The Aleph Blog » Blog Archive » Value Investing when Debt Levels are High

Value Investing when Debt Levels are High

I would ask yourself how to implement value investing in an era where debt is no longer expanding. Arguably an era where inflation is increasing (albeit from a low starting point).

A few years ago, everyone “knew” housing prices never went down nation wide. Today, CNBC constantly tells us that the consumer is 70% of the economy… undoubtedly true when debt levels were expanding. But consumer income is not growing as fast as the cost of living, and debt levels cannot expand again. The “consumer is 70% of the economy” assumption probably won’t hold over the next few decades like it did in the past few decades. How does one implement value investing in such an environment?

So asked on reader in response to last night’s post.  His full comment was similar to some of the musings of Bill Gross, in that we don’t live long enough to really prove we have skill in investing, but over the last 40 years the overall macroeconomic regime of expanding debt favored certain classes of investors.

A few thoughts:

1) Value investing is SAFE and cheap, not CHEAP and safe.  Focus on margin of safety.  Spend time asking what can go wrong.  Test the strength of moats.

2) In 2008-2009, there were a lot of value investors that got savaged.  Why?  They invested a lot in statistically cheap financial companies that were carrying a lot of credit risk.  Having worked for a hedge fund 2003-2007 that did the opposite, my own investing was constrained because I feared what might happen when the bear part of the credit cycle emerged (leaving aside a mortgage REIT that I foolishly held onto).

Credit-sensitive financials are like cyclical non-financials that have over-invested in productive capacity.  They have high operating leverage, and will only prosper when demand is strong/credit is good.  Cyclical companies often have low P/E multiples near the top of the cycle, because the bear phase is anticipated.  They have high or negative P/E multiples near the bottom of the cycle, because the bull phase is anticipated.

The main idea here is to be skeptical of companies carrying a lot of credit risk, particularly after they have succeeded for some time.  When the credit risk manifests, it is savage.

3)   Avoid debt and products that require it.  My portfolios ordinarily avoid companies with a lot of debt.  I like companies that finance themselves internally through retained earnings.  During bear market phases, companies with financial flexibility do better.  It is always better to get financing at a time when you don’t *have* to get it.  Seeking liquidity when little is available is never an attractive place to be.

Also remember that big ticket items like houses, cars, boats, RVs, college educations, do badly when credit conditions tighten.  Luxuries are disadvantaged versus necessities also.  Before the bear part of the credit cycle hits, own companies that are self-financing, and have stable revenues.

4) Inflation tends to favor value investing based on flow (income statement, cash flow statement) versus stock (balance sheet).  In one sense, corporate pricing power boosts the value of companies that can pass on the inflation and then some.  This was true in the ’70s when value investor did relatively well.

In summary, I would say that in the future, value investors need to focus on:

  • Safety first
  • Avoidance of credit risk, implicit and explicit
  • Investing in companies that don’t have to seek external finance
  • Companies that can pass on the effects of inflation.





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8 Responses to Value Investing when Debt Levels are High

  1. [...] David Merkel, “ Value investing is SAFE and cheap, not CHEAP and safe.”  (Aleph Blog) [...]

  2. Greg says:

    David — I do not remember channeling Bill Gross. I said that value investing generally works (and will continue to work) — but the exact tactics used need to adapt to changing economic conditions.

    You pointed out that many value investors did well in the 1970s; Warren Buffett did not. Actually, he closed his Buffett partnership and went into hiding for several years before restarting under the Berkshire umbrella. Berkshire Hathaway was originally a failed textile manufacturer that Buffett had bought via his closed partnership; basically it was a 100% loss. After a 4-5 year hiatus, Buffett took the shell corporation (with its tax loss “assets”) and started building the BRK we know today.

    Buffett’s investment performance in the early 1970s was terrible, and led to the closing of his investment partnership.

    That did not, and does not, invalidate value investing — it simply means that even the most widely known value investor of the current time has an investing style that depends on certain macro-economic environments.

    Buffett’s style needs big government spending, expanding debt levels, and free spending consumers. Eras like the 1960s or 1980s or 2000s. Buffett’s style gets mauled in eras like the 1970s, and does “blah” in the 1990s.

    Low price (aka cheap, aka high yield) is not the same thing as value. Value means figuring out what a company is really worth across a full business cycle, and then paying a price lower than that value. Easier said than done.

    Credit risk is one of many “off balance sheet” liabilities; while ability/willingness to leverage is one of many off balance sheet assets.

