The Aleph Blog » Value Investing

Archive for the ‘Value Investing’ Category

Book Review: The Education of a Value Investor

Friday, September 5th, 2014

91zBvc46zmL._SL1500_

Before I start, I would like to remind readers of a Q&A that I did with the author, which is available here. [For readers at Amazon: Google "Aleph Education of a Value Investor". There are other useful links in the version at my blog.  Wish Amazon allowed for links...]

This is a good book if you know what you are getting and want that.  If you want a book to compare it to, I would class it with Benjamin Graham: The Memoirs of the Dean of Wall Street.  The reason for this comparison is that the book focuses on character development, and spends relatively little time on detailed value investing methods.  It spends a lot of time on the good parts of the lifestyle of a value investor, and this is where the book has its highest value.

Is it possible to “get rich quick?”  I don’t think so, but it is possible to become rich if you focus, make few decisions, but they are the right actions to take.

This book describes the transformation of the author, who went from someone trying to get rich quick in the short-run, and failing, to being an investor who could wait until he had a good idea to invest in, and then concentrate his capital in the best ideas that he had, and succeed.

But getting there was not a linear matter.  First, he had to figure out he was miserable.  Then, he had to find a new way to support himself, handicapped because the last firm he worked for had a bad reputation.

He picked up an interest in value investing, particularly the style that Buffett follows, which led him to a clutch of contacts in the value investing world who would help to shape his view of the world.

Without spoiling the book, some events happened that enabled him to set up his own investment shop where he does value investing for clients and himself.  And as such, he lived happily ever after?

Well, not yet.  He meets one key person, Mohnish Pabrai, who helps him think through the key aspects of his business.  He makes a number of additional friends who are value investors, and he figures out what he is good at analyzing and acting on, and where he is less capable.  Armed with that data, he acts to make his entire life more effective for himself, his family, and his clients.

He moved so that he could be out of the “New York Vortex,” where groupthink can carry you along.  He moved to a quiet area, and set up an office where he could think, and the odds of being disturbed would be low.  He set up an action area and a contemplation area.  He limited electronics to the action area and made it uncomfortable to stay in the action area.  This enabled him to think longer-term, and avoid taking actions because others were doing so.  He also had to learn how to get advice from other intelligent investors, without letting their views short-circuit his thinking processes.

He enjoyed life a lot more.  He also realized he had enough assets to manage, and so he didn’t need to market much, which allowed for a focus on serving current clients well.  About the only thing he needs to do is develop a sell discipline, and that is not an uncommon problem with most asset managers.  [Two of my articles on the topic: one, two.]

Near the end of the book, he shares eight pointers that will improve the investing of most people, if they are willing to think long-term.  I endorse the principles there, though there may be other ways to achieve the same disciplined attitude.  He also gives four case studies that affects the checklist that he uses for making investments.

Now, I have purposely left out the most colorful part of the book, the lunch with Warren Buffett, to the end of this review.  He and Mohnish bid together for the lunch and win.  The main thing he takes away from the affair was how much Buffett focused on his guests, and not on himself.  Indeed, at the end of the book, he credits his relationship with Mohnish in helping him to become more selfless in many of his attitudes.  To him, that is the real prize, much as he has done well as an investor and a businessman.

Quibbles

Can all of ethics be summed up as being farsighted and unselfish?  No.  Those are good things, but the Bible has many more things to teach than that.

Summary

This book will help you understand the internal attitudes of some value investors.  It may help you invest to some degree, but that is not the main point of the book.  After all, what is it worth to be a great investor if you aren’t happy?  Being happy as an investment manager is the main point of the book.  If you still want to buy it, you can buy it here: The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, and Enlightenment.

Full disclosure: I received two copies from the author’s PR flack.  Good thing too, because someone swiped one of them before I finished reading it.

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.

Ranking Industries by Range

Thursday, September 4th, 2014

As part of a continuing quest to turn up stock ideas in the midst of a market hitting new highs, I wanted to trot out a less commonly used statistic called “range.”  Range is the distance that a company’s stock price is between its 52-week low and 52-week high.  0% means the current price is at the 52-week low, and 100% means the current price is at the 52-week  high.  So far, simple, right?  How might industries look if their weighted average range statistics were calculated, weighted by market cap?

