Fear of Losses
In the long run, markets are driven by fundamentals. In the short run, markets are driven by fear and greed.
The mere mention of emotion conjures up an image of an amateur. But, more often than not, it’s the professionals succumbing to fear. The fear of losing money, of losing clients, and of losing their jobs.
The professionals job is to try to outperform, but at the very least, to not lose clients. The job becomes “don’t make any huge bets that could make you underperform substantially.” This incentive and the emotionally baggage associated with thought of losing ones job for substantial underperformance leads to emotional decision making.
For example, in Fortune’s Investor’s Guide 2008, the experts wear their fear on their sleeve. One expert, Susan Byrne, is quoted saying, “Think in terms of being willing to lose opportunity instead of capital. Losing opportunity can be embarrassing, but losing capital is permanent.”
But, as any Economics 101 student will tell you, losses are losses whether they are due to a decline in market value or due to foregone profit. The only thing that rationally matters is what expected return for what risk. Trying to limit losses after the bubble has popped is more an emotional response than an analytical response. The professionals limiting their risk today are just compounding their mistake. It goes without saying, that when emotions drive decisions, the wrong decisions are often made.
The mere mention of emotion conjures up an image of an amateur. But, more often than not, it’s the professionals succumbing to fear. The fear of losing money, of losing clients, and of losing their jobs.
The professionals job is to try to outperform, but at the very least, to not lose clients. The job becomes “don’t make any huge bets that could make you underperform substantially.” This incentive and the emotionally baggage associated with thought of losing ones job for substantial underperformance leads to emotional decision making.
For example, in Fortune’s Investor’s Guide 2008, the experts wear their fear on their sleeve. One expert, Susan Byrne, is quoted saying, “Think in terms of being willing to lose opportunity instead of capital. Losing opportunity can be embarrassing, but losing capital is permanent.”
But, as any Economics 101 student will tell you, losses are losses whether they are due to a decline in market value or due to foregone profit. The only thing that rationally matters is what expected return for what risk. Trying to limit losses after the bubble has popped is more an emotional response than an analytical response. The professionals limiting their risk today are just compounding their mistake. It goes without saying, that when emotions drive decisions, the wrong decisions are often made.
Introduction to Value Investing — Books
Value investing is all about recognizing long-term value. It is more important to know timeless investing principles instead of short-term technical trends.
Therefore, much of what you need to know to be a value investor can be gleaned from books. Many of the important books on the list below were written well before current trends in the marketplace. However, the books are timely as when they were originally written.
One Up on Wall Street
, Peter Lynch (Invest in what you know)
The Essays of Warren Buffett (Timeless Advice from the master himself; you can also access the entire letters to shareholders here)
Fooled By Randomness (more about risk, but a very good book)
The Warren Buffett Way (always good to learn more about the Man)
Common Stocks and Uncommon Profits (The original growth investment classic; growth is a component of the value equation)
You Can Be a Stock Market Genius (Horrible title, good book)
Value Investing from Graham to Buffett and Beyond (good intro to the basic idea of value investing)
Contrarian Investing Strategies (Data showing value investing works)
I hope you enjoy these books as much as I did when I first read them.
Therefore, much of what you need to know to be a value investor can be gleaned from books. Many of the important books on the list below were written well before current trends in the marketplace. However, the books are timely as when they were originally written.
One Up on Wall Street
, Peter Lynch (Invest in what you know)The Essays of Warren Buffett
(Timeless Advice from the master himself; you can also access the entire letters to shareholders here) Fooled By Randomness
(more about risk, but a very good book)The Warren Buffett Way
(always good to learn more about the Man)Common Stocks and Uncommon Profits
(The original growth investment classic; growth is a component of the value equation)You Can Be a Stock Market Genius
(Horrible title, good book) Value Investing from Graham to Buffett and Beyond
(good intro to the basic idea of value investing)Contrarian Investing Strategies
(Data showing value investing works)I hope you enjoy these books as much as I did when I first read them.
So you want to be a value investor?
So you want to be a value investor? The first thing you should do is avoid short-term based thinking. This means avoiding the excitement of the markets daily fluctuations, emotional discussion board posts, and “research” based on technical analysis and short-term trends.
Value investors concentrate on the long-term, so it makes sense to use your time reading about long-term strategies. In addition to keeping up with industry news, I encourage you to learn about value investing by prioritizing your reading as follows:
1. Books
2. Magazines
3. Newspapers
4. Blogs/Websites
5. Analyst research
It may surprise you that I hold outside research in such low esteem. I do this for two reasons: (1) analyst expectations are usually baked into the share price and offer no unique information and (2) analysts are very concerned with the short-term view — value is only a component of the recommendation.
In the coming posts, I will recommend specific items within each category to read.
Value investors concentrate on the long-term, so it makes sense to use your time reading about long-term strategies. In addition to keeping up with industry news, I encourage you to learn about value investing by prioritizing your reading as follows:
1. Books
2. Magazines
3. Newspapers
4. Blogs/Websites
5. Analyst research
It may surprise you that I hold outside research in such low esteem. I do this for two reasons: (1) analyst expectations are usually baked into the share price and offer no unique information and (2) analysts are very concerned with the short-term view — value is only a component of the recommendation.
In the coming posts, I will recommend specific items within each category to read.
Comparing “Cheapness” Across Countries
If you read financial news, it’s easy to compare markets to one another. All you need to do is compare price to earnings, price to cash flow, and price to book. Using these ratios, articles can be written determining the relative attractiveness of investing in different markets.
In fact the “Heard on the Street” column on Friday compares these ratios between Japan, the U.S, the U.K., and the world and comes to the conclusion that Japan is relatively cheap. While their conclusions may be correct, their analysis is overly simplistic.
I am not an expert by any means in international accounting or Japanese securities but what I do know was not even addressed in the article. First, international accounting differences affect the income statement, cash flow statement, and balance sheet. This will change the “normal” P/E, P/CF, and P/B ratios across countries.
Second, Japanese companies have significant cross ownership. This means that earnings and cash flow will likely be higher than reported, raising expected P/E and P/CF ratios. Any analyses should at least acknowledge the shortcomings inherent in ratio comparisons across industries, let alone countries.
In fact the “Heard on the Street” column on Friday compares these ratios between Japan, the U.S, the U.K., and the world and comes to the conclusion that Japan is relatively cheap. While their conclusions may be correct, their analysis is overly simplistic.
I am not an expert by any means in international accounting or Japanese securities but what I do know was not even addressed in the article. First, international accounting differences affect the income statement, cash flow statement, and balance sheet. This will change the “normal” P/E, P/CF, and P/B ratios across countries.
Second, Japanese companies have significant cross ownership. This means that earnings and cash flow will likely be higher than reported, raising expected P/E and P/CF ratios. Any analyses should at least acknowledge the shortcomings inherent in ratio comparisons across industries, let alone countries.
Dell’s Earnings
Dell reported earnings yesterday afternoon and the stock promptly dropped 10% after hours. Obviously, investors did not like what they heard.
Dell reported earnings a penny shy of estimates and revenues that slightly beat forecast. With revenues higher and earnings lower, they obviously reported lower margins. Operating income, as a percent of revenue, declined quarter over quarter from 6.1% to 5.3%.
The cash conversion cycle, a measure of how quickly Dell is paid by their customers versus how quick they pay their suppliers dropped from 38 days to 35 days. In addition, management was not overly optimistic about the future, saying that they have seen some minor changes in purchasing by some financial firms, but overall, they have not seen a change in orders from the economic woes.
Despite all of these worrisome trends, the selling was overdone. As everyone knows, Dell has been pushing into the retail space. Selling through retail should reduce margins and hurt the cash conversion cycle. And management had a history of overpromising and stretching (sometimes illegally) to meet their guidance.
After the selling Dell had a market cap of $56 billion. They have $14.8 billion is cash and investments on their balance sheet. This leaves just over $40 billion in value attributable to the business. On the cash flow side, Dell reported free cash flow (after stripping out interest payments) of roughly $750-800 million last quarter. At this rate, Dell’s operations are selling for only 13 times cash flow.
This is extremely cheap given Dell’s huge return on capital. (Their return on capital has trended lower to 32%, in part due to a huge increase in cash on Dell’s balance sheet.)
Despite short term trends that may be negatively impacted by product mix, Dell is a huge value right now. Dell has ridiculous returns on capital and can be bought for only 13 times cash flow.
