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Archive for October, 2011

Value Versus Growth — II

Saturday, October 29th, 2011

One of my readers posted the following comment, and I felt it was worth following up:

I continue to struggle with the Growth vs Value designation (never mind where to invest). According to Buffet’s letter, they are joined at the hip (growth being an important part of value), whereas you indicate that there is a real difference between Value and Growth.

Does “Value” as a category of stock arise from the way it is priced or is it solely dependent upon the condition of the company? Is the “Growth” designation simply a function of the rate of change of earnings (or some other financial measure) or is it related to the eagerness of buyers?

If I am reading you right, you are saying that value applies to a stock (not a company), and that value investing does not require (earnings) growth to be successful, whereas growth investing is paying a premium, and thus requires sustained, substantial earnings growth to be successful (because you are paying so much for the shares).

It always seems like “value” stocks are the one’s investors don’t want (if people are paying a premium, it is not a “value” stock). If few people are interested in buying the stock right now, when the underlying business is fine (or at least unimpaired), why would they be willing to pay more in the future? It seems like that would only happen if earnings grow (so it is a “growth” company?) or if people decide they would like to pay more for the same earnings. Are future buyers going to pay more because they see that earnings simply aren’t falling? Or is most of the return going to come through dividends and/or share buybacks?

This seems like something very fundamental, but the amount of confusing comments (around the internet) about these terms seems second only to confusion related to the term “risk”.

Imagine for a moment that you had the influence over a company such that you forced them to liquidate it.  Going out of business.  Selling everything.  With a company characterized as a value stock, you would make money off of such a venture.  With a growth stock, you would certainly lose.  Growth stocks are going concerns, and need to continue in operations in order to increase their value.  Even a value stock does not generally want to liquidate, but they don’t need to grow much to maintain the value of the enterprise.

With value stocks, most surprises are positive, because expectations are low.  With growth stocks, most surprises are negative, because expectations are high.

Buffett is right.  Value and Growth are joined at the hip.  What he means by that is that a company with predictable growth deserves a higher valuation, with which I totally agree.  The stereotyping of growth and value stocks stems from human prejudices where people segment the market into two or three areas:

  • Buy the fastest growing companies, at any price.
  • Buy growth at a reasonable price.
  • Buy companies that will do okay even if they don’t grow.

Value is a question of price only.  There is no such thing as a bad asset, only a bad price.  I like buying growth companies, and I do so when they are offered to me at bargain prices.  I will pay up a little for a growth company, in the same way that I would pay up for bonds of higher credit quality, while losing a little yield, but not a lot of yield.

This is not to say that all value investing will succeed.  I have my share of failures.  The idea is to tip the odds into your favor by buying things that are out of favor relative to their current assets, or likely future earnings (or free cash flow, for the advanced).

Risk is a question of permanently losing capital.  That is the downside on which all investors should focus.  Though I do lose money on some stocks that I buy, my goal is to lose money on none of the stocks.  If I cover the downside, the upside will take care of the rest, because the goal of a value investor is to not lose money over the long haul.

Eliminate Leveraged ETFs

Saturday, October 29th, 2011

Have a look at this article.  He makes the case as to why leveraged ETFs should not be held over the long term, as I have argued before.

There is a problem with this.  Imagine for a moment that all users of leveraged ETFs extinguish their positions daily.  There would be no shares to be sold the next morning to those who want to take a position. Where would the shares come from to be bought or sold?

Leveraged ETFs rely on those that will not use them over one day only. They provide the supply/liquidity for everyone else.

Maybe there should be a tiny dividend accrued/paid to holders at the end of each day to equalize for the rebalancing losses.  I don’t know for certain, but I suspect that would ruin the economics of running a leveraged ETF.  It would add to the daily costs of hedging, which are already significant.  But maybe the overall costs would be borne more equitably with dividends corresponding to the hedging interval.  It would also deter paired shorting of leveraged ETFs.

But maybe losses for levered speculators is its own best reward.  The ability to take levered positions shouldn’t be free; someone trying to do it on his own would incur costs.