RANGE_16247_image002The top zone, which is shaded light red, are industries that are above the median range statistic in the market which is around 78.5% (average is around 72.2%).  The industries shaded yellow represent industries where the stocks are closer to their 52-week high than their 52-week low, but are have average range statistics lower than the median of the market.  Finally, the industries shaded green, what few there are, their current prices are closer to their 52-week low on average.

Personally, I would be inclined to look through the industries toward the bottom of the list, looking for misunderstood companies that have good potential of future outperformance.  That said, someone thinking that this rally would have a long way to go would be incented to look for companies at the top of the list who have trends that are underdiscounted.

As it is, this is where the industries are priced in terms of the past 52 weeks.  You could look at the industries with the view of finding things that are out of place, and prices could shift in the future to reflect it.

If nothing else, this is food for thought.  Technology, Utilities and Healthcare look strong.  Basic materials, Capital Goods, and Consumer Durables look weaker.

All for now.  Be careful.

My Time on RT America’s Boom Bust

Wednesday, September 3rd, 2014

You can never quite tell where blogging may take you.  I know that if I lived near New York City, some opportunities would open up that presently aren’t likely.  Living near Baltimore/DC has had its share of opportunities, though.

In general, if I get asked to appear somewhere, I’ll try to make time on my schedule for doing so, whether it is:

  • Internet TV
  • Internet Radio
  • Local Radio
  • Fox Business News (with Cody Willard)
  • Speaking at a local High School
  • Speaking to a local College
  • Speaking to meetings of the Society of Actuaries, local Actuarial Societies, local CFA Societies, etc.
  • Talking to the staff at SIGTARP, giving a lesson on how insurance companies work
  • And more… if someone had told me all of the things that I would do as a result of saying “yes” to Jim Cramer’s invitation to write for RealMoney.com eleven years ago, I would have been surprised.  The thing I would have been most surprised at would have been the total amount of words that I have written.  I viewed myself eleven years ago as a mathematical businessman, but not a writer.

About five days ago, I was invited to appear on RT America’s show Boom Bust.  What I did not know at the time was that Ed Harrison of Credit Writedowns was behind getting me onto the show.  I’ve known Ed for some time — he was one of the original attendees at the only Aleph Blog Lunch.

I also didn’t know what I would be talking about on the show, so when I got pulled into the makeup room (me?) ten minutes prior to airtime, I was saying to myself, “I guess I have to ‘wing it.'”  Then Ed popped his head through the door and said “Hi,” and explained everything to me.  What a relief!  I went back to the Green Room, scribbled out a few notes — not that I could take it with me, but just to get my mind in order for what I *might* be asked about.

As it was, it went fast, like every other time that I have been on live TV or radio.  What was eight or so minutes felt like two.  Are there things I would have said differently with more composure?  Yes.  But that’s part of the fun of it: thinking on your feet, because I knew little about what the actual questions would be.

If you want to, enjoy watching the video of RT America Boom Bust.  My particular portion is on from 3:30 to 12:00 or so.  Ed Harrison is on at the end.  I stayed to watch that segment live, and talk with Ed and the charming host Erin Ade afterwards.  It was a fun end to my workday.

Q&A with Guy Spier of Aquamarine Capital

Tuesday, September 2nd, 2014

91zBvc46zmL._SL1500_

In the near future, I will be writing a a review of Guy Spier’s The Education of a Value Investor, which will be released next week.  Until then, to whet your appetite, here is an 11 question Q&A that I did with Guy, for which I give him thanks, because his time is valuable.

  1. What company have you owned the past that was the most surprising to you? (In prospect or in retrospect)

I think that many have surprised me in one direction or another, but one of the more memorable was Duff and Phelps Credit rating – which I purchased in the mid-1990’s at a 7 Price to Earnings ratio. The company proceeded to increase in value by seven times over 2-3 years before being purchased by Fimalac, the owner of Fitch. I had expected the stock to double, but I did not understand that I had purchased a super high quality business with a manager who was committed to devoting every cent of free cash, which was in excess of reported earnings, to repurchasing shares.

  1. Which rule(s) of your checklist would surprise average investors the most, if any?

I actually think that none of them would. They are common sense items that anyone would look over and say, “yes – that makes obvious sense”. What is key is not that they are surprising, but that in the wrong state of mind, I might easily skip over a particular factor in evaluating an investment.

  1. Would you advise young people to get a CFA charter or an MBA or is there a better way to become an investor?

I don’t think that either is necessary in order to become a good investor. Attending the Berkshire Hathaway meetings, studying Warren Buffett and reading the Berkshire Annual Reports, along with Poor Charlie’s Almanack are an absolute necessity, in my view.