Dell reported earnings a penny shy of estimates and revenues that slightly beat forecast. With revenues higher and earnings lower, they obviously reported lower margins. Operating income, as a percent of revenue, declined quarter over quarter from 6.1% to 5.3%.
The cash conversion cycle, a measure of how quickly Dell is paid by their customers versus how quick they pay their suppliers dropped from 38 days to 35 days. In addition, management was not overly optimistic about the future, saying that they have seen some minor changes in purchasing by some financial firms, but overall, they have not seen a change in orders from the economic woes.
Despite all of these worrisome trends, the selling was overdone. As everyone knows, Dell has been pushing into the retail space. Selling through retail should reduce margins and hurt the cash conversion cycle. And management had a history of overpromising and stretching (sometimes illegally) to meet their guidance.
After the selling Dell had a market cap of $56 billion. They have $14.8 billion is cash and investments on their balance sheet. This leaves just over $40 billion in value attributable to the business. On the cash flow side, Dell reported free cash flow (after stripping out interest payments) of roughly $750-800 million last quarter. At this rate, Dell’s operations are selling for only 13 times cash flow.
This is extremely cheap given Dell’s huge return on capital. (Their return on capital has trended lower to 32%, in part due to a huge increase in cash on Dell’s balance sheet.)
Despite short term trends that may be negatively impacted by product mix, Dell is a huge value right now. Dell has ridiculous returns on capital and can be bought for only 13 times cash flow.
Losing = Winning?
It’s a wonder that in any serious pursuit, someone could be happy that they were behind. It’s even more perplexing when the pursuit is the alpha-dominated investment industry. But I think Jonathon Clements is on to something.
In an article written today, I’m a Loser and I Couldn’t Be Happier, Clements discloses that he has lost a “boatload” in recent weeks he “couldn’t be happier.” First, I have to “B.S.” — you would be happier with more money. Even the most passionate value investor can feel sick to his stomach after the recent turmoil. That being said, Clements is right.
As I wrote in a recent article, the time to buy is when you feel a sickness in your stomach, when all of the news reflects a depressed outlook, when people start asking you whether they should stop investing in stock market altogether. In short, the time to buy is when your stomach tells you run and your brain is starting to agree.
The reason it is such a good time to buy right now is that all of the rampant pessimism decreases the price of assets, especially in sectors connected to the bad news. As Clements states, “This sort of market turmoil scrambles valuations and creates opportunities.”
When the market is ruled by emotion and short-term thinking, as it is currently, opportunities are created to buy great businesses at low multiples. While it is true that in the short-run, many of these opportunities will continue to be volatile, money can be made by taking advantage of other investors short term thinking.
I can see how Clements has convinced himself he is happy. Intellectually, we should all be happy if we are able to purchase more with less. But, it’s hard to imagine that he is actually smiling underneath.
In an article written today, I’m a Loser and I Couldn’t Be Happier, Clements discloses that he has lost a “boatload” in recent weeks he “couldn’t be happier.” First, I have to “B.S.” — you would be happier with more money. Even the most passionate value investor can feel sick to his stomach after the recent turmoil. That being said, Clements is right.
As I wrote in a recent article, the time to buy is when you feel a sickness in your stomach, when all of the news reflects a depressed outlook, when people start asking you whether they should stop investing in stock market altogether. In short, the time to buy is when your stomach tells you run and your brain is starting to agree.
The reason it is such a good time to buy right now is that all of the rampant pessimism decreases the price of assets, especially in sectors connected to the bad news. As Clements states, “This sort of market turmoil scrambles valuations and creates opportunities.”
When the market is ruled by emotion and short-term thinking, as it is currently, opportunities are created to buy great businesses at low multiples. While it is true that in the short-run, many of these opportunities will continue to be volatile, money can be made by taking advantage of other investors short term thinking.
I can see how Clements has convinced himself he is happy. Intellectually, we should all be happy if we are able to purchase more with less. But, it’s hard to imagine that he is actually smiling underneath.
Market Turmoil
I tend to be more concerned about day to day fluctuations in the market than Brian does. I can’t help but be happy when all of our stocks are up and a little upset as things go down.
Brian used to have all of our portfolio information on yahoo, so at the end of everyday there would be a green or red number at the bottom displaying our gains or losses for the day. Unfortunately it was much too easy to check everyday or several times a day how we were doing. Now, since retirement is still decades away, the day to day fluctuations really mean nothing at all. Seeing how this was affecting me, he removed much of the information, though I still know what stocks we own.
Obviously I can still figure out rough estimates for the day, if I wanted to put the time into estimating, but I rarely know from day to day the value of our net worth. I would say that it’s made me calmer about Brian’s investment strategies. And if I want to know what our net worth is, I can check a spreadsheet on his computer, or ask him.
The past month in the market has been rather tumultuous - the timing of which couldn’t have been worse for me. I’ve been placed on bedrest for approximately 10 weeks (3 weeks down, 7 more to go) so I have even more time to kill. I’ve been trying hard not to follow the markets too closely.
But it’s fair to say that money has beeen on my mind throughout this bedrest experience. I’m still waiting for my short term disability claim to be approved (or denied) and I’m attempting to work remotely 20 hours a week, which has been a challenge in and of itself.
In the end I just remind myself that there is a reason that Brian manages our investments, in that he has the interest and knowledge of the subject while I find it rather dull and that the short term really doesn’t matter..
Brian used to have all of our portfolio information on yahoo, so at the end of everyday there would be a green or red number at the bottom displaying our gains or losses for the day. Unfortunately it was much too easy to check everyday or several times a day how we were doing. Now, since retirement is still decades away, the day to day fluctuations really mean nothing at all. Seeing how this was affecting me, he removed much of the information, though I still know what stocks we own.
Obviously I can still figure out rough estimates for the day, if I wanted to put the time into estimating, but I rarely know from day to day the value of our net worth. I would say that it’s made me calmer about Brian’s investment strategies. And if I want to know what our net worth is, I can check a spreadsheet on his computer, or ask him.
The past month in the market has been rather tumultuous - the timing of which couldn’t have been worse for me. I’ve been placed on bedrest for approximately 10 weeks (3 weeks down, 7 more to go) so I have even more time to kill. I’ve been trying hard not to follow the markets too closely.
But it’s fair to say that money has beeen on my mind throughout this bedrest experience. I’m still waiting for my short term disability claim to be approved (or denied) and I’m attempting to work remotely 20 hours a week, which has been a challenge in and of itself.
In the end I just remind myself that there is a reason that Brian manages our investments, in that he has the interest and knowledge of the subject while I find it rather dull and that the short term really doesn’t matter..
Banks
“When there’s blood on the streets, buy property.” - Baron de Rothschild
Every major bank is being hit with concerns over the debt they hold. Yesterday, Morgan Stanley reported a $3.7 billion hit to their fourth quarter earnings. Previously, Citigroup announced a $8-11 billion hit to their fourth quarter, after taking a hit in the third quarter.
While the fallout has been much higher than I anticipated, the recent sell-off has given everyone a great opportunity to buy.
Let’s look at Citigroup, for example. The big worry here is that Citigrup will need to raise capital or lower its dividend to increase its capital ratios. So what? Citigroup has many assets it can sell at less than firesale prices and who cares if they lower the dividend? It shouldn’t materially affect the long-term value of the company.
Even though the write-downs sound huge, Citigroup usually earns $5-6 billion per quarter after taxes. The two announced write-downs, after taxes, should only be equal to about 3 quarters of earnings for Citigroup.
After Citigroup takes the charges in the fourth quarter, the ship should start to right itself. In fact, analysts expect Citigroup to earn approximately $4.40 a share next year. This means you can buy this company, a company with an average ROE above 15% for a forward P/E of 7.6 (based on the price this morning of $33.41).
Citigroup looks cheap to me.
Disclosure: I own Citigroup. As always, perform your own research before making investment decisions.
Every major bank is being hit with concerns over the debt they hold. Yesterday, Morgan Stanley reported a $3.7 billion hit to their fourth quarter earnings. Previously, Citigroup announced a $8-11 billion hit to their fourth quarter, after taking a hit in the third quarter.
While the fallout has been much higher than I anticipated, the recent sell-off has given everyone a great opportunity to buy.
Let’s look at Citigroup, for example. The big worry here is that Citigrup will need to raise capital or lower its dividend to increase its capital ratios. So what? Citigroup has many assets it can sell at less than firesale prices and who cares if they lower the dividend? It shouldn’t materially affect the long-term value of the company.
