Book Review: Berkshire Beyond Buffett

Berkshire Beyond BuffettIt’s time to change what Warren Buffett supposedly said about his mentors:

“I’m 85% Ben Graham, and 15% Phil Fisher.”

For those who don’t know, Ben Graham is regarded to be the father of value investing, and Phil Fisher the father of growth investing.  Trouble is, Warren Buffett changed in his career such that this is no longer accurate.  Most of Buffett’s economic activity does not stem from buying and selling portions of public companies, but by buying and managing whole companies.  Buffett is the manager of a conglomerate that uses insurance reserves as a funding vehicle.

As a result, this would be more accurate about the modern Buffett:

Buffett is 70% Henry Singleton, 15% Ben Graham, and 15% Phil Fisher.

Henry Singleton was the CEO of Teledyne, a very successful conglomerate, and one of the few to do well over a long period of time.  It is very difficult to manage a conglomerate, but Teledyne survived for around 40 years, and was very profitable.  Buffett thought highly of Singleton as a allocator of capital, though the conglomerate that Buffett created is very different than Teledyne.

Tonight, I am reviewing a book that describes Buffett as a manager of a special conglomerate called Berkshire Hathaway [BRK] — Berkshire Beyond Buffett.  This Buffett book is different, because it deals with the guts of how Buffett created BRK the company, and not the typical and misleading Buffett as a value investor.

Before I go on, here are three articles that could prove useful for background:

The main point of Berkshire Beyond Buffett is that Buffett has created a company that operates without his detailed oversight.  As a result, when Buffett dies, BRK should be able to continue on without him and do well.  The author attributes that to the ethical values that Buffett has selected for when acquiring companies.  He manages to cram those values into an acronym BERKSHIRE.

I won’t spoil the acronym, but it boils down to a few key ideas:

  1. Do you have subsidiary managers who are competent, ethical, and love nothing better than running the business?  Do they act as if they are the sole proprietors of the business, and act only to maximize its long-term value consistent with its corporate culture?  These are the ideal managers of BRK subsidiaries.
  2. Acquiring such companies often comes about because a founder or significant builder of the company is getting old, and there are family, succession, taxation, funding or other issues that being a part of BRK would solve, allowing the management team to focus on running the business.
  3. Do the businesses have sustainable competitive advantages in markets that are likely to be relevant several generations from now?

The beauty of a company coming under the Berkshire umbrella is that Buffett leaves the culture alone, and so long as the company is producing its profits well, he continues to leave them alone.  Thus, the one selling a company to Buffett gets the benefit of knowing that the people and culture of the company will not change.  In exchange, Buffett does not pay top dollar, but gets deals done faster than almost anyone else.

This is a very good book, and its greatest strength is that it talks about Berkshire Hathaway the company as built by Buffett to endure.  If you want to understand Buffett’s corporate strategy, it is described ably here.

Quibbles

Now, my three ideas above *might* have been a better way to organize the book, rather than the hokey BERKSHIRE.  Also, a lot more could have been done with the insurance enterprises of BRK, which are a critical aspect of how the company owns and finances many of the other subsidiaries.

But will BRK do so well without Buffett?  Yes, his loyal son Howard will guard the culture.  The Board is loyal to the ethos that Buffett has created.  Ted Weschler and Todd Combs will continue to invest the public money.  The all-star subsidiary managers will soldier on, at least in the short-run.

But will the new CEO be the person that “you don’t want to disappoint,” as some subsidiary managers think of Buffett?  As a result, how will BRK deal with underperformers?  What new structures will they set up?  Tracy Britt Cool is smart, but will BRK need many like her, and how will they be organized?

Will he be a great capital allocator?  Will he maintain the “hands off” policy toward the culture of subsidiaries, or will the day come when some centralization takes place to save money?

Will Buffett’s replacement be equally intuitive with respect to acquisition prices, and sustainable competitive advantage?