It’s paternalistic, but maybe these products should be barred on public policy grounds.  On net, they guarantee losses to holders.   If people want to construct these strategies themselves, and bear the costs explicitly, fine.  But to have the costs borne implicitly by fools is another matter.

We limit market leverage partly for systemic reasons, but also because it prevents people from harming themselves.  As for me, I would not object if the regulators eliminated leveraged ETFs.  They serve no long-term useful purpose.

Ideas at the End of October

Friday, October 28th, 2011

After my trolling through 13Fs for the dream team, I decided to use the data, such that I would review all companies I have run across that have one member of the dream team owning it.  Beyond that, I looked at all companies that 2 or more members of the dream team own, and added to the list all companies that I have never heard of.  I did the same with my list of companies that I accumulate each quarter, and kept those that I had never heard of.  Here is the list of tickers:

A AAPL ABAX ABT ACGL ADBE ADP ADS ADSK AFL AGU AHL ALA ALR ALTR AMAT AMP ANR AON APA APEI ARCO ARRS ASEI ASH ASNA ASYS ATNI ATPG ATSG AVGO AVNW AVT AWH AXS BBBY BCE BCSI BDMS BGC BIDU BLT BLVN BRCM BRK/B BUD BVN CACH CACI CAH CBEY CBI CBT CEDC CELL CF CFK CIE CNQR COBK CODE CPB CPLCPS CPWR CPX CRL CSC CSCO CSGS CSX CTRP CTSH CVI CVS DAR DELL DEO DGIT DGX DIN DIOD DNB DOX DRIV EAG EBAY EDU EGY EMR ENH ENR ENTG ES ESRX ETFC EXP EXPE EXXI FCX FDX FFCO FICO FISV FLS FO FSR FVE GD GEN GIB GKSR GLRE GOOG GS HAL HCKT HFC HHC HNT HOLX HRC HRS HS HTZ IART IM IN INFA INXN IR ITT JOYG KAR KEG KFT KR KRA KRNY KW LH LIFE LLL LORL LTXC LYB MA MANH MASI MCK MCO MDCI MHS MOS MRH MSFT MSI MUR MUSA MWK MYL NAB NEWP NFLX NIHD NLY NOA NOK NSR NTAP NXPI OCR OMI OSHC OTEX PBH PCLN PCS PDCO PG PGR PLL POT PRE PT PTP PWER QCOM QSFT QUAD RBCN REIS RES RGS RIMM RJF RMD RNR RRC RRR RTN SD SHEN SHO SI SIGI SLE SMG SNDK SNPS SODA SOHU SPMD ST STLY SUN SVN SXC SYKE SYMC SYNA SYY T TAP TDC TDG TE TEL TEVA TGS THRX TLW TMO TNDM TRCR TUP TWI UPL USB UTX V VECO VOLC VRSN VRX WAG WBSN WDC WFR WFT WHR WLT WMB WOOF WST XO XOM XRAY XRS YHOO YOKU

An Insurance Hedge Fund

Friday, October 28th, 2011

Some friends of mine asked me if I could create an insurance-centric hedge fund.  I said that it was unlikely because I’m not good at shorting.  They pressed me on it, because they knew if I had good longs, with my quantitative skills, I could create a credible short position that might hedge the longs.

Ugh.  I don’t want to do it, but maybe I could make this work.  I certainly could use the revenue.  So what would I focus on in such a fund?

  • Relative valuations
  • Management quality
  • Reserve releases/strengthening from prior year claims
  • Momentum — yeh, momentum.
  • Long-term underwriting profitability

My goal is to make money for average people, not the wealthy, but if that is the only way that my firm can survive, I will set up a hedge fund in the insurance space.  I love insurance; I know it intuitively, but I know that once I  begin to take big bets, I may fail badly.

If you know me well, you know that I only take prudent risks.  I’m not risk-averse, I like taking risks when the odds are in my favor.

So I am puzzled at this point.  I have done better in evaluating the broad markets than the narrow insurance markets, but if I have to be a narrow investor in order to survive, I can do that.