Even though the write-downs sound huge, Citigroup usually earns $5-6 billion per quarter after taxes. The two announced write-downs, after taxes, should only be equal to about 3 quarters of earnings for Citigroup.
After Citigroup takes the charges in the fourth quarter, the ship should start to right itself. In fact, analysts expect Citigroup to earn approximately $4.40 a share next year. This means you can buy this company, a company with an average ROE above 15% for a forward P/E of 7.6 (based on the price this morning of $33.41).
Citigroup looks cheap to me.
Disclosure: I own Citigroup. As always, perform your own research before making investment decisions.
Misvalue
In the last post, I said that I would much rather mistime than misvalue. This reminded me of an article I read recently.
Michael Sivy writes an article every month for Money magazine in which he updates his recommended portfolio (the “Sivy 70″). Considering he only has to update his portfolio once a month and give a paragraph or two explanation, it could very well be one of the easiest jobs in the world.
The one hard part of the job is that he opens his picks up for criticism. One of his recent actions had to be based on psychological/technical reasons rather than fundamental analysis. In his September 12, 2007 post
he replaced Dell with HP.
Obviously, before his post HP was on a tear and Dell had been slumping for years. Just as obviously, Dell has been en fuego after the article. See chart.
The problem with this pick is that it wasn’t just a mistiming. He replaced Dell after a long period of underperformance. If anything, Dell’s fundamentals had only improved. But it can be hard to keep the faith if the stock price is stagnant. If Sivy would have stuck with his original analysis and not, presumably, been influenced by relative performance he could have seen which stock offered the more compelling value.
Disclosure: As I have disclosed earlier — actually just a week after Sivy replaced Dell with HP — I have an interest in Dell. See earlier post arguing that Dell was in fact cheap even though it had a high raw P/E ratio.
Michael Sivy writes an article every month for Money magazine in which he updates his recommended portfolio (the “Sivy 70″). Considering he only has to update his portfolio once a month and give a paragraph or two explanation, it could very well be one of the easiest jobs in the world.
The one hard part of the job is that he opens his picks up for criticism. One of his recent actions had to be based on psychological/technical reasons rather than fundamental analysis. In his September 12, 2007 post
he replaced Dell with HP.
Obviously, before his post HP was on a tear and Dell had been slumping for years. Just as obviously, Dell has been en fuego after the article. See chart.
The problem with this pick is that it wasn’t just a mistiming. He replaced Dell after a long period of underperformance. If anything, Dell’s fundamentals had only improved. But it can be hard to keep the faith if the stock price is stagnant. If Sivy would have stuck with his original analysis and not, presumably, been influenced by relative performance he could have seen which stock offered the more compelling value.
Disclosure: As I have disclosed earlier — actually just a week after Sivy replaced Dell with HP — I have an interest in Dell. See earlier post arguing that Dell was in fact cheap even though it had a high raw P/E ratio.
Timing
I have never been good about timing the market. My recent posts, buy financial companies and sell UEC (Uranium Energy Corp) have not performed as expected so far. (It has only been a couple weeks so far.)
Financial companies have continued to feel pressure from the mortgage crisis prompting further selling. This has only made these companies cheaper. Before they were on sale; now, it’s closer to a liquidation sale. I will continue to invest in this area.
My recent recommendation to short UEC based on the fact that they have no revenues, are losing money hand over fist, and will likely continue this pattern for the next year or so, has also not performed as expected yet. The stock is slightly higher than where I sold it short.
Again, I am not changing my opinion. UEC’s board recently approved an increase in pay for the CEO, despite posting record losses over the last year. I still believe the company will continue to bleed red and will continue to reward executives — at the expense of shareholders — despite the lack of performance.
In the long run, we will see whether my current valuations are correct. In the meantime, I’ll continue to reflect on my uncanny ability to mistime the markets. Of course, in the end, I’d much rather mistime than misvalue.
Financial companies have continued to feel pressure from the mortgage crisis prompting further selling. This has only made these companies cheaper. Before they were on sale; now, it’s closer to a liquidation sale. I will continue to invest in this area.
My recent recommendation to short UEC based on the fact that they have no revenues, are losing money hand over fist, and will likely continue this pattern for the next year or so, has also not performed as expected yet. The stock is slightly higher than where I sold it short.
Again, I am not changing my opinion. UEC’s board recently approved an increase in pay for the CEO, despite posting record losses over the last year. I still believe the company will continue to bleed red and will continue to reward executives — at the expense of shareholders — despite the lack of performance.
In the long run, we will see whether my current valuations are correct. In the meantime, I’ll continue to reflect on my uncanny ability to mistime the markets. Of course, in the end, I’d much rather mistime than misvalue.
Screening - Earnings Yield
This should be my last post regarding the book “Value Investing Today” by Charles Brandes. I think I’ve already given the book too much coverage, but I couldn’t pass up writing about this last screening variable.
According to Brandes, value investors should not invest in a company if the “earnings yield is less than twice current long-term (20 year) AAA bond yields.” (The earnings yield is simply earnings/price — the inverted P/E ratio.)
Presumably, if an investor pays more than two times current bond yields, he would be better off buying bonds. The rule, like many others, sets an arbitrary limit without justification.
Let’s take a look at what this rule means in the current market environment. As of today, 20-year AAA bonds are yielding 5.71%. Using Brandes’ math, we should only look for companies with an earnings yield of 11.42% or higher. Putting this into more familiar terms, we should only be investing in companies with a P/E ratio under 8.76!
This is, needless to say, hard to do.
This rule is ridiculously out of date. It reminds me of companies Graham and Dodd wrote about in “Security Analysis.” Companies that were reasonably profitable and could be bought for less than their liquid assets. These companies are harder to come by today.
A P/E ratio lower than 8.76 is almost always associated with operational difficulties or the end of an economic cycle. If you screen on such a low P/E ratio today, you will likely find many mortgage finance firms, some oil companies, and a few firms that recently reported unusually large non-operating gains.
If you want to find good long-term investments, you would be better of raising the P/E ratio of the screen and adding a return on equity/investment variable to weed out weak operators. While you will still have to sift through many dogs, you will raise your chances of investing in a good company.
According to Brandes, value investors should not invest in a company if the “earnings yield is less than twice current long-term (20 year) AAA bond yields.” (The earnings yield is simply earnings/price — the inverted P/E ratio.)
Presumably, if an investor pays more than two times current bond yields, he would be better off buying bonds. The rule, like many others, sets an arbitrary limit without justification.
Let’s take a look at what this rule means in the current market environment. As of today, 20-year AAA bonds are yielding 5.71%. Using Brandes’ math, we should only look for companies with an earnings yield of 11.42% or higher. Putting this into more familiar terms, we should only be investing in companies with a P/E ratio under 8.76!
This is, needless to say, hard to do.
This rule is ridiculously out of date. It reminds me of companies Graham and Dodd wrote about in “Security Analysis.” Companies that were reasonably profitable and could be bought for less than their liquid assets. These companies are harder to come by today.
A P/E ratio lower than 8.76 is almost always associated with operational difficulties or the end of an economic cycle. If you screen on such a low P/E ratio today, you will likely find many mortgage finance firms, some oil companies, and a few firms that recently reported unusually large non-operating gains.
If you want to find good long-term investments, you would be better of raising the P/E ratio of the screen and adding a return on equity/investment variable to weed out weak operators. While you will still have to sift through many dogs, you will raise your chances of investing in a good company.
Financial Companies are Undervalued
This is one of the best times to be an investor if you can just get over the psychological inconvenience of recent losses.
The third quarter earnings season has been a disappointment to say the least. Banks are taking huge charges related to the real estate mess. Even financial companies that are not normally associated with banking, such as E*Trade Financial, have been hit hard by mortgage write-downs.
The cause of the mortgage write-downs is of course the collapse of the real estate bubble. The probability of default has increased across the board, but especially for more exotic, hard to value securities. Even large companies are struggling to value some of these securities — see, for example, Merrill Lynch’s recent restatement.
The fact that the liabilities are hard to value is creating uncertainty and apprehension in the financial arena as no one knows who is going to be hit next. Consequently, everyone with any exposure is on sale. If you are able to ignore headlines, and hold a security for the long term, start allocating more capital to financial companies. You almost can’t go wrong buying any large bank or investment bank in the current environment.