Buffett’s not perfect — he has had his share of errors with textiles, shoe companies, airlines, Energy Future, and a variety of other investments, but his record will be tough to match, even if replaced by a team of clever people.  Say what you will, but teams are not as decisive as a single manager, and that may be a future liability of BRK.

Summary / Who Would Benefit from this Book

Most people will not benefit from this book if they are looking for a way to make more money in their life.  There are no magic ways to apply the insights of the book for quick gains.  Also, readers are unlikely to use Buffett’s “hands off” methods in building their own conglomerate.  But readers will benefit because they will get to consider the building of the BRK enterprise from the basic principles involved.  There will be indirect benefits as they analyze other business situations, perhaps using BRK as a counterexample — a different way to acquire and run a large enterprise.

But as for getting any direct benefit from the book? There’s probably not much, but you will understand business better at the end.  If you still want to buy it, you can buy it here: Berkshire Beyond Buffett: The Enduring Value of Values.

Full disclosure: I received a copy from the author’s PR flack.

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.

Full Disclosure: long BRK/B for clients and myself

Waiting to Buy

Photo Credit: Brett Davies || Waiting, but to what end?

Photo Credit: Brett Davies || Waiting, but to what end?

When I worked in the investment department of a number of life insurers, every now and then I would hear one of the portfolio managers say, “We know that the rating agencies are going to downgrade the bonds of XYZ Corp, but we like the story.  We’re just waiting until after the downgrade, and then we will buy, because they will be cheaper then.”

And, sometimes it would work.  Other times, nothing would happen at the downgrade, and they would buy at the same price.  But more interesting and frequent were the times when the bonds would rally after the downgrade, which would make the portfolio managers wince and say, “Guess everyone else was waiting to buy also.”

Now, there was a point in time where the corporate bond market was more strictly segmented, and getting downgraded, if was severe enough, would mean there was a class of holders that would become forced sellers, and thus it paid to wait for downgrades.  But as with many market inefficiencies, a combination of specialists focusing on the inefficiency and greater flexibility on the part of former forced sellers made it disappear, or at least, make it unpredictable.

But so what?  Bonds are dull, right?  Well, no, but most think so.  What about stocks?  What if you want to buy a stock that you think is going to rise, but you are waiting for a pullback in order to buy?

In order to to get this one right, you have to get multiple things right:

  • The stock is a good buy long term, and not enough parties know it
  • The stock is short-term overbought by flexible money
  • Other longer-term buyers aren’t willing to buy it at the current level and down to the level where you would like to buy.
  • The correction doesn’t make quantitative managers panic, sell, and the price overshoots your level.

Maybe the last one isn’t so bad — no such thing as a bad trade, only an early trade, if the stock is good long term?

That’s one reason why I do two things:

  • I tend to buy the things I like now.  I don’t wait.  Timing is not a core skill of mine, or of most investors — if you are mostly right, go with it.
  • I pursue multiple ideas at the same time.  If I have multiple ideas to put new money into, the probability is greater that I get a good deal on the one that I choose.

The same idea would apply to waiting to sell.  Maybe you think it is fully valued, but will have one more good quarterly earnings number, and somehow the rest of the world doesn’t know also.

Hint: do it now.  If you are truly uncertain, do half.  It’s tough enough to get one thing right.  Getting short-term timing right verges on the impossible.  Better to act on your strongest long-term sense of value than trying to get the short-run perfect.  You will do best in the long run that way.

Risk Tolerance — The Ability to Deal with Loss

Photo Credit: 401(K) 2012

Photo Credit: 401(K) 2012

No one knows their financial “risk tolerance” outside of the context of losing money.  Part of the trouble is that risk and return are often described in the same breath as if they are inseparable, when they are more weakly related than most think, and certainly not linear.

Surveys, no matter how well-intentioned or -designed do not typically grasp the asymmetry of gain and loss.  People feel losses much more acutely than gains, and are far more likely to change their behavior after losses.  Can’t tell you how many times I have had people say to me, “I’m never buying stock again,” after 2000-2 and 2008-9.

