Monday, June 8, 2009 0 comments

Reading material for an overcast Monday

Well, at least it's overcast in Toronto...will probably rain later. Not sure about your location... A list of items that you may find worthwhile. As usual, not in any particular order...

  • Job losses and gains across time for various industries in the US (New York Times): Interesting chart depicting the gains and losses in jobs over the last 5 years.
  • A bearish guide to the economy (New York): An article from New York magazine going over the bearish cases, ranging from that of Gary Shilling to Peter Shiff to Jeremy Grantham. Technically it briefly covers the bullish side too, in its first section, but the lack of any serious bulls or superbulls essentially makes this a summary of the bears.
  • Why do home prices take a long time to adjust? (New York Times): Robert Shiller speculates on why home prices take a long time—many years—to stop falling (in contrast, stock markets, bond markets, art market, and others adjust within a few years.) He suggests that the current decline may continue because pricing in residential real estate is generally not efficient. Residential real estate seems to be stabilizing, relative to the massive declines since the peak in 2005, but anyone making a bullish bet should be really careful. Real estate is being given a huge boost by the low interest rates. If long term rates rise, real estate can easily decline far more than the bulls believe. I'm in the mild deflation camp and think long term bond yields will stay low, but the consensus is for yields to rise with many forecasting high inflation and high bond yields. If the consensus becomes true, defaults on mortgages will go up significantly. The US government is socializing losses on mortgages, through their ownership of the GSEs, but even the government will probably stop subsidizing mortgages if yields rise to what they were in the 70's.
  • Interactive timeline history of GM (New York Times): An interactive timeline from The New York Times on key events in the history of GM.
  • Low quality stocks have rallied the hardest but one should be cautious (Wall Street Journal): Jason Zweig writes a regular column (The Intelligent Investor) for the Wall Street Journal and it's worthwhile to check it out once in a while. In this column, Zweig wonders about the fact that the lowest quality stocks have rallied the most. This is pretty normal during recoveries but there is a risk. (Further comment below)
  • (Recommended) Detailed Berkshire Hathaway annual meeting notes (Jerome V. Bruni; via GuruFocus): A very detailed recap, along with the opinion of the author, of the 2008 Berkshire Hathaway shareholder meeting. I find that I don't learn much related to investing techniques from Buffett & Munger anymore; instead, I find that I learn a lot more about how Buffett & Munger think about businesses on issues related to human behaviour, economics, politics, and so forth. For instance, you can see the brilliance of Warren Buffett when he responds to the question about the worst that can happen to their insurance businesses (which is their core business). Buffett actually cites the remote possibility of nationalization due to high premiums arising from high inflation. If you ever fall in love with a stock and marry it (i.e. invest a huge chunk of your wealth ;) ) you should start thinking in the manner of Warren Buffett. The risk isn't just that the company may post a massive loss or something. It is also worthwhile for all of us to consider consequences due to changing politics, culture, and so forth.
  • Federal Reserve gets ready to unwind liquidity programs... maybe (The Economist): Too early to tell but it is possible that the US Federal Reserve may soon remove some of the liquidity it has provided. Any such move, in a manner similar to removing oxygen tanks from a patient with damaged lungs, will test the strength of the real economy and the capital markets. As the article suggests, perhaps it's also time Americans and their government gave the Federal Reserve the ability to issue short-term bonds (some other central banks already do this.) Issuing bonds will provide an easier and arguably better route for the Federal Reserve to suck up liquidity.
  • (Highly Recommended) Being approximately right by using simple estimation of asset values (Avner Mandleman for The Globe & Mail; via GuruFocus): This is a great article by Avner Mandleman on valuing stocks and the market in general. Avner suggests that our goal should be to approximately price a security, rather than attempt to do it precisely. Notwitstanding my poor investment record so far :(, this is how I actually think about stocks. Similar to what is suggested in the article, I use a simple multiple to price stocks. In contrast, I see many using DCF (discounted cash flow). DCF is ok if you are good at it but I find it too sensitive to growth rate and discount rate assumptions. (Further comment below)
  • (Recommended) Jeremy Grantham Morningstar interview (Morningstar; via GuruFocus): I don't follow any portfolio allocation strategy (partly because I'm trying to be a stockpicker, and partly because my portfolio isn't large and isn't structured towards any long-term goal such as retirement, kids' education, or the like) so I don't look at investing quite like Jeremy Grantham. Nevertheless, Grantham is very good at macro investing so I like listening to what he has to say. Among many points, he says that it's possible for China to post good top-line numbers (i.e. GDP growth or sales) while return on capital is poor. He warns that everyone should normalize profit margins (he implies that the Shiller/Graham 10-year smoothing is too simplistic so I'm not sure what his computation is.) He also said that he is focusing his firm's research on causes of inflation, probability of inflation, early signs of inflation, and so on. He is not sure if we will have high inflation but is investigating the issue. (On a side note, very poor speaking by Grantham here, with him looking down at the ground instead of the camera :( His fine attire sort of saves him but it sort of shows how he doesn't talk to the media/public often).
  • Comparison of economic statistics between current recession vs Great Depression (VoxEU; via Naked Capitalism): The current situation is nothing like the 1930's but a comparison is still worth considering. I think the similarities between the two periods include a boom in world trade prior to the bust, huge credit build-up, and a deflationary bust. There are many differences that make the comparison invalid including the fact that most countries entered the Great Depression on the gold exchange standard, some faced hyperinflation or issues related to wars (e.g. Germany), and central banks and governments were tightening and trying to balance their budgets.