The third quarter earnings season has been a disappointment to say the least. Banks are taking huge charges related to the real estate mess. Even financial companies that are not normally associated with banking, such as E*Trade Financial, have been hit hard by mortgage write-downs.
The cause of the mortgage write-downs is of course the collapse of the real estate bubble. The probability of default has increased across the board, but especially for more exotic, hard to value securities. Even large companies are struggling to value some of these securities — see, for example, Merrill Lynch’s recent restatement.
The fact that the liabilities are hard to value is creating uncertainty and apprehension in the financial arena as no one knows who is going to be hit next. Consequently, everyone with any exposure is on sale. If you are able to ignore headlines, and hold a security for the long term, start allocating more capital to financial companies. You almost can’t go wrong buying any large bank or investment bank in the current environment.
Screening - Debt Levels
Given a choice, investing in a non-financial company that uses little debt is much better than investing in one that uses debt extensively. But it’s hard to create a simple rule for the amount of debt a company should use.
In Brandes’ book, “Value Investing Today” he uses a general rule of not investing if the level of debt is greater than 100% of tangible equity. Like any other rule with regard to the correct level of debt, this rule is a huge oversimplification.
First, financial companies use a tremendous amount of debt in their operations and should be evaluated against a much different target. The industry in which the company operates matters a great deal when evaluating the debt level of a company.
Second, tangible equity is an accounting idea only. It does not reflect the actual value of the company. The value of debt should be compared to the value of equity which is better reflected by market values than accounting values.
Third, debt should be adjusted for other debt items not reported as debt on the balance sheet. Capital leases and net pension liabilities, for example, should be added to the debt on the balance sheet to get a more realistic estimate of a companies debt level.
While the level of the debt used by a company in it’s operations should be closely evaluated because debt adds risk and can disguise low returns from operations, the evaluation of a companies debt level should involve more than a quick glance at their balance sheet.
In Brandes’ book, “Value Investing Today” he uses a general rule of not investing if the level of debt is greater than 100% of tangible equity. Like any other rule with regard to the correct level of debt, this rule is a huge oversimplification.
First, financial companies use a tremendous amount of debt in their operations and should be evaluated against a much different target. The industry in which the company operates matters a great deal when evaluating the debt level of a company.
Second, tangible equity is an accounting idea only. It does not reflect the actual value of the company. The value of debt should be compared to the value of equity which is better reflected by market values than accounting values.
Third, debt should be adjusted for other debt items not reported as debt on the balance sheet. Capital leases and net pension liabilities, for example, should be added to the debt on the balance sheet to get a more realistic estimate of a companies debt level.
While the level of the debt used by a company in it’s operations should be closely evaluated because debt adds risk and can disguise low returns from operations, the evaluation of a companies debt level should involve more than a quick glance at their balance sheet.
Screening - Share Price Above Book Value
This post continues a discussion of the screening criteria in Brandes’ book “Value Investing Today.” His third screeening criteria (I’ll get to the second in a later post) is that tangible book value is above share price.
This criteria is old-school Graham and Dodd. Not even hard-core value investors like Warren Buffett follow this criteria anymore.
There are a couple reasons for this transition. First, companies selling for less than book are harder to find today — not impossible — but harder. Second, most of the companies selling for less than book today either have some losses coming or have an overstated book value. Third, and most importantly, companies selling below book value are likely to have lower returns on capital.
In other words, screening based on book value can find companies selling at a great price, but it also likely to find mediocre companies. Companies selling below book value are likely to be companies with low returns on capital.
One of the major reasons for this is that great companies often have large intangible assets in their brand names. For example, you will likely never see the classic Buffett investment Coke selling anywhere near book since most of the value of the company is intangible.
Paraphrasing Buffett, I would rather own a great company at a good price, than a good company at a great price.
This criteria is old-school Graham and Dodd. Not even hard-core value investors like Warren Buffett follow this criteria anymore.
There are a couple reasons for this transition. First, companies selling for less than book are harder to find today — not impossible — but harder. Second, most of the companies selling for less than book today either have some losses coming or have an overstated book value. Third, and most importantly, companies selling below book value are likely to have lower returns on capital.
In other words, screening based on book value can find companies selling at a great price, but it also likely to find mediocre companies. Companies selling below book value are likely to be companies with low returns on capital.
One of the major reasons for this is that great companies often have large intangible assets in their brand names. For example, you will likely never see the classic Buffett investment Coke selling anywhere near book since most of the value of the company is intangible.
Paraphrasing Buffett, I would rather own a great company at a good price, than a good company at a great price.
Uranium Energy Corp (UEC)
Finally, I found a short: Uranium Energy Corp (UEC). UEC owns some land is currently doing surveys to find uranium deposits. While uranium has a great future, this fact is already reflected in the high valuations of nuclear power-related companies.
UEC has a market cap of $140 million. But they have no revenues and lose about $5 million per quarter.
They support their operation by diluting current shareholders. And will continue to dilute current shareholders as there are no revenues imminent.
If they have a large uranium find, they might survive for the long-term. More likely, they will be lucky to survive they way they dilute the value of the company to support management.
But don’t take my word for it. In their own words, as filed with the S.E.C.:
“WE HAVE A HISTORY OF OPERATING LOSSES AND THERE CAN BE NO ASSURANCES WE WILL BE PROFITABLE IN THE FUTURE.
We have a history of operating losses, expect to continue to incur losses, and may never be profitable, and we must be considered to be in the exploration stage. Further, we have been dependent on sales of our equity securities and debt financing to meet our cash requirements. We have incurred losses totaling approximately $16,969,779 from May 16, 2003 (inception) to December 31, 2006. As of December 31, 2006, we had an accumulated deficit of $16,969,779 and had incurred losses of approximately $14,818,318 during the fiscal year ended December 31, 2006. Further, we do not expect positive cash flow from operations in the near term. There is no assurance that actual cash requirements will not exceed our estimates. In particular, additional capital may be required in the event that: (i) the costs to acquire additional uranium exploration claims are more than we currently anticipate; (ii) exploration and or future potential mining costs for additional claims increase beyond our expectations; or (iii) we encounter greater costs associated with general and administrative expenses or offering costs.”
But don’t worry about the management. They have sweet contracts. In the same SEC filing, you can see that the CEO is paying himself a generous salary ($510,000 including bonus and options) for a company with revenues of $0.
Unless they stumble across a huge uranium find, the company is worth far less than the $140 million. This is especially true when you consider how well the management will compensate themselves if they happen to get lucky.
Disclosure: As you may have guessed, I am short the stock. As always, perform your own research before making investment decisions as even good investors can be wrong much of the time.
UEC has a market cap of $140 million. But they have no revenues and lose about $5 million per quarter.
They support their operation by diluting current shareholders. And will continue to dilute current shareholders as there are no revenues imminent.
If they have a large uranium find, they might survive for the long-term. More likely, they will be lucky to survive they way they dilute the value of the company to support management.
But don’t take my word for it. In their own words, as filed with the S.E.C.:
“WE HAVE A HISTORY OF OPERATING LOSSES AND THERE CAN BE NO ASSURANCES WE WILL BE PROFITABLE IN THE FUTURE.
We have a history of operating losses, expect to continue to incur losses, and may never be profitable, and we must be considered to be in the exploration stage. Further, we have been dependent on sales of our equity securities and debt financing to meet our cash requirements. We have incurred losses totaling approximately $16,969,779 from May 16, 2003 (inception) to December 31, 2006. As of December 31, 2006, we had an accumulated deficit of $16,969,779 and had incurred losses of approximately $14,818,318 during the fiscal year ended December 31, 2006. Further, we do not expect positive cash flow from operations in the near term. There is no assurance that actual cash requirements will not exceed our estimates. In particular, additional capital may be required in the event that: (i) the costs to acquire additional uranium exploration claims are more than we currently anticipate; (ii) exploration and or future potential mining costs for additional claims increase beyond our expectations; or (iii) we encounter greater costs associated with general and administrative expenses or offering costs.”
But don’t worry about the management. They have sweet contracts. In the same SEC filing, you can see that the CEO is paying himself a generous salary ($510,000 including bonus and options) for a company with revenues of $0.
Unless they stumble across a huge uranium find, the company is worth far less than the $140 million. This is especially true when you consider how well the management will compensate themselves if they happen to get lucky.
Disclosure: As you may have guessed, I am short the stock. As always, perform your own research before making investment decisions as even good investors can be wrong much of the time.