Nothing can prepare you for the event of loss except prior losses.  Those who have made it through losing money have coping strategies ranging from diversification to rebalancing to benign neglect, etc.  The best look at it as a cost of doing business, and try to view it together with all other investment decisions made — there will always be losses, but were there gains as well, and more of them over the long haul?

Risk is best faced in prospect, and not retrospect: ask yourself if the current assets that you hold offer fair compensation for the risks that they have.  Are they building value even if the market is not reflecting it yet?

I’m going to be starting a new irregular series at Aleph Blog, where I go through my past tax returns and pull out all of the blunders over the past 25 years.  I hope it will be instructive to my readers in many ways, but perhaps the most important of those ways is that you have to get up and fight again if you have been knocked down.  Don’t give up!  If you leave the game, it is typically at the time prior to gains.  Rather, ask whether what you are doing now is the right thing to do on a looking forward basis.  The past is gone, and the only time to affect the future is now.

So look for the new series, and appreciate my packrat tendencies that I still have the records for these matters.  Hopefully it will be fun, and particularly instructive for younger readers because I was young once too, and I started in this game as an amateur.  I made a lot of mistakes, but I did not compound my mistakes by leaving the game.

The Butterfly Machine

Photo Credit: whologwhy || Danger: Butterfly at work!

Photo Credit: whologwhy || Danger: Butterfly at work!

There’s a phenomenon called the Butterfly Effect.  One common quotation is “It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world.”

Today I am here to tell you that for that to be true, the entire world would have to be engineered to allow the butterfly to do that.  The original insight regarding how small changes to complex systems occurred as a result of changing a parameter by a little less than one ten-thousandth.  Well, the force of a butterfly and that of a large storm are different by a much larger margin, and the distances around the world contain many effects that dampen any action — even if the wind travels predominantly one direction for a time, there are often moments where it reverses.  For the butterfly flapping its wings to accomplish so much, the system/machine would have to be perfectly designed to amplify the force and transmit it across very long distances without interruption.

I have three analogies for this: the first one is arrays of dominoes.  Many of us have seen large arrays of dominoes set up for a show, and it only takes a tiny effort of knocking down the first one to knock down the rest.  There is a big effect from a small initial action.  The only way that can happen, though, is if people spend a lot of time setting up an unstable system to amplify the initial action.  For anyone that has ever set up arrays of dominoes, you know that you have to leave out dominoes regularly while you are building, because accidents will happen, and you don’t want the whole system to fall as a result.  At the end, you come back and fill in the missing pieces before showtime.

The second example is a forest fire.  Dry conditions and the buildup of lower level brush allow for a large fire to take place after some small action like a badly tended campfire, a cigarette, or a lightning strike starts the blaze.  In this case, it can be human inaction (not creating firebreaks), or action (fighting fires allows the dry brush to build up) that helps encourage the accidentally started fire to be a huge one, not merely a big one.

My last example is markets.  We have infrequently seen volatile markets where the destruction is huge.  A person with a modest knowledge of statistics will say something like, “We have just witnessed a 15-standard deviation event!”  Trouble is, the economic world is more volatile than a normal distribution because of one complicating factor: people.  Every now and then, we engineer crises that are astounding, where the beginning of the disaster seems disproportionate to the end.