The Risk With Low Quality Stocks

Jason Zweig, in his latest column, writes:

According to Strategas Research Partners, stocks in the S&P 500 with positive earnings have underperformed those with losses (or no profits) by a 24% margin since March 9. Stocks that pay dividends have been dragging behind those that don't. The smaller a company, the more money it is losing and the deeper in debt it is, the hotter its stock has been over the past three months. Investors are betting that when the economy finally rebounds from this recession, what went down the most will go up the most. In the past, the junkiest companies have often bounced the highest early in a recovery.

The fact that low quality companies are outperforming high quality ones during the recent rally should not be a surprise. Anyone that has looked at long-term history will find that low quality outperforms high quality during the start of many booms—in the stock market or in the economy. However, note that this is more a general case rather than something that must always happen. There are many reasons for this.

One reason is that most poor quality stocks are the smaller companies, and these are very sensitive to the economy. If the economy picks up they will benefit "more" than established ones.

Another reason that low quality, say money-losing ones, outperforms is that the equity has "leverage". Small changes in earnings will have huge impact on the value of the equity. This is especially true for cyclicals that are sold off by short-term investors due to poor earnings. A company bleeding red like Ford or USG will look really bad when earnings are poor but small positive changes can result in massive profits. You can easily see this with the commodity companies such as Rio Tinto or Teck Caminco. These over-leveraged companies look really bad if they post losses but if they ever start posting positive profits, they will look like spectacular buys (at prior low prices.)

The corrollary to all this is, of course, is that high quality stocks outperform during downturns. There is generally a survivorship bias and no one talks about the low quality companies that go bankrupt during downturns.

So is there a risk in buying low quality companies? After all, if the economy is improving, and profits are to going to be higher, as many expect, what is the risk with low quality stocks? Zweig asks and Jeremy Grantham suggests the following risk:

"The junky companies may be diluted to hell just to keep them alive," says money manager Jeremy Grantham of Grantham, Mayo, Van Otterloo in Boston. For companies too weak to generate surplus cash, a big rally in their shares will enable them to sell more stock. And that will dilute investors' returns by spreading future earnings more thinly across a greater number of shares.

We are already seeing this with some distressed banks and commodity producers. I wasn't investing back then but I believe this was also common with dot-com stocks after the bust in the early 2000's. In fact, one of selling pressures during rallies involve these companies selling shares.

So what's to like? Jason Zweig suggests Grantham's preference for high quality large-cap stocks but I don't find them attractive. You will likely post 10% annual returns but I'm looking for something larger (hope I'm not too greedy ;) ).

Another idea that is suggested is one that I have mentioned before: Japanese small-caps. Unfortunately, it's kind of complicated to invest in them—language barriers, different standards, poor corporate governance, terrible macroeconomic trends, high commissions—and I haven't found anything that I like. I suspect that a contrarian strategy of buying a basket of Japanese small-cap stocks is perhaps the only feasible strategy for amateur investors. This would be in the vein of John Templeton blindly buying a basket of distressed American stocks in the 40's.

