Month: December 2011

Why Profit Margins are High

Why Profit Margins are High

Why are profit margins so high?? I offer a few reasons:

1) Those that fund equity have high demands placed on them.? Many are pension plans and endowments, and they push firms to achieve higher profits.? This is true whether the business is public or private.

2) With globalization, there is downward pressure on wages for those in industries where goods are tradable internationally.? That downward pressure allows profit margins to stay fat.

That said, the big return is going to those who have scarce resources amid global growth.

Now will profit margins mean-revert? Certainly, but the proper question is when will it happen?? Profit margins will mean revert when, labor begins to be scarce again.? Given the changes in the world, that could be a long time.

If it is a long time, one could take heart that it means the world as a whole is developing.? It will mean greater opportunities for your children who will be able to sell to those who have developed.

Those are my summary thoughts; please feel free to comment below.

Musing Over Glass-Stegall

Musing Over Glass-Stegall

This is one area where I would like feedback from my readers.? My view is that the repeal of Glass-Stegall had little impact on the crisis.? Most of the crisis occurred as a result of ordinary failures in investment banking, and commercial banking, with little change from combining them.

I would argue that the overall model for investment banking failed.? No major investment bank survived the crisis intact.? Goldman Sachs and Morgan Stanley had to seek banking charters to survive and receive help from the Treasury/Fed (one entity, but like Janus, two faces).? Everyone else needed help from the Feds, or failed, or merged.

I would also argue that the overall model for commercial banking failed, with many making loans that were horrendously underwritten.

So, what aspects of the crisis stemmed from the repeal of Glass-Stegall? Remember, the Fed was chipping away at it for some time.? Feel free to comment below, but if you don’t want to do that, email me.? Thanks.

Peak Credit

Peak Credit

What I write here will not be rigorous.? We’ve heard about “peak oil.”? We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

It’s not just the US, debtor-friendly as it has been for most of its existence.? Most of the rest of the world has debt problems.

China has indebted municipalities and banks, and debts to many projects from Party members that will not pay off.? The EU is? overly indebted everywhere, not just the PIIGS, and finds its overall borrowing rates rising as lenders wonder what a Euro will be worth if the Eurozone dies.

In the US, government debt rises more than corporate and consumer debt falls.? We’ll pay the government debt off later.? Don’t worry. 😉

The simple solution to every problem is to say the it is a liquidity problem, not a solvency problem.? How do does one solve a liquidity problem?? Get a loan.? If the assets are really worth more than the liabilities, there should be some unencumbered assets that you can secure a loan with, and pay off the liquidity squeeze.? But absent that, it’s insolvency, regardless of what notional price one places on the assets.

But what if the problem is really a solvency problem?? Will a loan help cure that? No.? You can’t solve a debt problem with debt.

There are generally few liquidity problems relative to solvency problems.? As an example, most corporate bonds don’t default on principal payments, but on interest payments.? For individuals, balloon payments on loans might be relatively more of a problem, but since most people finance their homes, etc., on relatively thin ratios of income to debt service, interruptions of income lead to insolvency more often than balloon payments.

Consider for a moment that every liability is the asset of someone else, but not vice-versa, because some assets are owned free and clear.? Now pretend that we take everything in the world (the same could be applied to a nation), and put it on a single balance sheet, but we don’t net out the liabilities that would cancel out.

Which system would be more stable?? One where the liabilities are roughly equal to the net worth, or one where they are roughly five times the net worth?? The former, of course.? Now, not all liabilities are the same — long-dated claims like pensions only claim a little bit of the assets of the world at a time, whereas a large number of short-dated liabilities would make the system less stable, or perhaps lead to inflation.? Many dollars chasing few goods, or assets, or both.

I’m not sure exactly where the boundary line is for “peak credit.”? It would depend on the structure of the liabilities in question.? But once the fuzzy limits get exceeded:

  • Growth can slow.? (Think of the book, “It’s Different This Time.”)
  • Debt deflation may arrive. (Extend, Compromise, Default)
  • Inflation may arrive for assets, goods, or both, depending on the propensity to save versus consume.
  • And, if the debt gets high enough, and immediate enough, any entity may hit the “tipping point” where the market concludes that it is no longer possible for the entity to pay off its debts.? Short-term rates skyrocket, and the prices on long debt discount expected recovery levels.? For countries with their own currency, it may involve a lot of inflation, though a negotiation with creditors might be simpler.