If you have advice for me here, I will receive it with thanks.

The Dream Team

Wednesday, October 26th, 2011

Imagine for a moment that you put together your own “dream team” of investment managers.  Would you want to know what they are doing as a group?  Well, I compiled my dream team from a list of 59 managers that I respect, and I want to give you their most common holdings as of 6/30/2011:

Count of ManagerCompany

14

Microsoft

11

GOOGLE INC

9

Bank of America

9

Citigroup Inc

7

BERKSHIRE

7

Goldman Sachs

7

UnitedHealth Group Inc

7

Mastercard Inc.

7

AON CORP

7

Apple Inc

7

PFIZER INC

7

Wells Fargo & Co

6

BERKSHIRE

6

JOHNSON & JOHNSON

6

General Motors Co.

6

SEARS HLDGS CORP

6

LIBERTY MEDIA CORP

6

VALEANT PHARMACEUTICALS INTL

6

CISCO SYS INC

6

ConocoPhillips

5

Kraft Foods Inc.

5

Mosaic Co New

5

Willis Group Holdings PLC

5

SPDR GOLD TRUST

5

LOWES COMPANIES INC

5

Sanofi Aventis

5

LEVEL 3

5

EXPEDIA INC DEL

5

U S BANCORP DEL NEW

5

ABITIBIBOWATER INC

5

Comcast

5

Royal Bank of Scotland Group

5

BP PLC

5

DELL INC

5

Vodafone Group PLC ADR

5

WHIRLPOOL

5

NEWS CORP

5

STATE STR CORP

These are held by a large fraction of the clever managers. Note that Berkshire Hathaway is listed twice because of the A & B shares.  Also note that the Royal Bank of Scotland is preferred shares, and not the common.

But these aren’t the largest holdings of the group of managers.  What might that look like?

Sum of ValueCount of ManagerCompany

14,160,067

4

Coca Cola Co

7,890,391

4

American Express

4,894,639

2

Procter & Gamble

4,792,460

5

SPDR GOLD TRUST

4,783,600

5

Kraft Foods Inc.

3,407,245

1

ICAHN ENTERPRISES LP

3,330,862

9

Citigroup Inc

3,322,015

3

American International Group, In

3,258,955

6

JOHNSON & JOHNSON

3,141,680

1

Female Health Company

3,003,034

5

DELL INC

2,708,540

2

MOTOROLA CORP

2,664,145

4

CHESAPEAKE ENERGY CORP

2,534,143

1

INTL FCStone Inc

2,431,085

1

Interactive Intelligence Inc.

2,387,856

1

The Dolan Company

2,334,874

6

ConocoPhillips

2,226,061

7

AON CORP

2,219,531

4

YANDEX N V

2,164,765

9

Bank of America

2,127,572

7

Apple Inc

2,039,403

5

NEWS CORP

1,967,980

3

DirecTV

1,925,312

1

Hallmark Financial Services

1,856,970

14

Microsoft

1,854,213

2

YUM BRANDS INC

1,717,773

1

FEDERAL MOGUL CORP

1,680,880

1

ANGLOGOLD ASHANTI LTD

1,647,336

1

Tandy Leather Factory Inc.

1,643,992

2

Loews Corp

1,642,074

5

LEVEL 3

1,574,105

6

VALEANT PHARMACEUTICALS INTL

1,569,386

3

Citigroup

1,548,083

3

Moody’s

1,511,216

6

SEARS HLDGS CORP

1,410,112

4

CIT GROUP INC

1,404,444

4

ANADARKO PETE CORP

1,398,931

7

Wells Fargo & Co

1,374,090

1

CEMEX S.A.B. de C.V. ADR

1,371,120

2

PENNEY J C INC

1,368,007

6

LIBERTY MEDIA CORP

1,348,721

3

Brookfield Asset Management Inc

1,217,439

2

TRANSOCEAN LTD

1,205,581

1

GENERAL GROWTH PPTYS INC NEW

1,204,046

4

HARTFORD FINL SVCS GROUP INC

1,196,047

2

JEFFERIES GROUP INC NEW

1,196,012

4

FEDEX CORP

1,187,555

11

GOOGLE INC

1,180,466

4

Bank of New York Mellon Corp.

