at the height of the tech bubble in 1999 1,000 stock quotes per second crossed the tape at the New York Stock Exchange. By last year that number had exploded to 2 million quotes per second. An estimated 90-95% of those quotes come from high frequency trading systems, which also account for anywhere from 50-70% of all trading volume in U.S. Stocks. The firms with the most sophisticated trading programs, computer algorithms, the fastest machines and speediest lines into the now 13 public stock exchanges and 40-50 so called dark pools, the off- exchange trading platforms are the ones with a competitive edge… according to Lewis it is an unfair and sometimes even criminal advantage. Not everyone agrees with him. Some vehemently disagree. We will have several informed opinions on the issue on our website WealthTrack.com. But the controversy highlights how much the business of trading stocks has changed. And it raises the key question: what difference does it make if any to the average investor?

This week’s WealthTrack guest is known for his active trading style and stock picking prowess. He is legendary investor Ken Heebner, co-founder and longtime portfolio manager at Capital Growth Management where he runs several mutual funds including his flagship CGM Focus Fund. He is known for his concentrated holdings, aggressive bets and periods of substantial outperformance and underperformance versus the markets and his peers. His five year 13% annualized returns have him near the bottom of the pack, but his fifteen year 15 percent annualized returns have him at the very top. Heebner is also known for his active trading, although his recent 300% annual turnover is glacial compared to the high frequency trading done by computers. I asked Heebner if he felt the market was now rigged against traditional investors.

Ken Heebner: The way we run the money in our mutual funds, if we’re buying 50,000 shares in a day in any given minute we’re not buying very many shares and some guy is going to be in and out in less than a minute, it really isn’t going to affect what we’re doing. So the fact that our turnover is above average doesn’t mean that we are in these guys’ sights, and I don’t know who their target is, but it’s not us.

Consuelo Mack: Have you noticed any difference at all when you’re executing trades?

Ken Heebner: Well, probably what you see is that, whereas 20 years ago you can tell the traders, “Let’s get 35 percent of the volume because all the volume is available to you,” well, if all the volume is not available to you anymore maybe you’re better off saying, “I’d like to get 10 percent of the volume or 15 percent of the volume,” if I’m giving that kind of instruction to the traders. So there’s less available for our funds when we’re buying and selling, but we don’t have any liquidity issues. We don’t need to buy an awful lot of what traded in a day because we’re accumulating.

Consuelo Mack: And you don’t have liquidity issues as well because you’re also trading in very liquid stocks?

Ken Heebner: Very liquid stocks. And so there are no liquidity issues for us. Now, if I had, you know, a trillion dollars of assets under management it’s probably a very different question, but we’re small and nimble so we’re not really going to be affected, but other larger scale investors could be. I don’t know.

Consuelo Mack: Last question on this topic and that is the fact that instead of dealing with the New York Stock Exchange you’re now dealing with 13 public exchanges and 40 to 50 off exchanges, trading platforms called dark pools. Any difference there that the trading is now so dispersed among all of these different exchanges and traders?

Ken Heebner: Well, the traders have a bigger job to do. They’re not just figuring out how to gain the specialists, they’re looking at all the alternatives, but they have more alternatives in terms of where they can place the business. So that’s a positive for us.

Consuelo Mack: Is the market more volatile now than it was, let’s say, six years ago, seven years ago, ten years ago, and if so, how much of a concern is volatility for you?

Ken Heebner: Volatility, if you’re buying a stock and you think that over a period of a year you’re going to get significant appreciation what happens to the price day to day really doesn’t matter a lot. When I’m investing I’m looking at the earnings outlook and what the valuation of the stock is. So volatility when a stock goes down it’s an opportunity to buy, but it’s not a problem for our investments, no.

Consuelo Mack: Is there more volatility in the markets now than you remember there being, let’s say, ten years ago or 20 years ago?
Ken Heebner: That’s a tough question because if something goes wrong there’s always a lot of volatility to the downside. And probably you could say there’s more volatility because the size of the stocks that really move up big time, it’ll happen to a company with 50 billion or 100 billion or 200 billion market-cap, so there’s more volatility in the sense that you can have an inflating tech bubble in the year 2000 which then completely collapses. And I think that is really caused by the fact that there is a huge amount of global wealth that’s been created in the 20 years and a lot of it’s in the stock market, and more money chasing, admittedly a larger universe of stocks, but the volume of money chasing the stocks is naturally going to create bigger ups and downs. And we see that. In ’00, the market got up to 29 times trailing 12 months of earnings for the S&P 500. I would call that volatility.