  1. Would you ever consider setting up your own holding company like Buffett did? (Permanent capital has its attractions…)

Yes. It’s a no brainer to do it if you have the skills. I hope that I have the skills, but I don’t think that the time has been ripe for me. Mohnish Pabrai has recently launched Dhandho Holdings which I think will be an extraordinarily successful enterprise over the years. It’s one to watch.

  1. What would you say is the most common mistake that value investors make? Does this matter if the value investor is amateur or professional?

I think that all-too-often, we feel like we are forced to take a decision. Warren Buffett has often said that, unlike baseball, there are no “called strikes” in investing. That is a truism, but the point is that too many of use act like it is not true. Amateur investors, investing their own money, have a huge advantage in this over the professionals. When you are a professional, there is a whole system of oversight that is constantly saying, “What have you done for me lately!” or in baseball terminology, “Swing you fool!”

 Amateur investors who are investing unlevered funds that they don’t need any time soon have no such pressures.

  1. Financial companies are usually a big part of the portfolio of value investors, because they seem cheap to industrials and utilities. But every now and then financials wipe out in a credit crisis. Why don’t many value investors pay attention to credit conditions?

Yes, that’s absolutely true. Many value investors love the financial industry: Probably because, in a certain way, we are in it ourselves. And yes, value investors probably pay far too little attention to the credit cycle. In my case, I think that I was utterly convinced that my stocks were sufficiently cheap, such that I could invest without regard to financial cycles. But I learned my lesson big time in 2008 when I was down a lot. I now subscribe to Grant’s Interest Rate Observer so as to help me track the credit cycle.

  1. Are your wife and children happier as a result of the changes to your life since becoming a value investor in the style of Warren Buffett?

Absolutely. I spend more time with them. I am simply around more, although that can come with its own irritations. You might have to ask them.

  1. I appreciate your “investing tools,” and I do things mostly like that, but isn’t the main goal of them to be reasoned, dispassionate, independent-minded, etc.? The actual form of the rules is less important than the effect it has on our personalities in making decisions rationally, yes?

Yes – I 100% agree and thus a different personality might have a very different set of rules to guide them. That’s why the book is about my education as a value investor. It’s personal and idiosyncratic. I would fully expect someone else to come up with different rules of behavior.  I do hope though that it will allow people to see that getting to a reasoned, dispassionate, independent minded state is a struggle for this investor, at least and that thinking about our meta environment and making good decisions about that is just as, if not more important than the actual investment decisions.

  1. How do you balance keeping an independent view versus interacting with respected professional friends who have their views?

I try to switch off, or distance myself from people who I think communicate in a way that is not productive for me. The key is to have the kind of discourse that allows other people to come to their own conclusion. Asking open ended questions and not telling someone what to do are important aspects of that. When I come across people who do that, I try to build closer relationships with them. If they don’t I might still keep them in my circle, but I would not allow myself to interact with them too often – because I don’t want to be swayed.

  1. How do you feel about those who use 13F filings to generate ideas?

Mohnish Pabrai taught me to be a cloner. In the academic world, plagiarism is a sin. In business, copying other people’s best ideas is a virtue, and it is no different in investing. I would go further. In the same way that if I wanted to improve my chess, I would study the moves of the grandmasters, if I want to improve my investing, I need to study the moves of the great investors. 13F’s are a great way to do that.

  1. How do you feel about quantitative value investors?

I am not sure that I understand the way that you are using the term. If you mean to use statistical methods to uncover value, Ben Graham style, then I’m all for it. That is what I did when I created my Japan basket. That said, I found it hard and monotonous work. Monotonous because, in the case of Japan it did not lead to greater knowledge or wisdom about the world, because there was a limit on the degree to which I could drill down. But that said, I do run screens for value on S&P CapitalIQ from time to time, and then drill down on some of what comes up.

Again, thanks to Guy Spier for taking time to answer some questions for us… his book is being released on September 9th.  Look for it.

Full disclosure: The Author and some PR flack asked me if I would like a copy and I said “yes.”

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.

Book Review: Deep Value

Tuesday, September 2nd, 2014

deep-value-front-coverThis is a book that starts with a simple premise: buy stocks at a fraction of the per share intrinsic value of the company, conservatively calculated.  Neat idea, huh, and it is called value investing.