Screening - Recent Losses
I was just reading “Value Investing Today,” a book by the Forbes 400 member, Charles Brandes and I had a couple thoughts. I realize it’s way too early (5:15) to be up, let alone reading and having thoughts, but here they are.
In the book, he details a list of characteristics by which an aspiring value investor should screen. Although he does say that one or more of the criteria can be waived in certain circumstances, I take issue with some of the criteria he uses. Of course, I’m not the billionaire, so you’ll have to make your own judgment.
One of the criterion he uses is that the company should not have any losses for the last past 5 years. The problem with that is that there are many circumstances in which you would want to buy something with recent one-time losses. In fact many of my best performers have fit this criterion.
For example, I invested in both BLX and AES back in 2003. BLX is a Latin American bank that had just written off a large portion of its loans due to the Argentinian financial crisis. AES is an international power company that wrote off a large portion of its assets during some volatile times when some of its hedges broke.
The reason both of these companies survived was (1) losses due to write-downs are usually short-lived, (2) both companies were producing positive cash flow from operations before, during, and after their respective crises.
If you are looking at companies with recent losses make sure that the losses are probably short term and the company is still producing positive cash flow from operations. Or, of course, you could listen to someone who invested his way on to the Forbes 400.
In the book, he details a list of characteristics by which an aspiring value investor should screen. Although he does say that one or more of the criteria can be waived in certain circumstances, I take issue with some of the criteria he uses. Of course, I’m not the billionaire, so you’ll have to make your own judgment.
One of the criterion he uses is that the company should not have any losses for the last past 5 years. The problem with that is that there are many circumstances in which you would want to buy something with recent one-time losses. In fact many of my best performers have fit this criterion.
For example, I invested in both BLX and AES back in 2003. BLX is a Latin American bank that had just written off a large portion of its loans due to the Argentinian financial crisis. AES is an international power company that wrote off a large portion of its assets during some volatile times when some of its hedges broke.
The reason both of these companies survived was (1) losses due to write-downs are usually short-lived, (2) both companies were producing positive cash flow from operations before, during, and after their respective crises.
If you are looking at companies with recent losses make sure that the losses are probably short term and the company is still producing positive cash flow from operations. Or, of course, you could listen to someone who invested his way on to the Forbes 400.
Free Markets and the Law
Free markets are great, in theory. In practice, they are much closer to good.
The idea is that free markets allow people to advance their own self-interest, which in turn advances society at large. While this theory is oft-quoted and works better than other systems we have come up with, the truth is more complicated.
Free markets do not form in isolation. A series of laws creates the market. These laws can act as constraints or can encourage inefficient outcomes.
For example, making one form of compensation tax deductible (or off-balance sheet) in the case of base compensation under $1 million (or stock options) can create sub-optimal compensation schemes. These two pieces of the tax code encourage the use of options and discourage high base salaries. In other words, the equilibrium reached in such a market may not be optimal.
Recently, I experienced firsthand a law that created some perverse incentives. I was in Minneapolis this weekend for a wedding. The rehearsal was supposed to last until 3:45 but ended up lasting until 4:10. The problem was that my parking spot was only legal until 4:00.
As my pregnant wife walked out to our car with our son, a tow truck driver looked at them as they tried to stop him and drove away. My son’s car seat, diapers, and medicine were in the car. Needless to say, this was a costly inconvenience for us and could have been much worse. All because we were parked in a spot ten minutes over the limit!
After talking to the towing company, other stranded motorists at the impound lot, and the workers at the impound lot I pieced together the problem. Tow companies are paid based on the volume of cars they bring to the impound lot and they can only tow a car once a ticket has been issued. At least three of us stranded at the impound lot, including me, received a ticket and got towed within ten minutes.
It’s obvious what is going on here: Tow companies are following around ticketing officers and loading as many cars as they can as fast as they can. But do we really want people to be towed if they are parked ten minutes over the legal limit? It seems to me that the punishment does not fit the crime.
The problem is that the incentives created are encouraging an inefficient process. First, extra resources are wasted by creating excessively large towing and impound industries. Second, the people without cars have to find a way to reach the impound lot. Third, had my wife not seen the tow truck I probably would have wasted police resources assuming my car was stolen.
In short, it more efficient for people to be ticketed for minor violations of the law. Confiscation of property should be reserved for gross misconduct. In English, if you outstay your legal rights by a couple minutes you should receive a slap on the wrist; if you blatantly disregard the law, then other more dramatic remedies may be useful.
It is easy to see how this market, created by a legal structure, is far from optimal.
The idea is that free markets allow people to advance their own self-interest, which in turn advances society at large. While this theory is oft-quoted and works better than other systems we have come up with, the truth is more complicated.
Free markets do not form in isolation. A series of laws creates the market. These laws can act as constraints or can encourage inefficient outcomes.
For example, making one form of compensation tax deductible (or off-balance sheet) in the case of base compensation under $1 million (or stock options) can create sub-optimal compensation schemes. These two pieces of the tax code encourage the use of options and discourage high base salaries. In other words, the equilibrium reached in such a market may not be optimal.
Recently, I experienced firsthand a law that created some perverse incentives. I was in Minneapolis this weekend for a wedding. The rehearsal was supposed to last until 3:45 but ended up lasting until 4:10. The problem was that my parking spot was only legal until 4:00.
As my pregnant wife walked out to our car with our son, a tow truck driver looked at them as they tried to stop him and drove away. My son’s car seat, diapers, and medicine were in the car. Needless to say, this was a costly inconvenience for us and could have been much worse. All because we were parked in a spot ten minutes over the limit!
After talking to the towing company, other stranded motorists at the impound lot, and the workers at the impound lot I pieced together the problem. Tow companies are paid based on the volume of cars they bring to the impound lot and they can only tow a car once a ticket has been issued. At least three of us stranded at the impound lot, including me, received a ticket and got towed within ten minutes.
It’s obvious what is going on here: Tow companies are following around ticketing officers and loading as many cars as they can as fast as they can. But do we really want people to be towed if they are parked ten minutes over the legal limit? It seems to me that the punishment does not fit the crime.
The problem is that the incentives created are encouraging an inefficient process. First, extra resources are wasted by creating excessively large towing and impound industries. Second, the people without cars have to find a way to reach the impound lot. Third, had my wife not seen the tow truck I probably would have wasted police resources assuming my car was stolen.
In short, it more efficient for people to be ticketed for minor violations of the law. Confiscation of property should be reserved for gross misconduct. In English, if you outstay your legal rights by a couple minutes you should receive a slap on the wrist; if you blatantly disregard the law, then other more dramatic remedies may be useful.
It is easy to see how this market, created by a legal structure, is far from optimal.
Efficient Markets
It’s surprising to think that people think that the markets are efficient. After all the bubbles and crashes, all the fortunes won and lost, people still think one security is as good as the next.
If markets are efficient, then there should be no excess returns. That is, after adjusting for risk, every stock should have the same expected return. The problem is, they don’t.
Usually, people try to disprove this theory by finding people who beat the market. While those people can be found, it is more instructive to look at the ones that fail. If markets were efficient people should get the same risk-adjusted return before transaction costs and taxes. However, that’s not what we see.
People have a tendency to buy high and sell low. The returns people earn on their investments often trail the return they would earn by not trying to time the market by even more than transaction costs would suggest.
If markets are efficient, then there should be no excess returns. That is, after adjusting for risk, every stock should have the same expected return. The problem is, they don’t.
Usually, people try to disprove this theory by finding people who beat the market. While those people can be found, it is more instructive to look at the ones that fail. If markets were efficient people should get the same risk-adjusted return before transaction costs and taxes. However, that’s not what we see.
People have a tendency to buy high and sell low. The returns people earn on their investments often trail the return they would earn by not trying to time the market by even more than transaction costs would suggest.
A Quarter to Remember?
While stock markets overall are reaching new highs, the past quarter has been eventful. The beginning of the end for the real estate bubble is leading to a general credit slowdown across all parts of the economy. While passive long-term investors can still sleep easy at night, the current environment is turning into a disaster for some well-paid finance geeks.
First, the mortgage debt used to finance the real estate bubble also financed many financial alchemists. The companies that originate mortgages aggregate a large number of mortgages together (or sell them to another company that aggregates them) and sells them into a company whose sole purpose is to hold the debt.