In general, if we were starting over again, there are a lot of things that we should have done differently:

  • Dividends would be deductible, and not interest.
  • This would apply to all personal and corporate interest, including mortgages.
  • We would eliminate the GSEs, and all government lending programs.
  • We would run balanced budgets as a nation, and live with the modest volatility that induces.? We would not engage in fiscal stimulus.
  • We would eliminate or constrain the Fed, such that it could never let the difference between ten and two year Treasury yields exceed 1.5%, or be less than -0.5%.? We would let recessions do their work of eliminating bad investments, because if you don’t, you end up with the debt deflation we are facing now.
  • Or, go back to a gold standard, after analyzing what the proper value for the dollar would be, so as to avoid inflation or deflation.
  • We would constrain banks to match assets and liabilities, and not engage in maturity transformation.

Banks would be a lot less profitable under such an arrangement, but it would prevent debt bubbles.? Besides, the banks would make up for it by charging for deposit/checking accounts.

Summary

We may be near “peak credit” at present, and that is true of much of the world.? Better we should have had a smaller financial sector, and avoided the financialization of the economy.? As it is, we face many years of slower growth ahead as we bleed debt out of the economy, or a number of years of inflation ahead, as we inflate away debts.? I suspect the former, but I can’t ignore the latter.

Redacted Version of the December 2011 FOMC Statement

Redacted Version of the December 2011 FOMC Statement

November 2011 December 2011 Comments
Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.

 

Getting more optimistic about growth.? I think they are going to get surprised on the downside again.
Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. The unemployment rate is down, but jobs aren?t being created, as people drop out of the labor force.? This is improvement?
Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Shades down their view on business investment.? Shades up their view on consumer spending.
Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable. Gets more definite about inflation moderating, except that it hasn?t moderated.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. No change.
The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. No change.
Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. Strains in global financial markets continue to pose significant downside risks to the economic outlook. Focuses the risks on the financial sector, particularly as the risks in Europe & China could affect the US.? ?Not our fault!?
The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee?s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations. Drops language on commodity prices.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate. To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate. No change.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. No change.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability. No change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. No change.? Won?t miss the hawks that weren?t.
Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time. Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time. No change.? Won?t miss Evans.

?

Comments

  • The more I read the Fed statements, the more I think that they are paid to be Pollyannas.? The rose-colored glasses are glued to their faces.? There is never any criticism of their actions; blame always goes elsewhere.? They are similar to modern teenagers that lack talent, but have incredible self-esteem.
  • GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.? Inflation has not moderated significantly, either.
  • They point to the risks coming from global financial markets.? The Fed is the lead regulator in the US of banks and SIFIs; if trouble abroad leads to trouble here, they have no one to blame but themselves.
  • In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
  • Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
  • The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

  • Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing so well at present?
  • Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
  • Why will reinvestment in Agency MBS help the economy significantly?? Doesn?t that only help solvent borrowers on the low end of housing, who don?t really need the help?
  • Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
  • Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
  • Could we end up with another debt bubble from keeping short rates so low?
  • If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
  • Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
The Gold Medal Gold Model

The Gold Medal Gold Model

Eddy Elfenbein is a clever guy; he put together a model of gold prices that fits the data very well.? Tonight, I will share my own variation on the model, and try to give an intuitive explanation of why it works.

Ask yourself this: where does investor put his money if he wants to stay safe?? Most people are savers not investors, so ideally they would want to put their money on deposit and earn a real return with the ability to access their money at any time.? Then there is the alternative asset, gold.? Gold is a hedge against inflation, but it throws off no interest.? But at some level of real return, savers begin to conclude that they aren’t earning all that much, so they may as well hold gold.? Vice versa when real rates rise.

One more thing: gold doesn’t benefit from productivity increases, as stocks do.? Rapidly increasing productivity makes gold less attractive than stocks.