    These “hidden” assets/liabilities are never reported, but we all know they are present. Some people (eg Buffett) are really good at understanding the hidden assets (leverage, and being short gamma). These sorts of investors get hurt by off balance sheet liabilities / weapons of financial destruction, also known as derivatives. They benefit from political connections (which yield subsidized lending conditions).

    Others (perhaps Sam Zell? or Wilbur Ross?) are much better at understanding and managing the hidden liabilities. “Grave dancers” understand outsized credit risks, established legal/regulatory risks, etc — and they know how to contain them. They do really well when the economy is restructuring, but suffer when politicians are picking winners/losers (because the tactics for minimizing hidden liabilities don’t apply when public officials ignore precedent).

    While Bill Gross asked whether he might be the happy victim of the era in which he worked — I don’t remember him asking the follow up question of who wins and who loses in different economic environments, and how to identify them a priori.

    I do not know the answer. I don’t think applying “value investing” is a good enough answer, because value investors are not homogenous.

    Just my two cents… sorry for hijacking your blog

    • That was no hijack, that was a help. I LIKE answering reader questions.

    • slim says:

      Not sure where you got the following information:

      “Buffett’s investment performance in the early 1970s was terrible, and led to the closing of his investment partnership.”

      In fact, Buffett notified his partners in May 1969 that he intended to liquidate his investment partnership, for the stated reason that he found it difficult to meet his performance objectives in what he perceived to be an unpromising investment environment.

      His performance for the last two years of the partnership:

      1968: +45.6% net vs. the Dow +7.7%
      1969: +6.6% net vs. the Dow -11.6%

      I doubt many observers would consider that “terrible” performance.

  3. [...] Value investing when debt levels are high (The Aleph Blog) [...]

  4. Greg says:

    @slim — Buffett has the best PR machine money can buy. I doubt Buffett himself would buy a story on minimal research.

    In fact, Buffett wrote to his investors in 1967 (two years before you claim) that he foresaw no investment opportunities. The performance you mention is roll off from investments made years earlier — he was harvesting (realizing) past gains.

    You also forgot to mention that Buffett had at least three partnerships going at a time — supposedly there were seven partnerships in total (I could only find four). See this blog link as one example of the seven he supposedly had (7 might be correct, I just wasn’t able to independently verify)
    http://www.joshuakennon.com/buffett-associates-ltd-buffett-fund-ltd/

    As for “poor performance in the early ***1970s***” … I don’t see why you mention his 1968-69 performance. Is 1969 in the 1970s?

    Berkshire Hathaway, in its original form as a textile company, was essentially a write off for Buffett’s last partnership. The textile company’s worth was in tax loss carry forwards — not the business itself. The entire industry of textile manufacturing in the US was bankrupt.

    Since the partnership could not sell Berkshire for cash (no one wanted to buy a textile manufacturer), and since the tax benefits were substantial — Buffett distributed Berkshire shares to individual partners upon dissolution.

    In the 1973-1974 market plunge, Buffett’s net worth dropped more than 50%. Just for record, 1973-74 is in the early 1970s, unlike 1969 which is not.

    I am quite certain that a 50% draw down is terrible performance by every observer. It is not something that Buffett’s PR machine likes to emphasize; it doesn’t fit with the myth / legend.

    Please double check your information in the future, and don’t rely on PR spin.

  5. slim says:

    Greg

    I will repeat what you wrote: “Buffett’s investment performance in the early 1970s was terrible, and led to the closing of his investment partnership.” It was this statement to which I responded.

    Buffett notified his partners, in writing, in May 1969, that he was terminating his (single) partnership. (I did not “forget” to mention that Buffett at one time had multiple partnerships [seven appears to be the correct figure]; he merged them into one partnership in the 1961-1962 time frame, i.e., well before 1969, making the issue irrelevant.)

    I agree that Buffett has a marvelous P.R. machine. I will also stipulate, for purposes of our discussion but without verifying, that Buffett’s investment performance in the early 1970’s was terrible.

    Now a simple question: How did Buffett’s investment performance in the early 1970’s lead him to notify his partners in 1969 that he was terminating his partnership?

  6. slim says:

    Greg
    In your original comment, you stated that “Buffett’s style gets mauled in eras like the 1970s.” Here is Berkshire’s record during the 1970’s:
    1970 12.0
    1971 16.4
    1972 21.7
    1973 4.7
    1974 5.5
    1975 21.9
    1976 59.3
    1977 31.9
    1978 24.0
    1979 35.7

    This works out to a 22% annual return versus approx. 7% for the S&P 500 TR Index. I suspect many investors would welcome being mauled similarly. Or perhaps it’s just PR.

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.


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