Approximately Pricing Securities

Avner Mandleman writes a great article for The Globe & Mail about how he approaches investing. He suggests that investors may want to follow what Enrico Fermi, a physicist, has said in the past. Namely, one should roughly estimate the value of a security rather than trying to be precise. My investment track record is questionable so take anything I say with a grain of salt, but this is my thinking as well.

It's well worth reading the article but here is the approach Mandleman suggests:

This, in essence, is the value-investing method. To do it, you need to do five things:
(1) have a high certainty of a stock's intrinsic value (IV);
(2) wait for the stock to trade well below it;
(3) keep your firepower dry for such bargains;
(4) have the guts to buy when all others are selling, and
(5) hold patiently till the stock rises above its IV.

As Seth Klarman speculated in the interview I linked a few weeks back, newbies, like me and perhaps most readers of this blog, have difficulties with the first step of evaluating the intrinsic value. Professionals, I suspect, likely have difficulties with the latter steps. For instance, many professional investors have analysts working for them or with them; or pay for research reports or special information (e.g. visitors to an online retail website; market share; number of cars shipped across a rail network; e.t.c.) Small investors generally have very little of that so we generally have to compute the worth of a business on our own. Conversely, small investors can easily keep dry powder (i.e. high cash levels) or hold something as long as they see fit. Professionals face serious career risk if they hold too much cash, hold onto investments too long, or underperform for even 2 or 3 quarters. You could see an example of this by observing how Robert Rodriguez's funds saw massive outflows because he was holding too much cash a few years ago. If you were bearish or didn't find anything worth buying, what do you do in such a case?

The article gives an example of how to compute the value of a security. The example is that of the S&P 500 index rather than a single stock but the approach is quite similar.

Just as we do for stocks, first we need to estimate the S&P's expected earnings. For this, we first must find the S&P's long-term return – say its 5- or 10-year moving average, which comes to about 13.5 per cent. That's stage one. Next, we should obtain the S&P's latest book value. This, as any database would show, is about $516. By multiplying these two numbers we get the market expected earnings – about $70. The only remaining question is, what price-to-earnings (P/E) multiple would investors pay for these earnings?

This is where experience comes in: The typical market P/E should be about 14 times, for a 7 per cent “earnings yield” – the average long-term triple-A bond yield (7 per cent) – which brings the IV of the S&P to about 996. VoilĂ  (Other value investors – for example, Jeremy Grantham of Boston's GMO – see the S&P's IV at 975. Close enough.) The market is therefore trading at about 5- to 10-per-cent below its IV, well above its trough in February-March, when this column, using a similar method, noted it was substantially undervalued.

The method that is suggested amounts to taking a long-run return on equity and multiplying it by book value. Then you apply a multiple to it.

I don't share the view that the market is 5% to 10% undervalued (because I think the high ROEs of the recent past won't be duplicated in the future) but that's beside the point. The important thing is to develop a method that yields a rough estimate. The goal is to buy way below the intrinsic value.

As for stocks, the article says the approach is the same but Mandelman suggests that the method works well for "good, non-levered, stable, high-quality companies". It is very important note that this method needs to be tweaked for highly leveraged or high growth companies, among others.

This is very similar to the commonly used P/E multiple method, which is also what I primarily use. The difference between the two is that anyone using the simple P/E multiple method just multiplies the expected earnings by the expected P/E ratio. I typically get the expected/normalized earnings by taking an average of the past earnings, with some adjustments for the company thrown in. The method that is suggested here uses a "normalized" ROE based on book value to derive earnings.

You can see why this method, just like the P/E multiple approach, is kind of dangerous with cyclicals. You have to be careful that you aren't taking the average of temporarily high returns. For example, if you were looking at homebuilders 2 years ago, the ROE and the earnings would have been artificially high. I'm bearish on commodities in general so I would say the same thing about, say, copper mining companies. If you used the ROE or profitability of the last 5 years, you would end up with high intrinsic values for many commodity companies. (However, do note that if you are a macro investor, you may have other reasons for bypassing this thinking. Some commodity bulls believe in the commodity supercycle theory and the decoupling theory so they do not view the recent earnings as peak earnings.)

If earnings, or more importantly return on equity, were stable and predictable, this method should yield a rough estimate of the value of a firm.

Anyway, this is an additional way to generate an estimate. I like this method but most on the web, at least the amateur investors I see on forums/blogs/etc, seem to rely mainly DCF. Use whatever works for you and generates the best results in the long run.

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