There are many actors that take there places on stage for the biggest economic disasters.  Here is a partial list:

  • People need to pursue speculation-based and/or debt-based prosperity, and do it as a group.  Collectively, they need to take action such that the prices of the assets that they pursue rise significantly above the equilibrium levels that ordinary cash flow could prudently finance.
  • Lenders have to be willing to make loans on inflated values, and ignore older limits on borrowing versus likely income.
  • Regulators have to turn a blind eye to the weakened lending processes, which isn’t hard to do, because who dares oppose a boom?  Politicians will play a role, and label prudent regulations as “business killers.”
  • Central bankers have to act like hyperactive forest rangers, providing liquidity for the most trivial of financial crises, thus allowing the dry tinder of bad debts to build up as bankers use cheap funding to make loans they never dreamed that they could.
  • It helps if you have parties interested in perpetuating the situation, suggesting that the momentum is unstoppable, and that many people are fools to be passing up the “free money.”  Don’t you know that “Everybody ought to be rich?” [DM: then who will deliver the pizza?  Are you really rich if you can’t get a pizza delivered?]  These parties can be salesmen, journalists, authors, etc. whipping up a frenzy of speculation.  They also help marginalize as “cranks” the wise critics who point out that the folly eventually will have to end.

Promises, promises.  And all too good to be true, but it all looks reasonable in the short run, so the game continues.  The speculation can take many forms: houses, speculative companies like dot-coms or railroads, even stocks themselves on sufficient margin debt.  And, dare I say it, it can even apply to old age security schemes, but we haven’t seen the endgame for that one yet.

At the end, the disaster appears out of nowhere.  The weak link in the chain breaks — vendor financing, repo financing, a run on bank deposits, margin loans, subprime loans — that which was relied on for financing becomes recognized as a short-term obligation that must be met, and financing terms change dramatically, leading the entire system to recognize that many assets are overpriced, and many borrowers are inverted.

Congratulations, folks, we created a black swan.  A very different event appears than what many were counting on, and a bad self-reinforcing cycle ensues.  And, the proximate cause is unclear, though the causes were many in society pursuing an asset boom, and borrowing and speculating as if there is no tomorrow.  Every individual action might be justifiable, but the actions as a group lead to a crisis.

In closing, though I see some bad lending reappearing, and a variety of assets at modestly speculative prices, there is no obvious crisis facing us in the short-run, unless it stems from a foreign problem like Chinese banks.  That said, the pension promises made to those older in most developed countries are not sustainable.  That one will approach slowly, but it will eventually bite, and when it does, many will say, “No one could have predicted this disaster!”

Meeting the “Bond King”

Photo Credit: ~Sage~ || King of the Beasts, eh?

Photo Credit: ~Sage~ || King of the Beasts, eh?

It was winter in early 1995, and I was wondering if I still had a business selling Guaranteed Investment Contracts [GICs].  Confederation Life had gone insolvent the August prior, and I noticed that fewer and fewer stable value funds wanted to purchase my GICs, because our firm was small, and as such, did not get a good credit rating, despite excellent credit metrics.  The lack of a good rating kept buyers away.

Still, I felt I needed to try my best for one more year or so, despite my feelings that the business was dying soon.  With that attitude, I headed off in January to sunny Southern California, to attend GICs ’95, something my opposite number at AIG referred to as a Schmoozathon.

Schmoozathon?  Well, you took your opportunities to ingratiate yourself with current and potential clients, across four days and three nights of meetings, with a variety of parties going on.  I was not the best salesman, so I just tried to play it as straight as I could.

In the middle of the whole affair was a special lunch where Bill Gross was to be the Keynote Speaker.  Because I was talking with a client, I got to the lunch a little late, and ended up at a table near the back of the room.

Things were running a little behind, but Bill Gross got up and gave a talk that borrowed heavily from a recent Pimco Investment Outlook that he had written, comparing the current market opportunities to Butler Creek (see paragraph 6), a creek that he grew up near as a kid, which gently meandered, went kinda straight, kinda not, but didn’t vary all that much when you looked at it as a whole, rather than from a nearby point on the ground.

The point? Sell volatility.  Buy mortgage bonds.  Take convexity risk.  Clip yield.  Take a few chances, the environment should be gentle, and you can’t go too wrong.

After the horrible investment environment for bonds of 1994, this was a notable shift.  So he came to the end of his talk, and it was time for Q&A.  Suddenly, the moderator stormed up to the front of the room and said, “I’m really sorry, but we’re out of time.  We’ve got a panel waiting in the main meeting room to talk about the Confederation insolvency.  Please head over there now.”

Everyone got up, and dutifully headed over to the Confederation panel.  I was disappointed that I wouldn’t get a chance to ask Bill Gross a question, so as I started to leave, I looked to the front of the room, and I saw Bill Gross standing there alone.  It struck me. “Wait.  What don’t I know about Confederation? The best bond manager in the US is standing up front.”

So I walked up to the front, introduced myself, told him that I was an investment actuary, and asked if I could talk with him about mortgage bonds.  He told me that he could until his driver showed up.  As a result, for the next 15 minutes, I had Bill Gross to myself, asking him how they analyzed the risks and returns of complex mortgage securities.  His driver then showed up; I thanked him, and he left.

Feeling pretty good, I wandered over to the Confederation panel.  As I listened, I realized that I hadn’t missed anything significant.  Then I realized that the rest of the audience had missed a significant opportunity.  Oh, well.

As it turned out, I made many efforts in 1995 to resuscitate my GIC business.  It survived for one more year, and collapsed in 1996, with little help from senior management.  It was for the best, anyway.  It was a low margin, capital intensive business, and closing it enabled me to focus on bigger things that improved corporate profitability.  I never went to another Schmoozathon as a result, but the last one had a highlight that I would not forget: meeting Bill Gross.

Mantra: Interest Rates Have to Rise, Interest Rates Have to…

Photo Credit: Beto Vilaboim || No, you are not crazy -- it *is* hopeless

Photo Credit: Beto Vilaboim || No, you are not crazy — it *is* hopeless

I thought of structuring this post like a fictional story, but I couldn’t figure out how to make it good enough for publication.  Well, truth is often stranger than fiction, so have a look at this Bloomberg article pointing at a 37% loss in the ProShares UltraShort 20+ Year Treasury (TBT).

A few points to start with: shorting is hard.  Leveraged shorting is harder.  I think I have reasonable expertise in much though not all of investing, and I put most shorts in the “too hard pile.”

That said, I have taken issue with the “interest rates can only go up” trade for 8-9 years now.  It is not a major theme of mine, but I remember a disagreement that I had with Cramer over it back when I was writing for RealMoney.  (I would point to it now, but almost all content at RealMoney prior to 2008 is lost.)

Many bright investors (usually not professional bond investors) have taken up the “interest rates can only go up” view because of the loose monetary policy that we have experienced, and thanks to Milton Friedman, we know that “Inflation is always and everywhere a monetary phenomenon,” or something like that.

Friedman may or may not be right, but when banks do not turn the proceeds of deposits into loans, inflation doesn’t do much.  As it is, monetary velocity is low, with no signs of imminent pickup.

At least take time to read the views of those who are long a lot of long Treasuries, and have been that way for a long time — Gary Shilling and Hoisington Management.  Current economic policies are not encouraging growth, and that is true over most of the world.  We have too much debt, and the necessary deleveraging inhibits growth.

Think of this a different way: we have a lot of people thinking that they will retire over the next 10-30 years.  To the extent that you can live with the long-run volatility, I accept the idea that you can earn 6-8%/year in stocks over that period, so long as there isn’t war on your home soil, or a massive increase in socialism.

But what if you are running a defined-benefit plan, investing to back long-dated insurance products, or just saying that you need some degree of nominal certainty for some of your assets.  The answer would be debt claims against institutions that you know will be around to pay 10-30 years from now.

In an era of change, how many institutions are you almost certain will be here 10-30 years from now?  Personally, I would be comfortable with most government, industrial and utility bonds rated single-A or better.  I would also be comfortable with some municipal and financial company bonds with similar ratings.

If followed, and this has been followed by many institutional bond investors, this would result in falling long-term yields, particularly now when economic growth is weak globally.

Now, rates have fallen a great deal over 2014.  Can they fall further from here?  Yes, they can.  Is it likely?  I don’t know; they have fallen a lot faster than I would have expected.

I would encourage that you watch bank lending, and to a lesser extent, inflation reports.  The time will come to end the high quality long bond trade, but at present, who knows?  Honor the momentum for now.

Full Disclosure: Long TLT for my fixed income clients and me (it’s a moderate part of a diversified portfolio with a market-like duration)

Even with Good Managers, Volatility Matters

Photo Credit: sea turtle

Photo Credit: sea turtle

This is another episode in my continuing saga on dollar-weighted returns. We eat dollar-weighted returns.  Dollar-weighted returns are the returns investors actually receive in a open-end mutual fund or an ETF, which includes their timing decisions, as opposed to the way that performance statistics are ordinarily stated, which assumes that investors buy-and-hold.

In order for active managers to have a reasonable chance of beating the market, they have to have portfolios that are significantly different than the market.  As a result, their portfolios will not behave like the market, and if they are good stockpickers, they will beat the market.

Now, many of the active managers that have beaten the market run concentrated portfolios, with relatively few stocks comprising a large proportion of the portfolio.  Alternatively, they may concentrate their portfolio in relatively few industries at a time, as I do.  Before I begin my criticism, let me simply say that I believe in concentrated portfolios — I do that myself, but with a greater eye for risk control than some managers do.

My first article on this topic was Bill Miller, who is a really bright guy with a talented staff.  This is the “money shot” from that piece:

Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.  As Legg Mason Value Trust grew larger it concentrated its positions.  It also did not care much about margin of safety in financial companies.  It bought cheap, and suffered as earnings quality proved to be poor.

Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.  I’m not sure the situation has stabilized, but it is probably close to doing being there.

Investors in the Legg Mason Value Trust trailed the returns of a buy-and-hold investor by 6%/year over the time my article covered.  Investors bought late, and sold late.  They bought after success, and sold after failure.  That is not a recipe for success.

FAIRX_15651_image002Tonight’s well-known fund with a great track record is the Fairholme Fund. Now, I am not here to criticize the recent performance of the fund, which due to its largest positions not doing well, has suffered of late. Rather, I want to point out how badly investors have done in their purchases and sales of this fund.

As the fame of Bruce Berkowitz (a genuinely bright guy) and his fund grew, money poured in.  During and after relatively poor performance in 2011, people pulled money from the fund.  Even with relatively good performance in 2012 and 2013, the withdrawals have continued.  The adding of money late, and the disproportionate selling after the problems of 2011 led the dollar weighted returns, which is what the average investors get, to lag those of the buy-and-hold investors by 5.57%/year over the period that I studied.

(Note: in my graph, the initial value on 11/30/2003 and the final value on 5/31/2014 are the amounts in the fund at those times, as if it had been bought and sold then — that was the time period I studied, and it was all of the data that I had.  Also, shareholder money flows were assumed to occur mid-period.)

Lessons to Learn

  1. Good managers who have ideas that will work out eventually need to be bought-and-held, if you buy them at all.
  2. Be wary of managers who are so concentrated, that when they receive a lot of new cash after good performance, that the new cash forces the prices of the underlying stocks up.  Why be wary?  Doesn’t that sound like a good thing if new money forces up the price of the mutual fund?  No, because the fund has “become the market” to its stocks.  When the time comes to sell, it will be ugly.  If you are in a fund like this, where the fund’s trading has a major effect on all of the stocks that it holds, the time to sell is now.
  3. There is a cost to raw volatility in large concentrated funds.  The manager may have the guts to see it through, but that doesn’t mean that the fundholders share his courage.  In general, the more volatile the fund, the less well average investors do in buying and selling the fund.  (As an aside, this is a reason for those that oversee 401(k) plans to limit the volatility of the choices offered.
  4. Even for the buy-and-hold investor, there is a risk investing alongside those who get greedy and panic, if the cash flow movements are large enough to influence the behavior of the fund manager at the wrong times.  (I.e., forced buying high, and forced selling low.)
  5. The forced buying high should be avoidable — the manager should come up with new ideas.  But if he doesn’t, and flows are high relative to the size of the fund, and the market caps of investments held, it is probably time to move on.
  6. When you approach adding a new mutual fund to your portfolio, ask the following questions: Am I late to this party?  Does the manager have ample room to expand his positions?  Is this guy so famous now that the underlying investors may affect his performance materially?
  7. Finally, ask yourself if you understand the investment well enough that you will know when to buy and/or sell it, given you investing time horizon.  This applies to all investments, and if you don’t know that, you probably should steer clear of investing in it, and learn more, until you are comfortable with the investments in question.