1,159,088

1

BIDZ.com Inc.

1,119,035

3

The Travelers Companies Inc.

1,119,014

3

LIFE TECHNOLOGIES

1,108,718

7

Goldman Sachs

1,107,744

5

Willis Group Holdings PLC

1,096,716

2

Capital One Financial Corp.

1,096,221

1

SPECTRUM BRANDS HLDGS INC

1,094,933

1

FORTUNE BRANDS INC

1,036,654

4

HEWLETT PACKARD CO

1,024,100

4

SENSATA TECHNOLOGIES HLDG BV

1,017,038

1

Walt Disney Company

1,013,005

1

Stamps.com

1,000,693

4

FAMILY DLR STORES INC

That sums up the billion-plus holdings for my favorite managers.  That doesn’t mean that I endorse all of their holdings.  Only 3 out of my 34 holdings were revealed in the top holdings of these highly rated managers.

Full disclosure: long COP, VOD, TRV for myself and clients that get a clone of my portfolio.

Wall Street All Stars

Wednesday, October 26th, 2011

I have been contributing material to the website Wall Street All Stars.  Mostly I have contributed two things:

  1. They scrape my RSS feed.
  2. I post some of my best articles from the past, with commentary that brings it up to date.

You can find my contributions here.

I can give all my blog readers and twitter followers a free six month subscription to WallStreetAllStars.com. Simply go sign up on http://www.WallStreetAllStars.com/ and then shoot an email letting us know you subscribed to support@wallstreetallstars.com and we’ll rebate you the $49 monthly fee each and every month for the first six months — that’s worth almost $300.

Most of the writers at Wall Street All Stars are former contributors to RealMoney, and other properties affiliated with TheStreet.com.  I think it is a credible team, and might eventually rival TSCM, minus Cramer.

But my involvement will be limited to the public side of the site for the most part, because my clients deserve my best ideas.  I am not out to sell them.

What is this?

Tuesday, October 25th, 2011

 

 

 

 

 

 

 

 

What is this graph?  I’ll give you a hint — it has something to do with technical analysis where investors look for signals near turning points.

Ideas?  Let me know in the comments.  I’ll have a post on this later.

Occupy Your Time Productively

Tuesday, October 25th, 2011

I don’t have much sympathy for the protests called “Occupy Wall Street,” and those modeled after it.  Real societal change comes through the political process, and I would challenge those “protesting” to form a new political party, and articulate a distinctive set of views, so that average Americans could understand what they stand for.

At present, the lack of coherence is a plus, and everyone gives a positive spin on a movement that has no clear direction, but just likes to complain, because they are upset over their own economic prospects.

What I am trying to point out is that the protests have few elements in common aside from complaining.  Away from that, there is a dedicated group of pundits telling the “Occupy” crowd what they should be complaining about.  Re-explaining,
“We have our lives together, and you don’t.  We know there are problems, but you are losers that don’t have your lives together.  You can complain.  You have nothing better to do.  We have better things to do, but we know what is wrong.”  The pundits will have no impact on the “Occupy”crowd.  I will not tell “Occupy” what to do.  They would not listen, and they would not get it if I told them; they aren’t that smart.

My view is that most lasting change comes from within, slowly, and with a lot of hard work.  Complaining takes little work.  But suppose you don’t like the school system, and you can’t afford private schooling.  Home schooling is a lot of work, but it works a lot better, most of the time, than public or private schooling, because you can’t beat tutoring.  One-on-one is the best method of teaching, though it is costly from a resource perspective.  But at present, 2-3% of all children in the US are home schooled.  That’s a real change, with a lot of work behind it.

You want to change things?  Start a political party, and challenge races in the assemblies of states, and in the House and Senate.  Forget the Presidency, no one wins that unless lower offices have been filled by your party.

