Friday, August 21, 2009 9 comments ++[ CLICK TO COMMENT ]++

Some articles for your perusal

Continuing the 1933-like rally, the market continues to push higher. The key questions from my newbie perspective are to figure out what the new sales level will be and what is a reasonable profit margin. A lot of companies, across varying sectors, have seen sales fall 20% to 30%, while profits have declined 10% to 50%. Are these temporary, trough, numbers? Or are these the norm for the next decade? If they are the decade norm, the market is likely overvalued. S&P 500 forward P/E ratio is around 17 right now and the historical average is around 15. However, the P/E ratio is always tricky to read because interest rates are very low right now and hence can support a higher P/E ratio. If you thought short-term rates will remain below 1% for many years, then the P/E ratio wouldn't be perceived as being high by investors.

Here are some articles to consider... not as good as last week but some important ones...

  • In defense of value investing (Greenbackd): Megan McArdle at The Atlantic has always been a skeptic of stockpicking. Continuing that stance, she wondered, in a recent article, whether value investing would die after Warren Buffett. Greenbackd, who follows old-school Benjamin Graham investing techniques largely directed at special situations, presents a rebuttal and suggests that value investing will live on. I don't believe in efficient markets to the degree that Megan does, so I share little with her thinking, but I do think some of Greenbackd's arguments are debatable. I don't think value investing will die but it may go out of favour. For instance, Graham-type investing did dissapear for the most part in the late 60's and 80's to 2000's. There were very few stocks trading below liquidation value or below NCAV in those periods. My guess is that if we face a long deflationary bust, value investing will go of favour. Although some readers of this blog disagree with me, I think value investing will underperform under deflation. So, it's not the end of Buffett that will dampen value investing, but the onset of deflation. Most investors, including Warren Buffett, think high inflation is the likely outcome so this may never materialize but who knows...

  • (Recommended) Summary of Seth Klarman's thinking (Advisor Perspectives; via GuruFocus): If you have never heard of Seth Klarman, you may want to check out this piece. For those who are somewhat familiar with Seth Klarman, my opinion is that he has reached the state of Warren Buffett. That is, a lot of what he says is very important but is so basic and has been repeated countless times that newbies like me don't really learn much from him.

  • Run-down of Buffett's portfolio holdings (Old School Value): Old School Value takes a quick look at the holdings of Berkshire Hathaway.

  • Natural gas hits a 7 yr low (The Globe & Mail): A news story summarizing the current state of affairs in the natural gas business. The surprising thing to me is how natgas prices have remained low even with signs of economic recovery and improved credit/cheap money. The demand vs supply imbalance appears to be far worse than what I, or many others, thought.

  • Modelling Fannie Mae and Freddie Mac [several parts; link to part 1] (Bronte Capital): John Hampton at Bronte Capital takes an in-depth look at the two critical American GSEs in the thick of the mortgage bust. It's time to cross financial companies permanently off my circle of competence list ;)

  • (Highly Recommended) Grant's Beachhead issue (Grant's Interest Rate Observer; via The Big Picture): It's always worth checking out what Jim Grant says because he isn't afraid to be a contrarian. His publications aren't really for amateurs, either in their price—$850 per year!—or in their complexity—how many amateurs have access to the A-2C tranche of the ACE Securities Corp. Home Equity Trust, Series 2005-HE5, subprime mortgage bond?—but some of the topics are easy to understand and useful for the average investor. In this free document, containing a few of his past pieces, investment topics such as asset managers (e.g. Legg Mason) and emerging market mobile phone providers may interest some readers. For me, though, the most interesting and recommended piece, especially if you are macro-oriented, is the last article titled China channels 'Monkeybrains' presenting his bearish case for China.

  • Real estate is stabilizing but dark clouds still abound (The Economist): A good overview of the real estate situation in America. Things seem to be improving...or are they?

  • Is the carry-trade returning? (The Aleph Blog): Dave Merkel at The Aleph blog wonders if the carry trade is returning. Before I started this blog, I remember arguing with someone on a message board over the carry-trade. He/she implied that it entails low risk whereas I always feel that it is very risky. Unless you have a macro thesis for investing—say improving political stability, declining inflation, etc—there is a reason the market prices the yields higher. Blindly investing in higher yield currencies/bonds sounds like one of the dumbest strategies around. These strategies often amount to betting on inflation or a boom (because yields tend to be higher in countries with higher inflation or a boom) and when the boom ends, they come tumbling down.

  • Slideshow of world's most successful business immigrants (BusinessWeek): A slideshow that seems mostly from a US-centric point of view (I'm pretty sure there just as many immigrant success stories in Europe, especially given how there are many countries close to each other.)