The author starts by giving a preview of where he will end — with Carl Icahn when he was much younger, where he was buying closed-end funds at large discounts, and pressuring managers to liquidate the fund.  Eventually he started doing the same with overcapitalized companies trading a discount to the net worth of the company.

Then the author takes us on a trip through history, starting with Ben Graham buying the shares of companies at prices lower than the net liquid assets of the company, net of the debt.  It was easy money while it lasted, but eventually many of those companies were bought up and liquidated, and many of the rest had the stock price bid up until the value was no longer compelling.

Then we get to travel along with Warren Buffett and Charlie Munger, who note that the easy pickings are gone, and begin investing in companies that are inexpensive relative to their growth prospects.  This is more complicated, because these companies must have an advantage that will sustain their effort versus their competition.

Then we visit Joel Greenblatt, where he analyzes buying good companies at cheap prices, analyzing them the way an acquirer might do, but also looking for high returns on invested capital.  Lo, but it works, and furthers the efforts of those trying to obtain excess returns.

Then the book gets gritty, and looks at mean reversion of companies that have done poorly over the last four years.  Surprise! The worst tend to do quite well on average.  Also, raw application of simple valuation ratios tend to work on average in stock selection.  People undervalue the boring crud of the market, and overvalue the glamorous stocks, leaving an investment opportunity.

Then it tells a story that is personal to me, that of Litton Industries.  Litton Industries was one of two stocks I owned as a boy — gifts from relatives.  Litton Industries was a company that in the ’50s and ’60s used its highly valued stock to buy up companies that were not highly valued, and made Litton look like its earnings were growing rapidly, which propelled the value of Litton stock still higher.  So long as Litton could keep acquiring cheap-ish companies, the idea kept working, but eventually that ended, and the stock price crashed.  When did my relatives buy me shares of Litton?  Near the end, natch, when everyone know how wonderful it was.

Quite a lesson for an eight year old to see the stock price down by 80% in a year.  The other stock, Magnavox, did that also, so it is a testimony to my mother’s own clever investing that I ended up in this business… my story aside, the point of the Litton chapter was to point out that not all earnings growth is real, and that it is far better to focus on boring companies than what seems glamorous and successful.  Untempered optimism tends not to be rewarded.

The book then moves onto investors large enough to effect change outright, buying enough of a company to force change in a management team that is lazy, incompetent, or overly conservative.  The book goes through the experiences of Ronald Brierly, T. Boone Pickens, and Carl Icahn.  The art of spotting an undervalued company, and gaining enough influence to buy the company and fix it, or see the company sold to another company that will fix it, can lead to great gains.

Here the trail ends.  It started with Ben Graham buying companies that would be good investments regardless, moves to companies that will be good investments if you analyze them more closely, and ends with companies that good be good investments if you could influence a change in corporate behavior.  The same principles are being applied, but with much more analysis and potentially threat of a takeover.

In closing, the book talks about what can be a way of measuring moats, which is gross profits as percentage of assets.  It also reviews what factors activist investors look for when they invest, which may give the clever a guide into what stocks to pursue.

Quibbles

I liked the book, and I recommend it, but in one sense the book is a  statement of how tough the value investing game has become.  Ben Graham could sit back and do simple analyses, pursuing artistic endeavors and the good life in his spare time.  We have to analyze far more closely, and be aware of whether what companies larger activist players may consider.  Value investing still has punch for amateurs, but there is a lot more work and analysis to do.

Summary

This book would be good for investors looking to understand value investing better, and how it has changed over the years.  It would not likely be good for novices.  If you still want to buy it, you can buy it here: Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance).

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

Using Mean Reversion and Momentum for Possible Advantage

Saturday, August 30th, 2014

One of the challenges of fundamental investing is trying to find decent ideas that are off the radar. There are a number of ways to try to do that by looking at:

  • smaller foreign companies
  • companies that have made some significant losses.
  • companies where the relative performance is so awful that no manager benchmarked to an index would dare touch the company.
  • small companies with modest insider buying.
  • companies in boring industries that you know can’t have any significant growth.  (This excludes “buggy whip” industries.)
  • companies where insiders own so much of the company, that it can’t easily be taken over.
  • complex companies that are difficult to understand.

Okay, tall order.  That said, I’ll do a few articles over the next two months that try to unearth companies that might be suitable candidates for analysis.  Tonight’s article follows up on what I wrote in my last article, where I said:

Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year.  This can point out areas that are still ignored by most of the market, but where trend may have shifted.  I’ll post that screen after my software has its weekly update on Saturday.