You want to change things?  Ignore politics and teach illiterate adults to read.  Bring along a Bible, because many of them would like to read that.

Or, set up a foundation to ransom people out of the debt-slavery that arises from abuse of credit cards.

Or. set up a business that can use many people who are presently unemployed can work, maybe asking for a waiver from minimum-wage laws so that you won’t lose too much money in the process.

My view is that positive beats negative.  Build society rather than complain.

To that end, I ask that all those reading me cease supporting the “Occupy” movement.  It is a waste; they do not have coherent goals.  If they begin to put forth a positive program, then consider supporting them.

But negative programs rarely deserve support.  After all, I give nothing to the Republicans. ;)

Value Versus Growth

Thursday, October 20th, 2011

Value Investing and Growth Investing are variants of the greater school of Fundamental Investing.  Quoting Buffett from his 1992 Shareholders Letter:

Our equity-investing strategy remains little changed from what it was fifteen years ago, when we said in the 1977 annual report:  “We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”  We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute “an attractive price” for “a very attractive price.”

But how, you will ask, does one decide what’s “attractive”?  In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:  “value” and “growth.”  Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).  In our opinion, the two approaches are joined at the hip:  Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term “value investing” is redundant.  What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?  Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term “value investing” is widely used.  Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.  Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.  Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Similarly, business growth, per se, tells us little about value.  It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions.  But such an effect is far from certain.  For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth.  For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.  In the case of a low-return business requiring incremental funds, growth hurts the investor.

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:  The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.  Note that the formula is the same for stocks as for bonds.  Even so, there is an important, and difficult to deal with, difference between the two:  A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.”  Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended.  In contrast, the ability of management can dramatically affect the equity “coupons.”

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.  The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.  Unfortunately, the first type of business is very hard to find:  Most high-return businesses need relatively little capital.  Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future “coupons.”  At Berkshire, we attempt to deal with this problem in two ways.  First, we try to stick to businesses we believe we understand.  That means they must be relatively simple and stable in character.  If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.  Incidentally, that shortcoming doesn’t bother us.  What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.  An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying.  We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

In theory, growth factors into value calculations.  In practice, growth estimates disappoint.  Fast growing companies have negative surprises, whereas slow growing companies have positive surprises.

Growth stocks have stories.  Value stocks are in the shadows.

Growth stocks are the uncertain future.  Value stocks are the discounted past.

Growth investors expect high ROEs to continue.  Value investors often buy companies with low ROEs, and don’t expect much.  The difference is significant.

What Buffett describes as “Value Investing” is what he learned from Ben Graham.  Margin of safety, buy them cheap.

But margin of safety implies that if things go wrong, losses will be small.  This precludes growth investing, because if growth fails losses will be large.  Thus, value investors focus on situations where earnings are high relative to price, with growth likely low, and net worth high relative to market capitalization.

Yes, I understand about moats, and what they imply for growth investing, but given changes in technology, moats aren’t that common over a decade.

As such, I say to you that there is a real difference between value and growth investing.  Value looks for a margin of safety and buys cheap, knowing that growth is uncertain.  Growth assumes that earnings growth will continue, even if the market is getting saturated.

I am happy to be a Graham-and-Dodd value investor.  I don’t need growth to make money.

Weighing Beats Voting

Wednesday, October 19th, 2011

Correlations are high.  Risk-on, risk-off drives the market as market players trade ETPs and baskets rather than individual stocks.  Market players worry about policy, and whether it will be inflationary (bullish) or deflationary (bearish).

What an ugly time to be a value investor, and a long-term industry rotator.  The time cycle has shrunk to tiny proportions relative to the likely life of the assets being traded.

But I take heart that it will not always be this way.  As Ben Graham said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

Eventually, for industries where the companies are worth a lot more than the current price, there will be buyouts.  For industries where companies are worth less, there may be IPOs.

I believe that correlations will reduce from here.  It may not be dramatic, but they will fall.  Whenever there is a dominant paradigm for asset pricing, there are assets that get mispriced.

My expectation is that there are many companies earning money while trading at a discount to adjusted book that will be bought out by others.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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