  • Is this the beginning of the end for branded consumer goods in the developed world? (The Economist): A lot of value investors do not realize that Warren Buffett actually rode a big bullish macro wave in branded consumer goods. At least I think so. Branded consumer goods became dominant, I believe, on the back of the rising consumerism in America and other developed countries. A key was rising consumer incomes from, say, 1950 up to 1990. In the last decade, incomes have barely gone up, and in fact have been flat to slightly negative in real terms, in most developed countries. Is this going to spell the end of the high profitability of branded consumer goods? ... Something to think about, before ploughing your life savings in Coca-Cola, Pepsi, P&G, or Kraft. (note: the story is opposite in developing countries)

  • (Recommended) The end of the properity boom (Yahoo! Finance; article by The New York Times): No one considers prosperity to be a boom that can end, but, alas, it often ends in spectacular fashion. The so-called boom bypassed lower class people like me so we won't feel anything, other than greater job uncertainty. However, the upper-middle-class and higher up will feel it. The linked story is quite interesting and mentions how John McAfee, the founder of the McAfee anti-virus software company, has seen his net worth collapse from around $100 million down to $4 million. This is probably an extreme case but I still think most upper class individuals will see as much 50% to 70% of their net worth erode, if we end up in a decade-long slump, as I think we will :( Wealthier people tend to have a lot of their net worth in real estate or stocks, and it's hard to be optimistic for those two asset classes—unless you were buying right now, after a collapse (then it's great.)

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9 Response to Some articles for your perusal

August 21, 2009 at 11:35 PM

What does it mean when you say "value investing goes out of favor".

To understand the above statement, it is necessary to understand what it means to say "value investing is in favor". When a security is in favor, its prices get bid up. When a methodology like value investing is in favor, it means a lot of participants in the markets are searching for securities with price-value gap. But with such a participation the gap gets closed faster than when value investing is out of favor. 

So, now what happens when value investing is out of favor. Majority of the participants in financial markets, instead of looking for price-value gap, are either using momemtum or other styles of investing. Or it may be that the number of participants looking for price-value gap are same as before but there aren't many securities available with such a characteristic. But if this is the case, these participants (the value investors) recognize the lack of margin of safety and sit tight on their cash. Sitting tight and not participating in such a mania is also part of the value investing practice. If you read Seth Klarman's Margin of Safety carefully one of the important characteristic of a value investor is this ability to sit on cash and not be fully invested. And it isn't only Seth Klarman. In the most recent period, Bob Rodriguez at FPA Capital, recognized such a madness going on and would sit on 40-50% cash. When the tide turns, and it always does, it is these managers who preserve their clients capital. The managers who practice whatever is in favor other than value investing lose their clients capital and their clients.

I hope you are right that value investing goes out of favor. Because it means that value investors will anyways come out ahead !!

August 22, 2009 at 1:09 PM

I agree with everything you are saying. Value investing goes out of favour, not because the methodology is dead or obsolete, but because the opportunities shrink. In such a scenario, there will be fewer value investors who participate in the market. Some who were fake value investors--equivalent to fair-weather fans in sports who keep switching teams based on who is winning--would switch to other investment techniques; while the true value investors, as you suggest, will sit on ever-increasing cash.

In a very simplistic sense, I would say value investing went out of favour from 1966 to, perhaps, 1974. Recall how Warren Buffett basically shut down his hedge fund in the late 60's because he couldn't find opportunities. It's not that value investing died all of a sudden in 1966 (or whenever he closed his fund), but the opportunities dissapeared (at least for someone like Warren Buffett, who has high standards.) There were other value investors (including the ones Buffett recommended to his hedge fund investors) but they were dwindling down as well.

As for whether value investors will come out ahead in the end, that's debatable. In the very long run, spanning decades, sure. But I can see value investing underperforming or posting tiny returns for as long as two decades (I'm not predicting this; I'm just giving the worst case.) I can see strategies such as trading, which is a form of momentum investing in some sense, outperforming. So, even if value investors sit on cash, they can underperform other strategies for many years or even a decade. I have no proof to support this but how well did hte value investors in Japan do in the last 20 years? I suspect not very well. Some foreign value investors (funds investing in Japan) have claimed they have done well in Japan in the last two decades but I see very few positive stories from any local Japanese fund, even so-called value funds.

August 22, 2009 at 1:33 PM

You are right. In the scenario you are talking about, value investors mays underperform or post tiny returns for a long time. However, the goal of value investors is not to beat the market. They have an absolute return orientation. When the margin of safety is shrinking, value investors care less about benchmarks or underperformance. Warren Buffet recognized this in the 60's and decided that his fudiciary duty to his shareholders required him to close his shop and return all the money. So, although others may beat the market when bargains have shrunk, value investors are either willing to sit tight or get out of the game.