I’m going to show you the list, with some additional data to give some context, but remember this: the only reason these stocks are here is that they underperformed the market massively for the last four years, and have had a turn in performance in the last year.  Anyway, here is the list:

 

 

BADTHENGOOD_21692_image002

I’ve been analyzing stocks for over 20 years… out of the 49 companies listed here, I recognize 24 of them.  I own none of them at present, though I have owned four of them in the past [AKS, DYN, TNP & YRCW].  That said, four years of lousy relative performance likely means that few are actively looking at these companies.

As with any analysis on the internet, purchasing or selling shares of companies like this is at your own risk.  I’m planning on looking through this list for ideas, and if I find one good enough to buy for my clients and me, I will do a write-up after we have established our position.

In order to get there, I would have to be satisfied about a number of things regarding any one of these companies:

  • What went wrong over the last four years?
  • Has management fixed what was wrong?  (Or, is there a new management with better ideas?)
  • Is the business adequately capitalized?
  • Is the accounting likely honest/conservative?
  • Do they have a large area where they can earn money sustainably, or are they up against stronger competition almost everywhere?
  • If they are in a tough industry, are they one of the few that could survive if conditions got markedly worse?
  • Does management seem intelligent in using excess cash?

The question is to look for a margin of safety, and then see whether the company will earn a return on its business that is attractive at your entry price.  This is a challenge, but maybe one or two companies out of 49 could make it.

Or not.  Be careful.

 

Two Portfolios. Pick One.

Friday, August 29th, 2014

I’m going to show you two portfolios — I’m not initially going to tell you much about either one, but then you can consider which one you might like better.  Here’s portfolio A:

LOSERS_9447_image002

And here is portfolio B:

WINNERS_3286_image002

There is one obvious difference in the two portfolios: portfolio B has gone up more than portfolio A in the past year.  But the hidden story is that portfolio A’s stocks have had price returns of -85% or worse over the past four years, whereas portfolio B’s stocks have has price returns of 1000% or better.  They are the only stocks with current market caps of over $100 million that meet those criteria.

Now, which one would you choose, if you had to hold one portfolio for the next year? The next four years?

Oddly, the right answer might be portfolio A.  Currently, I am reading through a book called Deep Value, which I will review in a week or two, and they cite in Chapter 5 some research by Thaler and De Bondt which indicates that portfolios that have gone through extreme failure tend to outperform portfolios that have gone through extreme success.

Though the momentum anomaly (weak as it has been recently) usually favors portfolios with stronger price momentum, the relationship breaks down over longer periods of time, and more severe moves, where mean-reversion tends to take over.  One thing that I can tell looking at the two portfolios — the expectations are a lot, lot higher for portfolio B than portfolio A.  Things only have to stop getting worse for there to some positive price action there.

Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year.  This can point out areas that are still ignored by most of the market, but where trend may have shifted.  I’ll post that screen after my software has its weekly update on Saturday.  Until then.

PS — as an aside, it will be fun to review the relative performance of these portfolios.

Return to Behemoth Stocks

Wednesday, August 27th, 2014

7234354130_55d1aaf1b8_z

Photo Credit: Benh LIEU SONG

Somewhat less than three years ago, I wrote two articles on Behemoth stocks [one, two], which I define as stocks with over $100 Billion of market cap.  Today I want to revisit those stocks, and those that have joined them.  The last time I wrote, there were 39 of them actively trading on US Exchanges.  Now there are 61, for a difference of 22.  24 stocks are new, and two have dropped out.  Let start with those two:

  • Vodapone plc [VOD] sold off its interest in Verizon Wireless to Verizon, creating a lot of value, and returned a lot of capital to shareholders.  For those of us who were shareholders, I can only say, great job.  You made Verizon pay up, and you didn’t blow all of the new free capital on suboptimal projects.
  • The stock price of Vale, SA [VALE] has gone down considerably (~40%).  China is no longer a giant vacuum cleaner for minerals The pace of China’s expansion has slowed, and that has had an impact on base metals producers like Vale.

This highlights three things:

  • In a bull market, once you are big, you tend to stay there.
  • If you want to create value for shareholders as a behemoth, you need to take radical actions that sell off parts of the company, and return capital to shareholders.  Managements should think, “How can we reorganize the company such that each component part will be better managed, and lines that we aren’t so good at are sold off.”
  • In general, these companies are too large to be taken over; change must come from within.  Activists will only succeed if the managements let them.