Once these mortgages are aggregated, the cash flows are very predictable, assuming there is no shock to the system. The problem right now is that there has been a couple shocks: a decline in the price of housing coupled with a huge rise in the use of exotic mortgages. The current crisis is having a huge effect on the mortgage issuers, aggregators, and trading desks, mostly effecting banks, investment banks, and hedge funds.
Second, the mortgage crises has led to a general credit/liquidity crisis. It is harder for less than ideal debtors to finance their companies. It’s not that creditors are now being stingy — it’s just that debtors were used to easy money. It’s similar to the problems in housing — companies were able to get financing, even when they couldn’t afford it.
Now that markets are returning to sanity, many of deals struck before the bubble burst are now being renegotiated or scuttled. The main effect of this will be to decrease the leverage used by private equity firms to take firms private, decreasing the potential returns and number of deals completed. This will be partially offset by an increase in strategic mergers — or companies buying rivals, suppliers, and users.
In the final tally, this quarter’s events were substantial for certain segments of the economy but could hardly be felt by a conservative investor with a conventional mortgage. While it remains to be seen how much the real estate and liquidity crises will reverberate throughout the economy, my own feeling is that the damage will be largely contained in select corners of the financial markets and, of course, to homeowners with exotic mortgages.
Despite the constant use of the word crisis the quarter, most long-term investors may not remember this quarter in a year.
First, the mortgage debt used to finance the real estate bubble also financed many financial alchemists. The companies that originate mortgages aggregate a large number of mortgages together (or sell them to another company that aggregates them) and sells them into a company whose sole purpose is to hold the debt.
Once these mortgages are aggregated, the cash flows are very predictable, assuming there is no shock to the system. The problem right now is that there has been a couple shocks: a decline in the price of housing coupled with a huge rise in the use of exotic mortgages. The current crisis is having a huge effect on the mortgage issuers, aggregators, and trading desks, mostly effecting banks, investment banks, and hedge funds.
Second, the mortgage crises has led to a general credit/liquidity crisis. It is harder for less than ideal debtors to finance their companies. It’s not that creditors are now being stingy — it’s just that debtors were used to easy money. It’s similar to the problems in housing — companies were able to get financing, even when they couldn’t afford it.
Now that markets are returning to sanity, many of deals struck before the bubble burst are now being renegotiated or scuttled. The main effect of this will be to decrease the leverage used by private equity firms to take firms private, decreasing the potential returns and number of deals completed. This will be partially offset by an increase in strategic mergers — or companies buying rivals, suppliers, and users.
In the final tally, this quarter’s events were substantial for certain segments of the economy but could hardly be felt by a conservative investor with a conventional mortgage. While it remains to be seen how much the real estate and liquidity crises will reverberate throughout the economy, my own feeling is that the damage will be largely contained in select corners of the financial markets and, of course, to homeowners with exotic mortgages.
Despite the constant use of the word crisis the quarter, most long-term investors may not remember this quarter in a year.
Credit Card Financing
I have historically used credit cards extensively to finance a portion of my stock portfolio. But now, credit card companies are making it harder to arbitrage.
In the past, I would receive cash advance offers for 0% financing for at least a year, with usually a $50-$100 transaction fee. It was easy money to take that money, invest in a money market or stocks and lock in some attractive returns.
Lately, however, the offers haven’t been as kind. I’m not sure if they caught on to my money making machine or if interest rate increases or credit defaults have made the companies reign in their offers.
In any event, I would like to roll over some cheap financing but am finding most of the offers lacking. At least I should have the cash to pay off any debt coming due. But I am going to miss the free lunch.
In the past, I would receive cash advance offers for 0% financing for at least a year, with usually a $50-$100 transaction fee. It was easy money to take that money, invest in a money market or stocks and lock in some attractive returns.
Lately, however, the offers haven’t been as kind. I’m not sure if they caught on to my money making machine or if interest rate increases or credit defaults have made the companies reign in their offers.
In any event, I would like to roll over some cheap financing but am finding most of the offers lacking. At least I should have the cash to pay off any debt coming due. But I am going to miss the free lunch.
Raw P/E Ratios
It’s so easy to figure out the cheapness of a stock. All you have to do calculate the P/E ratio by dividing the price of the stock by the earnings per share. Right? If only it was that easy…
Even though many well-regarded newspapers mainly limit themselves to the P/E ratio and the projected growth rate.
Many stories read like this, “HP trades at a forward P/E multiple in line with IBM and several points cheaper than Dell. This is a bargain of a growth technology company with the Price-Earnings-Growth ratio now under 1.”
In other words, all you have to do is compare P/E ratios — either current or forward (projected one year forward) — and you can figure out what is cheaper.
The problem with the raw P/E ratio is that it is overly simplistic. For example, the $14 billion in cash on Dell’s balance sheet is not accounted for in the ratio. If we account for the cash on the balance sheet, by taking out the interest income from income and the cash from the market cap, the adjusted P/E will show a much more accurate picture.
While this calculation is only the beginning of the analysis, it is an easy adjustment to make and can make a huge difference in the analysis.
(Disclosure: I own Dell but do not own any of the other securities mentioned)
Even though many well-regarded newspapers mainly limit themselves to the P/E ratio and the projected growth rate.
Many stories read like this, “HP trades at a forward P/E multiple in line with IBM and several points cheaper than Dell. This is a bargain of a growth technology company with the Price-Earnings-Growth ratio now under 1.”
In other words, all you have to do is compare P/E ratios — either current or forward (projected one year forward) — and you can figure out what is cheaper.
The problem with the raw P/E ratio is that it is overly simplistic. For example, the $14 billion in cash on Dell’s balance sheet is not accounted for in the ratio. If we account for the cash on the balance sheet, by taking out the interest income from income and the cash from the market cap, the adjusted P/E will show a much more accurate picture.
While this calculation is only the beginning of the analysis, it is an easy adjustment to make and can make a huge difference in the analysis.
(Disclosure: I own Dell but do not own any of the other securities mentioned)
Health Care Politics
Today, Hillary Clinton unveiled a universal health care plan. The first of many health care schemes that will come out of this election. While I support a reasonable solution to our serious health care problems, I am nervous that we will end up with another half-baked policy that will make our health care system worse off.
While it may seem hard to imagine that we could be worse off than we currently are: we have an increasingly large uninsured population, relying on expensive ER services for their primary care. Hospitals are increasingly at risk of going under because they have to provide services to those who can’t pay, while they are having their profitable services cherry-picked by specialty providers.
We have a government-funded services (Medicare and Medicaid) that already can’t be funded by the government. If we expand the government’s role, are they going to start accounting for these liabilities?
On the other hand, an increasing government role could improve some problems. Insurance and medical services are increasingly expensive. This is partially because people who pay their bills are subsidizing those who can’t or won’t. Making insurance mandatory should decrease the losses experienced by providers and drive down costs.
While I support decreasing the cost of health care by making insurance mandatory, I have some reservations about the politics of health care. My main reservation is how any program is going to get funded when the government can’t even fund it’s current medical obligations.
While it may seem hard to imagine that we could be worse off than we currently are: we have an increasingly large uninsured population, relying on expensive ER services for their primary care. Hospitals are increasingly at risk of going under because they have to provide services to those who can’t pay, while they are having their profitable services cherry-picked by specialty providers.
We have a government-funded services (Medicare and Medicaid) that already can’t be funded by the government. If we expand the government’s role, are they going to start accounting for these liabilities?
On the other hand, an increasing government role could improve some problems. Insurance and medical services are increasingly expensive. This is partially because people who pay their bills are subsidizing those who can’t or won’t. Making insurance mandatory should decrease the losses experienced by providers and drive down costs.
While I support decreasing the cost of health care by making insurance mandatory, I have some reservations about the politics of health care. My main reservation is how any program is going to get funded when the government can’t even fund it’s current medical obligations.
When Volatility Hurts
We have gone from the best of times to the worst of times — at least in terms of volatility. The market, at least in terms of the Dow Jones Industrial Average, has seen 200-300 drops become common. However, for most of us, this news should be on page 9 instead of the front page.
For most of us, the recent volatility is a non-event. The market is still solidly higher in the last six months. And therefore we should be better off than we were six months ago.
However, volatility does hurt some investors. The following is a list of some people who may have been hurt:
(1) Investors with a weak stomach. If you are likely to sell based on volatility, volatility does indeed hurt.
(2) Investors with too much leverage. Think hedge fund investors who are being forced to redeem their investments as their prime brokers became more risk averse and their positions move against them.