Consuelo Mack: A year ago on Wealth Track you said that the US stock market was an extraordinary opportunity for investors. We had a great year last year. What’s your view of the US stock market now?

Ken Heebner: I continue to think that the US stock market is very attractive. It is not as cheap as it was last year. It’s selling at 15 times at what I think S&P 500 is going to earn in 2015, but we have a very low inflation environment. Just basically, last year I was looking at a number of years for the US economy to grow and for successful companies to deliver strong earnings progress. The outlook is the same today in that sense as it was a year ago. Even though the prices are up, the earnings are up and the outlook is unchanged. You have to worry if the Fed feels that there are excesses developing and they need to tighten because there’s an inflationary issue. And what they say now is we need more inflation. You know, you never would have heard that ten or 20 years ago. So when the Fed says we need more inflation I don’t think you have to worry about the duration of the cycle.

Consuelo Mack: You are a self-confessed numbers junkie and you’re also an economist by training.

Ken Heebner: By training, no degree.

Consuelo Mack: Training is good. So looking at the economic environment right now as a numbers junkie, what are you seeing in the economy?

Ken Heebner: The economy has been growing slowly. This winter we had the most bitter winter in two-thirds of the country in 20 years. When the weather is that severe it constrains consumer behavior, it interferes with manufacturing operations, it holds back the economy. But more recently the numbers that I’m looking at, particularly the ISI seasonally adjusted weekly numbers, show fairly robust strength in key sectors of the economy emerging after the winter.

Consuelo Mack: And let me just stop you there because ISI is Ed Hyman’s group and Ed Hyman has been actually an exclusive guest on Wealth Track every year for our first of the year show. So you’re looking at ISI’s weekly numbers such as what?

Ken Heebner: The automobile sales and home building orders. And these are two key areas of the economy and they are the ones where 20 years ago when you saw home building and autos turn up that was the sign of the real consumer economy, strengthening consumer economy and that’s what you’re seeing today. The home building orders spiked through May of last year. They pulled back with the rise in mortgage rates and the rise in house prices, but several months ago they started to recover sharply. And they’re not quite back as high as they were last May, but they’re way off their lows and I don’t think when people talk about the home building business with all their cautionary concerns they’re really aware of what this strength is. And the companies don’t tell you much.

Consuelo Mack: How strong is the economy then, do you think? And do you think it has legs several years down the road? What’s your outlook?

Ken Heebner: I think that the economy is going to continue to grow until we draw down capacity to the point where the Fed has to exercise restraint to slow it down. I think that in terms of momentum there was a lot of latent strength that didn’t show in the bitter winter that’s starting to show now. And I talk about home builders and trucking orders and I think in the next several months when that becomes evident you’re going to see, among the companies that are participating in this accelerated growth, you’re going to see very strong stock market performance.

Consuelo Mack: At CGM Focus you can invest anywhere in the world and in any asset class, you can short anything you want to short and you are very heavily focused on the US and on, instead of small cap or mid cap companies, you’ve got a heavy focus on large brand name companies. Why is that?

Ken Heebner: I’m looking at the companies where the outlook for stock market appreciation is most significant based on the earnings pattern I’m looking at and the overall environment. And I think the United States has got the best overall environment. When you look around the world a lot of these developing countries have inflationary problems, they have weak currencies, they have balance of payments deficits, and the outlook is very uncertain.

Consuelo Mack: You’ve got, you know, Morgan Stanley and Citigroup in financials, and you’ve got Lennar and Whirlpool and Toll Brothers in housing, and you’ve got Delta Airlines in the airline sector. Why do those continue to be the big things? And let’s take them one at a time. The airlines, for instance, what is so attractive about the airline industry still?

Ken Heebner: The airline industry for the first time in 30 years has got pricing power. Consolidation has reached the point where the pricing, particularly in the big markets is oligopolistic. So that the companies are exercising pricing discipline. They are maybe not raising the fare directly, they’re charging you for bags, they’re charging you for leg room, they’re charging you for early boarding. They’re eating the cow one bite at a time. And I always say that if you want to fly the airlines, you don’t want to own the stocks when you want to fly and if you hate flying maybe you ought to think about buying the stocks.

Consuelo Mack: Just rewind that for a minute. So if you hate to fly that’s when you should think about buying the stocks?

Ken Heebner: About buying the stocks, yes.

Consuelo Mack: Because they’re making so much money?

Ken Heebner: Well, because they’re in the driver’s seat. They know that they can overcharge you and abuse you and you’re going to fly anyway, and that’s when they make all the money.