Now let’s look at the new companies, which fall into six main groups: Consumer Oriented, Banks, Pharmaceuticals, Information Technology,  Industrials, and  Internet.

Consumer Oriented

  • Anheuser Busch Inbev SA (ADR) [BUD]
  • British American Tobacco PLC [BTI]
  • Comcast Corporation [CMCSA]
  • Home Depot, Inc. [HD]
  • Visa Inc [V]
  • Walt Disney Company [DIS]

Banks

  • Banco Santander, S.A. (ADR) [SAN]
  • Bank of America Corp [BAC]
  • Citigroup Inc [C]
  • Royal Bank of Canada [RY]
  • Westpac Banking Corp (ADR) [WBK]

Pharmaceuticals

  • Amgen, Inc. [AMGN]
  • Bayer AG (ADR) [BAYRY]
  • Gilead Sciences, Inc. [GILD]
  • Sanofi SA (ADR) [SNY]

Information Technology

  • Cisco Systems, Inc. [CSCO]
  • QUALCOMM, Inc. [QCOM]
  • Taiwan Semiconductor Mfg. Co. [TSM]

Industrials

  • Siemens AG (ADR) [SIEGY]
  • United Technologies Corp [UTX]
  • Volkswagen AG (ADR) [VLKAY]

 Internet

  • Amazon.com, Inc. [AMZN]
  • Facebook Inc [FB]

 Energy

  • China Petroleum & Chemical Corp [SNP]

Most of these stocks have become Behemoths as a result of rising earnings and expanding P/E multiples amid the bull market.  A few, like Facebook and Amazon don’t require much in the way of earnings to support their stock price versus something like an Apple or a Google.  But let me show you my summary graph regarding now and three years ago for Behemoth stocks:

BEHEMOTH 8-2014_11021_image001

 

Three years ago, 2011-13 earnings were estimated, versus 2014-16 earnings today.  If you look at 2008-10, you can see the impact of the new stocks on the median P/E of the group as a whole.  In general, the P/Es of the new Behemoth stocks were higher than those that were already Behemoths three years ago, pulling the median at least one multiple turn higher.

And looking at 2011-13 estimated versus the actual, you can see how much valuations have increased over that period.  It didn’t happen all at once, but the S&P 500 is ~60% higher now than when I wrote the first two pieces (not counting dividends).

In December 2011 you could consider getting 9-10% earnings yields out of the Behemoths.  Today, you’re looking at 7%.  Quite a difference.  Some of it could be attributed to tighter yield spreads, but not to changes in Treasury yields, which are actually higher now than they were in December 2011.

You aren’t as well-compensated today relative to BBB corporate yields to play in the Behemoth stocks today.  Now, the Behemoths may be safer than many other stocks in the market, and are priced at a discount to the market averages, but your absolute margin of safety is lower.

What Can Behemoth Stocks do for You?

  • They can pay you dividends.  They have relatively protected market niches, and they pay above average dividends — 2.9% on average, and that is with seven that have dividends of less than 1%.
  • They can go down less than other stocks whenever the next bear market hits.

What Can’t Behemoth Stocks do for You?

  • They can’t grow as rapidly as smaller companies.
  • They can’t be taken over, so improvements from entrenched management teams must come from sweet reason convincing them, rather than barbarians at the gates.

What Could Behemoth Stocks do for You, if Management Teams were Willing to Take Some Chances?

These ideas aren’t likely, because those that manage Behemoth companies like managing these monstrosities, but if they did consider shareholders first:

  • Energy companies would split into upstream, midstream, refining and retail companies.
  • Conglomerates would divide into more focused companies.
  • Large financial companies would split into companies focused on serving specific markets, realizing that there are few advantages from diversification, and much loss from lack of focus.
  • Companies would segment into slow-growing legacy businesses which can be reliable income vehicles, and the rapidly-growing portions that could be amazing with some focus.
  • Frito-Lay would spin off Pepsi.
  • Procter and Gamble and GE would be even more aggressive about spinning off entities.

The main problem with Behemoths is that they are undermanaged.  There is only so much a single senior management team can do; the incentives of management teams get rather dull with respect to each division.  Even the radical decentralization of Berkshire Hathaway can only do so much; a day will come when they will centralize, reorganize and prune, but not while Warren Buffett still leads.