(3) Investors with a cash crunch. If you need to access your portfolio for living expenses, you may have been forced to cash out some positions at inopportune times.
(4) Investors with short term goals. Many people who invest other people’s money fit into this category. Short term goals come at the expense of long term results. The past few months, hedge funds have been seeing record redemptions.
In the long run, the volatility we have recently been experiencing is a non-event. While it can be emotionally painful to see the price of your portfolio change so drastically, the volatility should not effect the value of most of our portfolios.
For most of us, the recent volatility is a non-event. The market is still solidly higher in the last six months. And therefore we should be better off than we were six months ago.
However, volatility does hurt some investors. The following is a list of some people who may have been hurt:
(1) Investors with a weak stomach. If you are likely to sell based on volatility, volatility does indeed hurt.
(2) Investors with too much leverage. Think hedge fund investors who are being forced to redeem their investments as their prime brokers became more risk averse and their positions move against them.
(3) Investors with a cash crunch. If you need to access your portfolio for living expenses, you may have been forced to cash out some positions at inopportune times.
(4) Investors with short term goals. Many people who invest other people’s money fit into this category. Short term goals come at the expense of long term results. The past few months, hedge funds have been seeing record redemptions.
In the long run, the volatility we have recently been experiencing is a non-event. While it can be emotionally painful to see the price of your portfolio change so drastically, the volatility should not effect the value of most of our portfolios.
TUBR Update
Two months ago, I blogged about a company called Tubearoo, speculating that it may be bankrupt by early next year. (See the original blog.)
I complained that I could not short the stock, as it had no operations and debt coming due — not exactly a promising combination. The stock can not be shorted because it is traded over-the-counter.
When I wrote the article two months ago, the stock was trading at $2. Today, it sells for $0.50. I expect that this is only the beginning of the end for this stock. By next year, it will likely be worth even less.
I complained that I could not short the stock, as it had no operations and debt coming due — not exactly a promising combination. The stock can not be shorted because it is traded over-the-counter.
When I wrote the article two months ago, the stock was trading at $2. Today, it sells for $0.50. I expect that this is only the beginning of the end for this stock. By next year, it will likely be worth even less.
Hedge Fund Excuses
Hedge funds offer a service. A most valuable service to be sure. Generally speaking, they offer the opportunity to profit in all types of markets. The idea is to profit, even when everyone else isn’t.
And it all worked…until, of course, it didn’t. Apparently, “all types of markets” doesn’t include the exact time a hedge is useful — when everyone else is hurting.
In fact, their excuse is that all of the other hedge funds are being forced to liquidate the same securities they hold in their portfolios. Their performance is not their fault — the problem is that everyone else has the same securities as them.
So what happens when they have good performance? Did they just front run other hedge funds?
In addition, if all of the funds hold the same securities, what are investors paying for? Is it really worth it to pay 2-and-20 for a common strategy?
And it all worked…until, of course, it didn’t. Apparently, “all types of markets” doesn’t include the exact time a hedge is useful — when everyone else is hurting.
In fact, their excuse is that all of the other hedge funds are being forced to liquidate the same securities they hold in their portfolios. Their performance is not their fault — the problem is that everyone else has the same securities as them.
So what happens when they have good performance? Did they just front run other hedge funds?
In addition, if all of the funds hold the same securities, what are investors paying for? Is it really worth it to pay 2-and-20 for a common strategy?
Knowledge
“When you do not know a thing, to allow that you do not know it — this is knowledge” –Confucious
One of the biggest enemies investors face, is overconfidence. It doesn’t seem to matter whether the investor is professional or novice, one of the hardest things to admit is that you don’t know something.
Nearly all investors are confident in the direction of the economy, interest rates, stock markets, and even individual securities. Surprisingly, the returns of these overly confident investors often lag the comparable indexes.
So, what went wrong? After all, given their level of confidence, wouldn’t you expect them at least to earn a return equal to their benchmark?
The problem most investors face is not their knowledge or lack thereof, but their overconfidence. Investors that “know” exactly what is going to happen trade too much, trying to take advantage of their superior “knowledge.”
If investors would just admit to their lack of knowledge, they would be better off by sticking to their core competencies.
For example, my core competency is being able to perform a reasonable valuation of individual companies. I can not predict where the economy is heading, where the price of securities are going in the short term, where interest rates are heading, or what the next big thing is. So I don’t pretend to know what is happening in these domains.
As an investor, it helps to figure out what your core competency is and exploit that. Effort spent satisfying your ego by researching areas in which you don’t add value, is pointless. Knowing what you are able to do is something every investor should spend time figuring out.
One of the biggest enemies investors face, is overconfidence. It doesn’t seem to matter whether the investor is professional or novice, one of the hardest things to admit is that you don’t know something.
Nearly all investors are confident in the direction of the economy, interest rates, stock markets, and even individual securities. Surprisingly, the returns of these overly confident investors often lag the comparable indexes.
So, what went wrong? After all, given their level of confidence, wouldn’t you expect them at least to earn a return equal to their benchmark?
The problem most investors face is not their knowledge or lack thereof, but their overconfidence. Investors that “know” exactly what is going to happen trade too much, trying to take advantage of their superior “knowledge.”
If investors would just admit to their lack of knowledge, they would be better off by sticking to their core competencies.
For example, my core competency is being able to perform a reasonable valuation of individual companies. I can not predict where the economy is heading, where the price of securities are going in the short term, where interest rates are heading, or what the next big thing is. So I don’t pretend to know what is happening in these domains.
As an investor, it helps to figure out what your core competency is and exploit that. Effort spent satisfying your ego by researching areas in which you don’t add value, is pointless. Knowing what you are able to do is something every investor should spend time figuring out.
Opportunity Cost of Capital
I could have a blog just documenting the material errors I read in the financial press. My biggest victim would be “Money” Magazine. While they have many good articles that should help a lot of people manage their finances, they need to refresh their economics.
This month, they made a mistake any Econ 101 student could find. In an article entitled “Landlords in Waiting” (page 62 of the September edition for avid readers), they analyze involved in whether someone should rent or sell a house they own.
Depending on the assumptions used (i.e. the increase in value of the property and assumed net income per year), after two years the rental could be -$600 or $33,940. (Of course, these are only two outcomes, neither of which will occur, but the scenarios give you an idea of how important your assumptions are.)
The author claims that if you should rent if you think you are going to clear $33,940 but sell if you think you are going to lose.
The problem with this analysis is two-fold. First, the analysis doesn’t account for the paydown of principle on the mortgage. Second, and more importantly, there is no cost of capital for the equity portion of the investment.
People rarely forget about the explicit costs of the debt associated with an investment, but often forget about the cost of the equity. In fact, the article neglects to mention what the equity investment is.
Without this information, there is no way to know what the return on the investment or net present value of the investment actually is. The investment may be good or bad (which is found by comparing the expected return to the cost of capital), but we will never know.
This month, they made a mistake any Econ 101 student could find. In an article entitled “Landlords in Waiting” (page 62 of the September edition for avid readers), they analyze involved in whether someone should rent or sell a house they own.
Depending on the assumptions used (i.e. the increase in value of the property and assumed net income per year), after two years the rental could be -$600 or $33,940. (Of course, these are only two outcomes, neither of which will occur, but the scenarios give you an idea of how important your assumptions are.)
The author claims that if you should rent if you think you are going to clear $33,940 but sell if you think you are going to lose.
The problem with this analysis is two-fold. First, the analysis doesn’t account for the paydown of principle on the mortgage. Second, and more importantly, there is no cost of capital for the equity portion of the investment.
People rarely forget about the explicit costs of the debt associated with an investment, but often forget about the cost of the equity. In fact, the article neglects to mention what the equity investment is.
Without this information, there is no way to know what the return on the investment or net present value of the investment actually is. The investment may be good or bad (which is found by comparing the expected return to the cost of capital), but we will never know.
Blackstone’s Tax Arguments
Blackstone, a private equity firm that recently went public, has a huge tax problem. Currently, Blackstone pays taxes at a rate well below that of most U.S. Corporations. Congress may be about to change this.
As Congress debates whether to increase the taxes Blackstone and other (public) private equity firms pay, Blackstone is not standing still. Blackstone is trying to pressure Congress into letting them keep their sweetheart tax deal.
The firm argues that increasing taxes is counterproductive. One of the funniest arguments the firm has come up with is that increasing their taxes will reduce the value of their firm, thus reducing the capital gains taxes realized by their investors.