Eddy’s model boils down to this (in my implementation):

Percentage change in gold price = Multiplier * Percentage change in (Deflator Index / Real return Index)

where the Real Return index compounds three month T-bill yields less inflation via the 12-month CPI-U in arrears.

Here is how well the mode works, since 1970:

The first model attempts to minimize absolute dollar price differences between actual and model.? The second attempts to minimize the ratio between actual and model prices.? Both have R-squareds over 90%.

The deflator return is constant in percentage terms.? For the two models it is around 2.3%/yr, which is not far from productivity gains.

As for the multiplier, it is near six.? The multiplier is like a duration figure with bonds.? What this means is that the percentage change in real interest rates, three-month T-bills less CPI-U inflation, is projected to persist for six years.? Six years is a reasonable figure, because monetary policy changes slowly, but not glacially.

Now, at present levels of real interest rates, with T-bill yields near zero, and the CPI above 3%, it implies a gold price rising at 3% per month.? If inflation stays where it is and the Fed holds good on its promises, that means a gold price in the $3000s in mid-2013.

Do I believe this?? Partially.? I own lots of oil stocks, but nothing in metals at all.

Eddy’s model helps to clarify the value of gold.? It is a store of value, as its price anticipates the degradation and strengthening of the dollar, because changes in real rates will persist on average for six years.

Industry Ranks December 2011

Industry Ranks December 2011

I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and to a lesser extent Reinsurance, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle ? I am not interested there even at present levels.? The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their ?regulators.?

I?m looking for undervalued and stable industries.? I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is pretty cyclical at present.? I will be very happy hanging out in dull stocks for a while.

P&C Insurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.? Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.? Would I increase the overweight here?? Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.? Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.? One more note, I am still not tempted by banks or real estate related stocks.? I am beginning to wonder when the right time to buy them as a sector is.? As for that, I am open to advice.

Improve the Position

Improve the Position

It’s hard to take a loss.? But taking losses is necessary to avoid even larger losses.

This is prompted by Barry Ritholtz tweeting to me a piece he wrote 3 months ago called, Take The Loss.? Good piece, worth a read.

What I suggest to you today is that there is a better way to manage portfolios.? Ignore the cost basis — the price at which you bought it.? Instead, focus on improving the economic value of your portfolio.

It is hard, really, really hard to choose the best assets.? I? can’t do it. It is easier to choose assets that are better than the ones you currently own.

This assumes that you have a reasonable way of estimating the value of assets.? When I was a corporate bond manager, it was easy, because I had a large number of rules to help me estimate the proper yield tradeoffs, perhaps more than most managers had at the time.

  • Discount vs Par vs Premium bonds
  • Differing maturities
  • Special covenants
  • Deal size
  • Secured, senior unsecured, junior unsecured, trust preferred, preferred stock
  • Implied credit betas of different industries (take more/less risk when you want to)
  • Spread tradeoffs needed for capital requirements and likely default/capital losses
  • Holding company vs operating subsidiary
  • Public bond vs 144A vs private placement

There are probably more, but they aren’t coming to me now.? It is generally easier to estimate the tradeoffs with fixed cash flow streams with a maturity than unlimited life instruments where any cash flow back to you is uncertain.

Thus equities are squishier, where you have to compare valuation, industry trends, use of free cash flow, company quality, etc., to determine what is more valuable.? This is a much harder game, but one that can be played with discipline to good effects.

It is a lot easier to do swaps in equity portfolios than to to try to create the current optimal portfolio.? It is much easier to make comparative judgments (these are better) than absolute judgments (these are the best).

Other things equal, can you:

  • Improve the cheapness of your portfolio?
  • Improve the quality of your portfolio (unless you are in a period where leverage is expanding dramatically, and the opposite will pay off for a time)?? This applies both to balance sheet and accounting quality in earnings.
  • Improve your industry allocations?
  • Own management teams that use cash flow more effectively, and are more shareholder oriented?

Always trade for what is better, and ignore the price where you bought the assets.? It doesn’t matter what you paid; that is a historical artifact.? Trade for better securities regularly, subject to transaction costs and other limits.

 

Book Review: What Works on Wall Street (4th Edition)

Book Review: What Works on Wall Street (4th Edition)

I previously reviewed the First Edition.? Now it is time for the Fourth Edition.? Rather than do a teardown, I think it would be more useful if I explained how the book can best be used.? Here goes:

There has been a lot of research done on stock returns, the results of which have encouraged investment in:

  • Cheap stocks relative to book value, earnings, sales, EBITDA, FCF, etc.
  • Stocks with strong price momentum.
  • Stocks with strong earnings quality.

And such is true of this book.? And so, I encourage investors to focus on earnings quality, cheapness, and maybe, momentum, which hasn’t done so well of late.? (Probably too many following it.)

Now, the wrong way to use the book is to look at the highest returning strategy of the past, and follow it.? Since they test so many strategies, the one at the top is an accident of the historical period it covered.? Far better to be more humble and use a strategy that borrows from many successful strategies.? In doing that, there is less chance of amplifying the noise of the past.

Quibbles

The danger of this book is data-mining.? The deeper you dig to find what would have worked best in the past, the more you mirror the idiosyncrasies of the past, which does not then reveal the long-term principles that generally work, over intermediate-term periods.

Far better to stick with “pretty good” methods that never reach the top, but usually work.? Don’t be concern about hitting home runs, as much as getting on base regularly.? I say this because it works well for me and my clients.

Who would benefit from this book: Most investors would benefit from this book, if they are careful not to grab for the “brass ring” and imitate the strategy that has worked best in the past.? If you want to, you can buy it here: What Works on Wall Street.

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Valuing Behemoths, Redux

Valuing Behemoths, Redux

A few things I left out last night.? Here’s a country breakdown for Behemoths trading on US exchanges:

Note: if I had a Bloomberg terminal and could give you global data, this would look much less US-centric.

And, here is a sector and industry breakdown:

Going cell-by-cell, Oil & Gas – Integrated had the largest concentration. The companies were Exxon Mobil Corporation, Royal Dutch Shell plc (ADR), Chevron Corporation, Petroleo Brasileiro SA (ADR), BP plc (ADR), and TOTAL S.A. (ADR).? Oil & Gas Operations was not all that different, and that company was PetroChina.? These are simple companies, as I view them, mining all over the world to find energy for a hungry planet.

Then there is Schlumberger, in the Oil Well Services & Equipment industry.? They are the elephant in their industry, though small compared to the majors, and smaller compared to the national oil companies that control most of the world’s oil resources.

Computer services are IBM and Google, two very different companies.? Software & Programming is Microsoft and Oracle, also very different.? Apple is Computers & Hardware.? Intel is Semiconductors.? The hard question with this group is who is managing their companies to use free cash flow wisely.? This is a maturing industry, and the best companies in the future will treat their capital providers well.

In Healthcare the differences in industries is not worth considering.? The companies are: Johnson & Johnson, Merck, Pfizer, Novartis AG (ADR), Roche Holding Ltd. (ADR), GlaxoSmithKline plc (ADR).? They are all big pharmaceutical developers, though J&J has significant hardware businesses.

Communications Services boils down to China Mobile Ltd. (ADR), AT&T Inc., Vodafone Group Plc (ADR), Verizon Communications Inc.? Big companies pursuing their advantages in the US, UK and China, with wireless dominating over wireline.

As for Retail, that is WalMart.? Who else could it be?? No other company in retail is so extensive. The hard question for them is how they move the needle.? Are there no more worlds to conquer, a la Alexander?

Those that call regional banks are not so — JP Morgan and Wells Fargo are Money Center banks.? HSBC (ADR) is as well.

Rounding out the financials are two nontraditional companies — Berkshire Hathaway, and General Electric.? BRK is an insurance company funding an industrial conglomerate.? GE is an industrial company with a finance arm attached to it.

Beverages (Non-Alcoholic) are simple. Coke and Pepsi.? What could be simpler?

The other three in Consumer Non-Cyclical are Unilever N.V. (ADR), Procter & Gamble, and Philip Morris.? It would be very difficult to reverse-engineer the competitive advantages that these companies have built up.

With Metals Mining it is BHP Billiton Limited (ADR), Vale (ADR), and Rio Tinto plc (ADR).? They have become almost an oligopoly for a variety of minerals.

Finally, among auto and truck manufacturers, there is Toyota Motors, a well-run company that has had its share of problems lately.

=-=–==-=-=–=

Most of these companies are likely to be slow growers.? One exception is some of the tech and pharmaceutical companies, where they will fight for new markets versus obsolescence of old markets.? Unless one is an industry expert, hard to see how the battle comes out.

And, as I commented on last night’s piece:

Maynard, that?s a concern of mine as well. Will they dispose of noncore assets attractively? Even slack cash, after a suitable buffer, is noncore. How will management use the free cash flow?

1) Dividends?
2) Small value-creating acquisitions that can be grown organically?
3) Buybacks at discounts to the firm?s private market value?

Those create value, but it is hard to manage a complex company ? so growing via acquisition is tough without overpaying by buying scale, or creating a company that is even more complex, and unmanageable.

That?s why I think management is the key with large companies ? will they make the right capital allocation choices or not?

Tough analysis — but to me it boils down to how shareholder friendly behemoth companies will be. Try to analyze what the main strategies are, and only invest where you think they are managing for the good of shareholders, rather than management.

Full disclosure: my clients are long CVX, PBR, TOT, VOD, WMT, INTC, ORCL

Valuing Behemoths

Valuing Behemoths

There have been a lot of articles recently about how cheap the Behemoth stocks are — I define Behemoth stocks as those with over $100 Billion of market capitalization.? At the close on December 2nd, there were 39 of them that trade on US Stock exchanges.

It’s no secret that Behemoth stocks have underperformed.? One example of it comes from looking at the cap-weighted S&P 500 versus the equal-weighted S&P 500 over the last decade.? The larger cap stocks underperformed, particularly the financials, as they ballooned, and popped.

Here is a graph showing how the median P/Es of the current behemoths have declined, and may decline further, if prices don’t rise, but earnings do.

So why have the P/Es of the largest companies compressed? In an environment where low global growth is expected, the biggest companies have felt it most severely.? They are so big that they cannot compensate much for changes in global demand, as opposed to smaller companies that can try to tap markets that they haven’t tapped so far.

For Behemoth companies to achieve large earnings growth, they have to find monster-sized innovations to do so.? Those don’t come along too regularly.? Even for a company as creative as Apple (or Google), it becomes progressively more difficult to create products that will raise earnings by a high percentage quarter after quarter.

As a result it should not be a surprise that Behemoth stocks trade at discounts to the market when global growth prospects are poor.? They have more assets and free cash flow to put to work than is useful in a bad environment.? Not every environment offers large opportunities.

My clients and I own 7 of the 39 Behemoths (18% of assets).? When is it reasonable to own Behemoths?

It makes sense in a period where leverage is expanding, but that’s not now.? It also makes sense to own them when the earnings yield (E/P) exceeds the return on high-yield bonds by 3% or more.? In that case, like Buffett, we look at the stock like a bond, and look for growth in the book value per share to drive the growth in the price.

There is another value driver — I have a saying: “The equity always holds the capital structure option.”? For small companies, they can decide to merge or lever up.? For Behemoth companies they can decide to pay special dividends, buy back stock, or spin off or sell subsidiaries.

I don’t know that the Behemoth companies that I own will do this, but I expect at valuation levels like we are at today, where the prospective earnings yield is 9% or better, there will be enhancements to value and plenty of them.? After all, the Behemoths for the most part don’t face liquidity issues, and most of them have cash flow in excess of investment needs.

But the big payoff may come from Behemoths splitting into smaller companies.? Management abilities peak out after a certain level of asset value… it’s hard to manage Behemoth companies, unless the company is simple — energy companies can grow larger, because it is only a question of more geography.? There is no threat that they need to sell a different product.

As a result of all of this, we should pay much greater attention to how shareholder-friendly the Behemoths are.? Analyze the management teams, and see how willing they might be to take actions that will enrich shareholders.

Personally, I think almost all companies with market caps over $100 billion would perform better if they broke themselves into more logical pieces.

 

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