As for me and my clients, we own six of the cheaper Behemoth stocks, comprising  14% of our holdings, biding our time until I see better opportunities.

Full Disclosure: Long BRK/B, BP, CVX, SNP, TOT, and WFC

Peddling the Credit Cycle

Monday, August 25th, 2014

9142514184_9c85b423ae_z Starting again with another letter from a reader, but I will just post his questions in response to this article:

1) How much emphasis do you put on the credit cycle? I guess given your background rather a great deal, although as a fundamentals guy, I imagine you don’t try and make macro calls.

2)  What sources do you look at to make estimates of the credit cycle? Do you look at individual issues, personal models, or are there people like Grant’s you follow?

3) Do you expect the next credit meltdown to come from within the US (as your article suggests is possible) or externally?

4) How do you position yourself to avoid loss / gain from a credit cycle turn? Do you put more emphasis on avoiding loss or looking for profitable speculation (shorts or quality)

1) I put a lot of emphasis on the credit cycle.  I think it is the governing cycle in the overall economic cycle.  When some sector of the economy finds itself under credit stress, it has a large impact on stocks in that sector and related areas.

The problem is magnified when that sector is banks, S&Ls and other lending enterprises.  When that happens, all of the lending-dependent areas of the economy tend to slump, especially those that have had the greatest percentage increase in debt.

There’s a saying among bond managers to avoid the area with the greatest increase in debt.  That would have kept you out of autos in the early 2000s, Telecoms after that, and Banks/Finance heading into the Financial Crisis.  Some suggest that it is telling us to avoid the junior energy names now — those taking on a lot of debt to do fracking… but that’s too small to be a significant crisis.  Question to readers: where do you see debt rising?  I would add the US Government, other governments, and student loans, but where else?

2) I just read.  I look for elements of bad underwriting: loosening credit standards, poor collateral, financial entities focused on growth at all costs.  I try to look at credit spread relationships relative to risks undertaken.  I try to find risks that are under- and over-priced.  If I can’t find any underpriced risks, that tells me that we are in trouble… but it doesn’t tell me when the trouble will hit.

I also try to think through what the Fed is doing, and think what might be harmed in the next tightening cycle.  This is only a guess, but I suspect that emerging markets will get hit again, just not immediately once the FOMC starts tightening.  It may take six months before the pain is felt.  Think of nations that have to float short-term debt to keep things going, particularly if it is dollar-denominated.

I would read Grant’s… I love his writing, but it costs too much for me.  I would rather sit down with my software and try to ferret out what industries are financing with too much debt (putting it on my project list…).

3) At present, I think that an emerging markets crisis is closer than a US-centered crisis.  Maybe the EU, Japan, or China will have a crisis first… the debt levels have certainly been increasing in each of those places.  I think the US is the “least dirty shirt,” but I don’t hold that view strongly, and am willing to be challenged on that.

That last piece on the US was written about the point of the start of the last “bitty panic,” as I called it.  For a full-fledged crisis in US corporates, we need the current high issuance of  corporates to mature for 2-3 years, such that the cash is gone, but the debts remain, which will be hard amid high profit margins.  Unless profit margins fall, a crisis in US corporates will be remote.

4) My goal is not to make money off of the bear phase of the credit cycle, but to lose less.  I do this because this is very hard to time, and I am not good with Tactical Asset Allocation or shorting.  There are a lot of people that wait a long time for the cycle to turn, and lose quite a bit in the process.

Thus, I tend to shift to higher quality companies that can easily survive the credit cycle.  I also avoid industries that have recently taken on a lot of debt.  I also raise cash to a small degree — on stock portfolios, no more than 20%.  On bond portfolios, stay short- to intermediate-term, and high to medium high quality.

In short, that’s how I view the situation, and what I would do.  I am always open to suggestions, particularly in a confusing environment like this.  If you’re not puzzled about the current environment, you’re not thinking hard enough. ;)

Till next time.

Ranking P&C Reserving Conservatism

Wednesday, August 20th, 2014

6791185245_9cb9b5ccc1_zAbout 1 1/2 years ago, I wrote a seven-part series on investing in insurance stocks.  It is still a good series, and worthy of your time, because there aren’t *that* many writers freely available on the topic.

This particular article deals expands on part 4 of that series, which deals with insurance reserving.  I wanted to do this at the time, but I was short on time, and wrote out the general theory there, while not actually doing the time-consuming job of ranking the conservativeness of P&C insurers reserving practices.