Warren recognized that in a parnership he was still a bit at the mercy of redemptions, so he changed his game and started investing through a vehicle where he had a more permanent capital like insurance premiums. Prem Watsa at Fairfax and Ian Cumming at Leucadia have the same strategy. Seth Klarman can practice value investing because his funds only accepted money from the wealthy families, no fund of funds, no institutional money. Wealthy families can afford to have long-term orientation and thus the fear of redemptions is lesses than the value-oriented mutual funds but more than someone running a vehicle like Berkshire. The mutual funds have a everyday fear of redemptions, but the good value-oriented mutual funds treat their assets as if they are liabilities and sit on good amounts of cash to meet redemptions, and still continue to be long-term oriented agnostic of benchmarks and underperformance. An example of this - marty whitman at third avenue or bob rodriguez at fpa capital.

August 22, 2009 at 1:40 PM

My main point through the above post is that, at some point you have to decide that (a) is absolute return with protection of capital is your primary goal? or (b) is beating benchmarks is your primary goal? If it is the first one, value investing is the only way to go. If it is beating benchmarks, you might be more willing to throw value investing out of the window, when bargains start disappearing. Nothing wrong with that - but in my opinion, the two are mutually exclusive.

August 22, 2009 at 1:45 PM

The other thing is that there are many funds with the morningstar category being the left box (value) vs the right box (growth). In my opinion, this title has nothing to do with value investing. They are relative value funds that invest based on metrics and formulas like P/E etc.

August 22, 2009 at 2:06 PM

Guest: "<span>The other thing is that there are many funds with the morningstar category being the left box (value) vs the right box (growth). In my opinion, this title has nothing to do with value investing. They are relative value funds that invest based on metrics and formulas like P/E etc."</span>

<span>Yes, and I hate referring to them as well, but the thing is, we need some way to classify investors. The automatic classifications using price-to-book-value or earnings growth, or whatever, may be misleading but we need a way to classify investors. Furthermore, who is to say a fund that advertises and promotes itself as a value fund is or is not one?</span>

<span>If you go with a strict defintion that is often suggested by Buffett and Graham, only value investing is true investing and everything else is speculation. However, many, including me, like to break it up to differentiate styles. Even within speculation, I would like to break it up into, say, macro investing and quantitative investing. There is clearly different approaches.</span>

August 22, 2009 at 2:20 PM

Guest: "...(a) is absolute return with protection of capital is your primary goal? or (b) is beating benchmarks is your primary goal? If it is the first one, value investing is the only way to go..."

You cannot prove that value investing is the only way to protect your capital, or to even generate absolute returns. In fact, many so-called value investors, including the likes of Martin Whitman, have probably suffered, massive, permanent losses in the recent bust (I'm guessing.)

In fact, many funds that target absolute returns are quantitative funds. These funds, assuming they are not the post-10-years-of-profits-to-blow-up-in-year-11 funds, probably can generate absolute returns better. I'm not familiar wtih this area but I believe funds such as Renaissance Technologies has posted absolute returns for more than two decades now.

I'm not arguing against value investing as a methodology. Rather, I'm just saying that it can underperform, even if you were targetting absolute returns, in certain types of environments. A pure value investor may view those markets as being irrational or risky, but that is dependent on one's views. For instance, a macro investor that successfuly foresees a commodity boom and blindly invests in commodities may do well even if a value investor perceives the same market as being overvalued and having no margin of safety. In such a scneario, the value investor would sit on the sidelines, perhaps safely in cash, and underperform.

I would argue that if value investing was the only way to post absolute returns, someone like George Soros wouldn't exist. As far as I could tell, he doesn't target the market and has posted strong returns for many decades, across different conditions.

August 23, 2009 at 1:58 AM

Sivaram you need to read a paper called "Fight the Fed Model" by Cliff Asness. Low interest rates do not justify high P/E's. Stocks are real assets whereas bonds are nominal. Additionally if you look at the ENTIRE 20th centure data, you will see that treasury yields and P/Es do not correlate.

Sivaram Velauthapillai
August 25, 2009 at 10:52 AM

I'll take a look a the paper you suggested...

Although there is no perfect correlation between bond yields and earnings yields, there is some  theoretical backing for why they should be correlated. Present value of assets are discounted by the bond yield (which is generally the opportunity cost) so if yields are high, the present value of assets (say stocks) should be lower; and vice versa.

However, in practice, one can't blindly rely on bond yields because it is manipulated by the government. For instance, the US govt essentially "forced" the FedRes to keep rates low and to continuously buy Treasury debt from the 40's to the 60's I believe (don't remember exactly when they stopped doing that). If you wanted to own bonds during that period, your returns were extremely low due to manipulation of the long bond yields.

I don't know what you mean when you say "stock are real assets whereas bonds are nominal". I don't see why stocks are real assets. There is nothing to say they are. They produce returns that are nominal as well. Stocks can post negative real returns for long periods of time. In the 70's, stocks posted negative real returns. I'm not sure why you say stocks are real and bonds are nominal. Can you elaborate? Thanks...

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