Consuelo Mack: Airlines used to be so cyclical. There used to be early economic indicators, but you had to get in and out of them, you know, in two weeks. That has completely changed?

Ken Heebner: Well, the cyclicality remains. The next time there’s a recession in the picture I don’t think this is a good place to be. Because if the man starts to fall away I think the earnings will go down, but I’m very bullish on the economic cycle right now so I’m not concerned at this point.

Consuelo Mack: Banking. The banking industry has changed dramatically. Why would you own a major bank like Citigroup or Morgan Stanley, an investment firm?

Ken Heebner: Now, in the case of Morgan Stanley, I think some of the very astute moves that the management has made to improve their business are becoming recognized in the investment community. So I think that the idea that everybody hates Morgan Stanley is no longer true. I think people recognize. That takes some of the attraction away.

Consuelo Mack: That worries you, right?

Ken Heebner: I’m less excited. But now let’s talk about Citigroup. The new management is the one that regulators wanted to come in. They wanted Corbat to run the company and he’s doing a great job.

Consuelo Mack: And look what happened.

Ken Heebner: And so what it is, everybody’s piling on. The fact is eight times earnings for one of the leading companies in global finance and this is a company that’s got an incredibly strong business position around the world. And they’re very capable in all their businesses. There’s no reason why this stock shouldn’t sell 50 percent higher.

Consuelo Mack: And yet the regulators would not allow…

Ken Heebner: Well, they said that they want to see changes made in the governance of the company and I would guess that a year from now Citigroup will do whatever they’re supposed to do and they’ll allow them to buy back more stock. They are allowed to continue to buy in stocks slowly. They wanted to accelerate the rate of buy back and the regulators said, “You can’t.” So the regulators said, “You can’t buy in stock any faster than you’re now buying in it.” Is that a reason for a stock to decline five percent or ten percent? I don’t think so. I mean, if it was 25 times earnings maybe it should go down, but at the current multiple of the stock? No. But every time you pick up a newspaper they’re bashing the banks and I think that rubs off on investors. It creates a negative psychology and people are not looking at these as great businesses, strong business with growing earnings and a strengthening globally competitive position.

Consuelo Mack: Explain the investment process though. So for instance, you have a company like Citigroup that you think the rest of Wall Street has got the story wrong and that you’ve got it right. Do you buy large, you know, holdings in it? Do you buy it gradually?

Ken Heebner: I bought the stock before the latest round of negative articles came out, but I look at what’s being said and I see it has nothing to do with the fundamental outlook of the company. Sure, they may have been able to increase earnings by two percent or three percent if they were able to implement their buyback program, and now they can’t do that, but that doesn’t change the outlook for the company. As a matter of fact, a year from now I think they’ll get permission. So the stock becomes more attractive. But I key on the fundamentals. If I was looking at something that said, okay, you know, major pieces of their business, credit risks are revolving, non-performing loans are going to be rising. They’re going to have to take charge-offs. That’s fundamental and that’s a reason to change. But newspaper articles are generally not a reason to change.

Consuelo Mack: One of the things that you told me last year that I thought was so neat and so unique for you is that if you go to an analyst meeting, a company is holding an analyst meeting and there are very few analysts there that’s one reason to get interested. Once the room is crowded with analysts following a stock you are less interested because you feel that it’s recognized. So where are there very few analysts looking at a company, for instance, that you’re interested in.

Ken Heebner: Homebuilders.

Consuelo Mack: Homebuilders? No one’s going to home builder meetings?

Ken Heebner: Well, I wouldn’t say that, it reminds me of Citigroup for a whole different set of circumstances. Everybody is saying, “Oh, my gosh, the mortgage rate is going up from 3.5 to 4.5 percent, housing prices are up 10 percent. Housing demand is going to fall off and so we don’t like these stocks.” And one of the things that people are ignoring is that this is a big industry. Consolidation, although it’s not on the scale of the airline industry, the big have gotten stronger and they took advantage of the severe depression in housing to buy land cheap.

Consuelo Mack: So Toll Brothers, for instance, or I mean, who’s getting larger?

Ken Heebner: Well, continuing to grow and also they’re able to find the choicest pieces of land because all home sites are not created equal. Toll Brothers and Lennar.

Consuelo Mack: Lennar.

Ken Heebner: And in a different way Horton. Horton isn’t cherry picking California developments, but it is very good at getting attractive purchases in the State of Texas where they were founded. So that when you talk about homebuilding generically, you’re ignoring the fact that there are companies that are distinguishing themselves in the way they’re functioning in this environment.