By that same logic, if taxes on every corporation were cut, the values of those firms would go up, increasing capital gains taxes. The argument is not unique to Blackstone and the private equity industry, in general.
The reason for not letting a company pay less than it’s share of taxes is obvious. A lower tax rate is a subsidy, artificially increasing the amount of capital into that particular industry. Do we really want to subsidize private equity? I can think of many other industries I would rather subsidize.
As Congress debates whether to increase the taxes Blackstone and other (public) private equity firms pay, Blackstone is not standing still. Blackstone is trying to pressure Congress into letting them keep their sweetheart tax deal.
The firm argues that increasing taxes is counterproductive. One of the funniest arguments the firm has come up with is that increasing their taxes will reduce the value of their firm, thus reducing the capital gains taxes realized by their investors.
By that same logic, if taxes on every corporation were cut, the values of those firms would go up, increasing capital gains taxes. The argument is not unique to Blackstone and the private equity industry, in general.
The reason for not letting a company pay less than it’s share of taxes is obvious. A lower tax rate is a subsidy, artificially increasing the amount of capital into that particular industry. Do we really want to subsidize private equity? I can think of many other industries I would rather subsidize.
Re-Balancing
During times of market turbulence, it is tempting to seek safety and comfort. This is often done in one of two ways: (1) through selling risky assets for safer assets (think selling stocks for treasuries) and (2) through rebalancing.
Selling risky assets and purchasing safer assets after a market drop is never a good idea. It is either an emotional reaction or the result of a need for liquidity. In either case, the reaction is the result of a portfolio that was too risky to begin with.
The second reaction is often the correct one. By rebalancing, investors can allocate more capital to segments that have recently declined more. The idea rebalancing increases diversification and can increase returns. It can increase returns because segments that have recently declined are more likely to be undervalued.
In today’s market, financial advisors are recommending investors allocate more capital to real estate, cyclical firms, and international firms due to recent underperformance. However, the recent underperformance comes on the heels of many years of spectacular performance. The recent underperformers are still overvalued.
While I encourage people to re-balance their portfolio periodically, the current recommendations are misplaced due to the fact that many of the securities recommended are still grossly overvalued.
Selling risky assets and purchasing safer assets after a market drop is never a good idea. It is either an emotional reaction or the result of a need for liquidity. In either case, the reaction is the result of a portfolio that was too risky to begin with.
The second reaction is often the correct one. By rebalancing, investors can allocate more capital to segments that have recently declined more. The idea rebalancing increases diversification and can increase returns. It can increase returns because segments that have recently declined are more likely to be undervalued.
In today’s market, financial advisors are recommending investors allocate more capital to real estate, cyclical firms, and international firms due to recent underperformance. However, the recent underperformance comes on the heels of many years of spectacular performance. The recent underperformers are still overvalued.
While I encourage people to re-balance their portfolio periodically, the current recommendations are misplaced due to the fact that many of the securities recommended are still grossly overvalued.
No More HGTV for Me?
I have this vision for my bedroom - brown walls, white molding, hardwood floors, custom made curtains (made by myself), beautiful light fixture…
Of course, this is the product of watching too much HGTV, TLC, and the occassional decorating/house flipping show on Discover. It’s a problem. Every show has some gorgeous finished product that I would love to have in my own home. It wouldn’t really improve my life, but these show always lead you to believe that you’ll be calmer, more organized, a better hostess…
I painted by bedroom over the past couple of weeks and I’m in the midst of a quilt that will complete the bedding portion of the vision. However, all the other improvements would take large capital investments. I tend to be cheap (let’s say frugal) and Brian’s frugality makes me look like a spendthrift, which means that the larger projects won’t be happening any time soon… or ever.
Of course, I try to internally justify home improvement projects by thinking of increased value of our house. Surely putting hardwood floors in the bedrooms or tile floors in the bathrooms would improve the overall presentation our house would make when we sell it. But then there’s the question of when, if ever, we are going to sell our house. The home improvement shows would tell you that if you put in a $10,000 deck, you’ve increased the value of the property by $20,0000 - instant profit. Of course, some of the profit comes from doing the work yourself.
Then there’s the enjoyment that I would get from having a perfectly decorated bedroom. When I’m honest with myself, I think about the piles of clean and not so clean clothes that are always scattered all over the bedroom, the layer of dog hair that even a twice a week vacuuming regimen wouldn’t contain and toddler that tears through the room without regard for anything fragile (which is why there is nothing fragile in the room, or any other room in the house).
In theory I should stop watching these shows, but in the end, I’m sure I won’t. There’s nothing wrong with ideas. As long as the price tag stays reasonable.
Of course, this is the product of watching too much HGTV, TLC, and the occassional decorating/house flipping show on Discover. It’s a problem. Every show has some gorgeous finished product that I would love to have in my own home. It wouldn’t really improve my life, but these show always lead you to believe that you’ll be calmer, more organized, a better hostess…
I painted by bedroom over the past couple of weeks and I’m in the midst of a quilt that will complete the bedding portion of the vision. However, all the other improvements would take large capital investments. I tend to be cheap (let’s say frugal) and Brian’s frugality makes me look like a spendthrift, which means that the larger projects won’t be happening any time soon… or ever.
Of course, I try to internally justify home improvement projects by thinking of increased value of our house. Surely putting hardwood floors in the bedrooms or tile floors in the bathrooms would improve the overall presentation our house would make when we sell it. But then there’s the question of when, if ever, we are going to sell our house. The home improvement shows would tell you that if you put in a $10,000 deck, you’ve increased the value of the property by $20,0000 - instant profit. Of course, some of the profit comes from doing the work yourself.
Then there’s the enjoyment that I would get from having a perfectly decorated bedroom. When I’m honest with myself, I think about the piles of clean and not so clean clothes that are always scattered all over the bedroom, the layer of dog hair that even a twice a week vacuuming regimen wouldn’t contain and toddler that tears through the room without regard for anything fragile (which is why there is nothing fragile in the room, or any other room in the house).
In theory I should stop watching these shows, but in the end, I’m sure I won’t. There’s nothing wrong with ideas. As long as the price tag stays reasonable.
Thornburg Mortgage
As a value investor, I’m always looking for ways to exploit opportunities presented by other’s fear and greed.
Obviously, the major current fear concerns any company in the housing sector. In particular, mortgage companies are feeling the brunt of the pessimism.
I thought I found a good candidate in Thornburg Mortgage (Ticker: TMA), but before I could do the necessary research, the price of TMA recovered enough for me lose most of my interest.
Before I lost interest I found some juicy tidbits — more fun than any investment opportunity.
While most people thought they were buying a safe Real Estate Investment Trust (REIT) they were in fact purchasing something more like a hedge fund. Or, at least incurring the fees of a hedge fund.
Thornburg Mortgage is managed by a separate company. The management company has has a sweetheart contract. It boils down to a hedge fund management contract for managing a very leveraged mortgage REIT. The management fees are 1% of assets and 20% of profits (above LT treasuries +1%) — a hedge fund fee structure — plus expenses, plus long-term incentive compensation.
To say this is a sweetheart contract understates the contract. To increase fees, all they have to do is keep issuing shares — which they do on a quarterly basis, diluting current investors.
While the company still sells below book value, go into any investment with your eyes wide open. You would be paying hedge-fund fees, you should expect the same performance.
Obviously, the major current fear concerns any company in the housing sector. In particular, mortgage companies are feeling the brunt of the pessimism.
I thought I found a good candidate in Thornburg Mortgage (Ticker: TMA), but before I could do the necessary research, the price of TMA recovered enough for me lose most of my interest.
Before I lost interest I found some juicy tidbits — more fun than any investment opportunity.
While most people thought they were buying a safe Real Estate Investment Trust (REIT) they were in fact purchasing something more like a hedge fund. Or, at least incurring the fees of a hedge fund.
Thornburg Mortgage is managed by a separate company. The management company has has a sweetheart contract. It boils down to a hedge fund management contract for managing a very leveraged mortgage REIT. The management fees are 1% of assets and 20% of profits (above LT treasuries +1%) — a hedge fund fee structure — plus expenses, plus long-term incentive compensation.
To say this is a sweetheart contract understates the contract. To increase fees, all they have to do is keep issuing shares — which they do on a quarterly basis, diluting current investors.
While the company still sells below book value, go into any investment with your eyes wide open. You would be paying hedge-fund fees, you should expect the same performance.
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