Let me quote the two most important sections from part 4:

 

When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.

Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don’t know for sure.  Some lines of insurance do not have a strong method of calculating reserves.  This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.  The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.

Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.  That is why I try to underwrite insurance management teams to understand whether they are conservative or not.  I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.

and

What is the company’s attitude on reserving?  How often do they report significant additional claims incurred from business written more than a year ago?  Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.

So get out the 10K, and look for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.”  That value should be consistently negative.  That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.

One final note: point 2 does not work with life insurers.  They don’t have to give that disclosure.  My concern with life insurers is different at present because I don’t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.

As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.  Simplicity of product design is a plus to investors.

P&C reserving_14389_image002Today’s post analyzes Property & Casualty Insurers, and looks at their history of whether they consistently reserve conservatively each year.   Repeating from above, management teams that reserve conservatively establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.  This should give greater confidence that the accounting is fair, if not conservative.

So, I went and got the figures for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years,” for 67 companies over the past 12 years from the EDGAR database.  Today I share that with you.

When you look at the column “Reserving by Year,” that tells you how the reserving for business in prior years went over time.  A company that was consistently conservative of the past twelve years would have “12N’ written there for twelve negative adjustments to reserves.  Using Allstate as an example, the text is “5N, 1P. 3N, 3P” which means for the last 5 years [2013-2009], Allstate had negative adjustments to prior year reserves.  In 2008, it had to strengthen prior year reserves.  2007-2005, negative adjustments.  2004-3, it had to strengthen prior year reserves.

Now, in reserving, current results are more important than results in the past.  Thus, in order to come up with a score, I discounted each successive year by 25%.  That is, 2013 was worth 100 points, 2012 was worth 75, 2011 was worth 56, 2010 was worth 42 points, etc.  Since not all of the companies were around for the full 12 years, I normalized their scores by dividing by the score of a hypothetical company that was around as long as they were that had a perfect score.

Now, is this the only measure for evaluating an insurance company?  Of course not.  All this measures in a rough way is the willingness of a management team to reduce income in the short-run in order to be more certain about the accounting.  Consult my 7-part series for more ways to analyze insurance companies.

As an example, imagine an insurance company that consistently writes insurance business at an 80% combined ratio.  [I.e. 20% of the premium emerges as profit.]  I wouldn’t care much about minor reserve understatement.  Trouble is, few companies are regularly that profitable, and companies that understate reserves tend to get into trouble more frequently.

Comments and Surprises

1) Now, it is possible for a company to game this measure in the short run, where the management aims to always release some reserves from prior year business whether it is warranted or not.  That may have happened with Tower Group.  Very aggressive in growth, after their initial periods, they consistently released reserves for eight years, before delivering huge reserve increases for two years.

Now, someone watching carefully might have noticed a reserve strengthening for their non-reciprocal business in 2011, and then strengthenings in mid-2012, before the whole world realized the trouble they were in.

2) Notice in the red zone (scores of 40% and lower) the number of companies that did subprime auto insurance — Infinity, Kingsway, and Affirmative.  That business is very hard to underwrite.  In the short run, it is hard to not want to be aggressive with reserves.

3) Also notice the red zone is loaded with companies with much recent strengthening of reserves.  Many of these companies are smaller, with a few exceptions — the law of large numbers doesn’t apply so well with smaller companies, so they mis-estimate more frequently.  I won’t put companies with less than $1 billion of market cap into the Hall of Shame.  It’s hard to get reserving right as a smaller company.

4) As for larger companies, they can be admitted to the Hall of Shame, and here they are:

Hall of Shame

  • AIG
  • The Hartford
  • AmTrust Financial Services
  • Mercury General, and 
  • National General Holdings

AIG is no surprise.  I am a little surprised at the Hartford and Mercury General.  National General Holdings and Amtrust are controlled by the Karfunkels, who are aggressive in managing their companies.  Maiden Holdings, another of their companies is in the yellow zone.

Final Notes

I would encourage insurance investors to stick to the green zone for their investing, and maybe the yellow zone if the company has compensating strengths.  Stay out of the red zone.

This analysis could be improved by using prior year reserve releases as a fraction of beginning of year reserves, and then discounting by 25% each year.  Next time I run the analysis, that is how I will update it.  Until then!

Full disclosure: long TRV, ENH, BRK/B, ALL

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.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin