In value investing, it is imperative that one considers the state of the industry invested in, the balance sheet of the company, and earnings quality.? These are basic concerns for any investor, and all of my failures in investing can be be linked to neglect of one of these three items.
Ben Graham used the phrase “margin of safety.”? Actuaries, even less poetic, use “provision for adverse deviation.”? In either case, the idea is investing in such a way that you won’t get badly hurt if you are wrong.? It handles risk at the security selection level — choose your companies carefully; make sure they are survivors.
Does the industry have pricing power?? Is it under pressure from rising costs?? (Credit losses are a cost for financials.)? Pricing power, and lack thereof, should be considered in valuation decisions.? Are things so bad that companies are going bankrupt?? Perhaps it is time to buy the strongest one in that industry, because it often takes defaults to make pricing power turn.? Fewer competitors means profit margins can rise.
Does the company have a lot of debt?? Is the tangible net worth small relative to the liabilities?? Be careful, because a small negative change in the economics of the business could kick the company over the edge.
Do the earnings come from cash earnings, or do accruals dominate the earnings?? Cash earnings are always higher quality than accrual earnings.? This is one reason why financials almost always trade at a discount, becausethey are a bag of accruals.? Also, with financials, the quality of the accrual entries affects valuations.? Asset managers will have higher valuations than long-tail P&C insurers.? Who knows whether the reserves are right or not?
All that said, it was with sad amusement when I heard on the radio this afternoon that Legg Mason had become the largest shareholder of Freddie Mac.? Is Bill Miller (or Private Capital) doubling down?? He will look like a genius or a fool after this, depending on the outcome.? I think it is foolish, and an willing to say that he doesn’t understand the credit risk in the current environment, and should get advice from someone who gets the current credit crisis better, like me, or Eric Hovde.
After all, at the present time, even the rating agencies are downgrading everything at Fannie and Freddie except the senior debt ratings.
Value investors often invest in financial stocks.? That is their undoing in the present market, as earnings and net worth get eaten by credit losses.? But to any value investor that does industry analysis, this was avoidable, because the risk of credit losses to the banks grew as the banks were willing to lend on terms that were loose.
As a value investor, I have been able to avoid the current crisis.? I avoided credit-sensitive financials, and have bought cheap names among industrial stocks.? But that was yesterday, what of tomorrow?? I don’t think the credit crisis is done, and so I urge a conservative posture at present.
This is a repeat of a prior comment/request, perhaps it fits better under this topic:
David, one of your Investing Rules is:
?Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.?
It seems that choosing the right value metric for a specific industry would be an important piece of the analytic process.
Would you be willing to discuss more of the background of how you have determined which value metrics to use for which industries and industry groups?
Also, what are your preferred methods for determining Pricing Power and Cost Momentum for your industries?
That’a quite a bit of bravado that you know more about the credit crisis than Bill Miller.Since Dodge&Cox just increased their position in Fannie Mae to 12% of the common do you know more about the credit crisis than them,too?
Why stop there, Richard Pzena also has a position in Freddie/Fannie in addition to other financials, you know more than him? He’s been managing money in his own shop since 1998 and has compiled an incredible track record barring the last 2 years.
Dodge&Cox has been investing since 1930 with a terrific track record. Bill Miller has had a horrible two years but compiled an incredible 15 year record. Yes the long term returns have been hammered due to the last two years but betting against investors with terrific long term returns is probably not the best strategy.
Since your holding yourself out as an expert on the credit crisis what is the current price-to-book ratio of the 1500 largest stocks and how does that compare to the last 40 years?Is it cheap or dear? IF it is cheap would that not be the time to buy since their is blood in the streets?
I’m certaintly no expert and don’t pretend to be but your holding yourself out as Mr.Expert. Okay, then start giving us some facts as to why the financial sector is not cheap.Are people not going to be useing credit cards anymore? Are all mortgages going to stop so no one can buy a home anymore? Is the crisis so bad that the financial system as we know it will disappear? Are banks with worlwide franchises’ going to disappear?
IMO the system is deleveraging and its painful,BUT THIS TO SHALL PASS.
Best Wishes
Larry Grubart
You read me wrong, sir. I am not claiming to be the world’s best on any topic. I am claiming to understand the credit crisis better than Mr. Miller. I also mentioned a man who is my better in the area, Eric Hovde. He and his staff, and a number of his former employees are my betters on this topic. Or, consult my blogroll: I am a generalist portfolio manager who gathers good minds together to learn from them.
Bill Miller benefited from a benign credit environment for most of his 15-year run. His brand of value investing does not have a strong emphasis on margin of safety; it has a strong emphasis on what could go right. This is common knowledge. He is not really a value investor. Nor is he like Buffett, who uses growth stocks mostly intelligently. Note how he has sidestepped most of the credit crunch.
I admire both Dodge and Cox, and Pzena, but they have gotten tripped up recently by an overly rigid view of the world. The insurance analyst at Pzena is a sharp guy; we used to talk a lot.
Value managers developed a crutch of using certain valuation criteria that are no longer valid. On financials, book value is a cruel mistress when bad debts are being realized.
I don’t know where the bottom is, but we have not worked through half the losses on residential lending yet. We have barely started on commercial real estate, which is heading down. We haven’t had our losses yet in the junk bond market, nor on small business lending. The investment banks still have a lot of bad debt to work through.
I have written about the credit crunch pretty extensively both here and at RealMoney. Do your own homework if it is worth that much to you.
Or, just read along as I write on these issues. No offense sir, but you should reconsider your tone in posting. I can’t answer every question, but I am more inclined to answer if you are polite.
I have read a number of things you have wrote.Some i agree with and some i don’t. That’s okay thats what makes the markets.
But what you said and i quote ” it is with sad amusement when i heard on the radio this afternoon
that Legg Mason had become the largest shareholder
of Freddie Mac.”
The implication from that quote is that you know more about the value of Freddie Mac than Bill Miller. Okay,your certaintly entitled your opinion and you may be right.Now lay out your facts as to why you think Freddie is overvalued.Since there are a number of very smart investors buying into the GSE’s your implication is you know more than them. What do you know?
ere are some questions i would have for you regarding the GSE’s.What do you expect their losses to be? What are there current reserves? With credit spreads going through the roof and guarantee fees being increased how much capital will that add to their reserves going forward?Is market-to-market accounting front loading the losses and if so will some of those losses be written back up?
Whether you choose to respond to my comments or not,i’ll still be reading and wish you nothing but the best.
Best Wishes
Larry
Margin of Safety: that was the name of the post. Bill Miller could be right, but he is taking a lot of risk in the process.
I have my failures, but I avoid names where I can’t quantify the risk.
With Freddie Mac, and FNM, the fair market value of their equity is negative. They also have their estimates of payments from their guarantees. Given that I think that housing prices are going down by another 10% minimum, those costs will rise.
I don’t have all of the answers, but I avoid areas where I can’t get comfortable with the risk. I’m not going to go short. I have better names to go long.
Mr. Grubart,
If I may jump in here, you ask a lot of questions. How about answering a few. What do _you_ think the GSE’s equity is worth? What is Bill Miller’s cost basis (rough estimate)? Do you own either of the GSE’s? Where was your first purchase? What is your cost basis?
I’ve been reading various mainstream market pundits for a while now. They all say roughly the same thing about the worst being behind us. And yet write-downs have continued, capital raises and their commiserate dilutions have continued, drops in equity prices have continued, the last 4 weeks not withstanding. So, to my mind, I want to know why July should be different from the previous lows in March, January, November, and August ’07. Because at the time each of those lows looked like *the* lows.
For the record, I short ’em. Hard. But I remember well the reversal in fall of ’98 after LTCM blew-up and Easy Al cut rates. For that I stay vigilant listening to the long side, but so far I’ve yet to hear anything justifying why the markets should improve. Just a lot of wishful thinking from people talking their book or selling eyeballs to advertisers.
Best.
-Allan
Hello Allan
My cost basis on Freddie(i don’t own Fannie) is $10. Bill Millers cost basis can only be a guess on my part based on his filings is around $17-20 but that is a VERY VERY rough estimate.
You have asked what i think their equity is worth here is my take on the GSE’s since you asked.
The GSE’s insure roughly $5 trillion in mortgage debt with about $90 billion in reserves wuth an implied leverage ratio of over 50-1. Soooo… a small downturn in the real estate market would appear to wipe them out. At least i believe thats the argument.
However, that $5 trillion also secures $7.5 trillion of real estate at current prices. In addition, since the guarentee fees have been increased 35% and the mortgage spreads have widened and they now have roughly 80% of the mortgage market. Which means they are making a tremendous amount of money going FORWARD.It appears they will increase earnings $20 billion going forward which added to their reserves would give them $110 billion in capital.
Now from what i read the worst case loss estimates are $100 billion.The CBO has estimated a 5% chance or less they will get to $100 billion. But even if they do they would have enough capital to weather the storm.
Of course i could be dead wrong and the losses could go to $300 billion and wipe them out.It also appears dilution to existing holders is coming at some point.But when the mortgage crisis ultimately plays out what is their earning power?
My best guess is $7.00/share which if you assign an average p-e appears to give tremendous upside.
Imo part of the reason this has gotten so out of hand is market-to-market acounting.These losses are being fronloaded and a certain percentage of these losses are going to be written back up.I got a feeling if we took a time out on market-to-market acounting you would have a lot less capital raising.
Having said that, there is no question we have had a real estate bubble, there is a mass deleveraging going on and some financial institutions will not survive.It’s definitely a minefield out there and wouldn’t blame anyone from staying away.
Only time will tell if my analysis turns out to be correct, but at this time your short position has the day.
Best Wishes
Larry
Larry,
For someone who apparently has great conviction and done their homework you seem to have not read FNM and FREs 10Q. Where did you get the idea that they have $90bn in reserves? Loan & Guarantee Reserves for losses only total $14.739bn for the 2 GSEs. If you add the ‘imbedded’ reserves on REO ($2.058bn) and the bad loans repurchased from the pass through pools ($2.656bn) you get to only $19.453bn. Evenif you add the liabilty they have booked for Guarantee Obligation ($30.463bn) you still only get to $49.916bn but to be accurate if you ae going to count the Guarantee Obligation you must deduct the Guarantee Asset (that’s the NPV of expected G-Fees they expect to recieve) of $21.277bn. So that comes to a grand total of $28.639bn in ‘reserves’ on $5.2 trillion (not $5 trillion) of credit that they own or guarantee.
Lets put that expanded version of reserves in context. You elect ‘current’ value of the underlying real estate but first let compare that to the current level on non-performing assets. The gross (ie before the embeded reserves)amount of non-perfoming assets (+90 day Del., troubled debt restructurings, loan mods with < 6 months of performance and REOs) for the 2 GSEs was $83.708bn as of June 30th. So that’s just a coverage of 34.2% In other words loss severity on existing bad loans exceeds that they have no cushion for any further bad loans. Granted they won’t have losses on every single existing bad loans but loss severity on the ones they have been foreclosing on are already 30%. Secondly, where did you get the $7.5 trillion for the current value of the underlying real estate backing these loans & guarantees? You must have ‘estimated’ it assuming that all the loans & guarantees have a current LTV of 66.66%. Even management’s estimate is not that optimitic and they are caling for house prices to drop another 8% or so. Furthermore a low LTV on one loan does not help on the the one that is high. So the relevant figure on losses is not the average current LTV but the % of the portfolio that has a LTV that exceeds 1 less the transaction cost/loan value – the expected % decline in house prices. Using management’s rosey outlook and 10% transaction costs (that may be low given that REO disposal time is rising fast) that number wold be 82%.