Consuelo Mack: You tend to be skeptical about technology. Why?

Ken Heebner: I’ve always been skeptical of technology because it changes so fast it’s very hard to get an analytical advantage and the venture capital people really get a lot more information about the newest, greatest thing than I’m ever going to get. And you talk about people, I haven’t been to any of the meetings, but I’m assuming that the rooms are full and everybody loves these stocks, but if the multiples are 100 times earnings or 70 times earnings you don’t even have to go to the meeting to know that the room is full.

Consuelo Mack: And retailing is the other area that you said is changing and that you are concerned about.

Ken Heebner: It’s complicated because online shopping is becoming an increasing part of the market. Not huge at this point, but Amazon has done a much better job than the brick and mortar retailers in drawing the customer into their network and they’re trying to go there, but they don’t have the skills that Amazon does. Now, Amazon is being very aggressive in its pricing so when the stock gets way up there at 70 times earnings and the earnings aren’t growing very fast because they’re being very aggressive with the pricing, I don’t know what you with that. I don’t want to own the stock because I don’t know what the outlook for Amazon is. But at the same time, they are depreciating the outlook for all the other companies so that they are, they’re continuing to earn money, but the earnings outlook is diminished by the fact that they have a competitor who is underselling them and doing a better job of addressing the growing part of retailing which is online.

Consuelo Mack: Not only are you a numbers junkie you are also a student of history and one of the big headlines that you have been watching has been what’s going on in the Ukraine. Why is that so important to you as an investor?

Ken Heebner: Now, suppose you are an investor that’s 60 percent in technology stocks and 70 times earnings and suddenly you read in the paper that the Cold War is heating up because there’s an invasion of the Ukraine and our government has decided that we’re not going to tolerate this new Russian activity and we’re going to increase defense spending 30 percent? Well, I think you might decide you don’t want to own any technology stocks and you need to own some defense stocks and you’re completely in the wrong place. So I think that it could, if he invades, you could really see a leadership change and leadership changes generally create market corrections.

Consuelo Mack: A leadership change?

Ken Heebner: From technology to defense.

Consuelo Mack: Therefore, looking at this on your radar screen, is there anything that you are doing differently in your portfolio just in case?

Ken Heebner: Well, since I haven’t been involved in technology stocks I don’t have to have a fire drill, an investment fire drill. But at the same time, I do think automobile stocks and housing stocks and airline stocks which are heavily influenced by domestic activity would not be adversely affected, and the stocks are cheap. So I don’t think there’s any reason to consider selling those. If I was 50 percent in technology stocks I don’t know what I’d do. That’s why I don’t want ever to be 50 percent in technology stocks.

Consuelo Mack: One investment for a long term diversified portfolio, is there anything we should all own some of in a portfolio that’s a long term portfolio?

Ken Heebner: I’ve got to tell you, 25 years ago I was in a client meeting and I had this great idea called Silk Greenhouse. I thought it was going to be Walmart of artificial flower retailing. And so the client says, “What’s your favorite stock?” And I told him, “Silk Greenhouse.” A year later Silk Greenhouse goes bankrupt. So I go to the meeting, his portfolio is up and everything’s great. He said, “I bought that in my personal account. What do I do now?” So I don’t give those things anymore.

Consuelo Mack: Well, Ken, you do a lot of other investing in your own accounts and for many clients. So thank you very much for sharing that process with us.

Ken Heebner: Always good to be here.

Consuelo Mack: Really appreciate it.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is a fun and educational assignment: It is read three Michael Lewis’ books about Wall Street. I am in the middle of Flash Boys, which we discussed earlier, about the impact he thinks high frequency trading is having on the markets. True to Lewis’ style there are independent and principled figures who take on the monied machines and at this juncture, just might come out on top. The Big Short is about the handful of nerdy analysts who made a fortune trading against the mortgage bubble. It is an incredible and shocking story. And Liar’s Poker, his first book about his unforgettable experiences as a novice on the trading floor of Salomon brothers, the then master of the bond trading universe is already a classic. You will enjoy each and every one!
Next week we are going to explore the opportunities in small cap stocks with another investment legend, the Royce Funds’ Chuck Royce. In our extra feature on our website we will have more of our interview with Ken Heebner. He will tell us why he is following developments in the Ukraine so closely.
Also in our new WealthTrack Women section we will have more financial advice specifically for women from our panel of women financial advisors. Thank you so much for spending your precious time with us. Have a great weekend and make the week ahead a profitable and a productive one.

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