One final note: I am *not* a fan of AIG at the current price (I think reserves are understated, among other things), so I am not a fan of the Fairholme Fund here, which has 40%+ of its assets in AIG.  But that is a different issue than why average investors have underperformed buy-and-hold investors in the Fairholme Fund.

Factor Glut

Photo Credit: Dan Century

Photo Credit: Dan Century

I use factors in my investing. What *are* factors, you ask?  Factors are quantitative variables that have been associated with potential outperformance.  What are some of these factors?

  1. Valuation (including yield)
  2. Price Momentum (and its opposite in some cases)
  3. Insider Trading
  4. Industry factors
  5. Neglect
  6. Low Volatility
  7. Quality (gross margins as a fraction of assets)
  8. Asset shrinkage
  9. Share count shrinkage
  10. Measures of accounting quality
  11. and more…

This is a large portion of what I use for screening in my eighth portfolio rule.  I’m not throwing this idea out of the window, but I am beginning to call it into question.  Why?

I feel that the use of the most important factors are getting institutionalized, such that many major investors are giving their portfolios a value tilt, sometimes momentum tilts, and other sorts of tilts.  I also see this in ETFs, where many funds embrace value, yield, momentum, accounting, or other tilts.

Now, we have been through this before.  In 2007, momentum with value hedge funds became overinvested in the same names, with many of the funds using leverage to goose returns.  There was quite a washout in August of that year as many investors exited that crowded trade.

I’m not saying we will see something like that immediately, but I am wary to the point that when I do my November reshaping, I’m going to leave out the valuation, yield and momentum factors, and spend more time analyzing the industry and idiosyncratic company risks.  If after that, I find cheap stocks, great, but if not, I will own companies that are hopefully not owned by a lot of people just because of a few quantitative statistics.

I may be a mathematician, but I try to think in broader paradigms — when too many people are looking at raw numbers and making decisions off of them solely, it is time to become more qualitative, and focus on strong business concepts at reasonable prices.

Numerator vs Denominator

Photo Credit: Jimmie

Photo Credit: Jimmie

Every now and then, a piece of good news gets announced, and then something puzzling happens.  Example: the GDP report comes out stronger than expected, and the stock market falls.  People scratch their heads and say, “Huh?”

A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.”  This much is true, but why is it true?  How can the market go down on good economic news?

Some of us as investors use a concept called a discounted cash flow model.  The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow discounted to reflect to reflect the time value of money and the riskiness of that cash flow.

Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better.  But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.

Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?

Refer back to a piece I wrote earlier this week.  Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash.  When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:

  • More firms are going to want to raise capital to invest for growth, or
  • The Fed is going to have to tighten policy sooner than we thought.  Look at bond prices falling and yields rising.

Even if things are looking better for profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms.  Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble?  Don’t worry, most people don’t.  But as those prices slumped, value was building in those companies.  No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.

The cost of capital was exceptionally low for the dot-com stocks 1998-early 2000, and relatively high for the fuddy-duddy companies.  The economy was doing well.  Why no lift for all stocks?  Because incremental dollars available for finance were flowing to the dot-com companies until it became obvious that little to no cash would ever flow back from them to investors.

Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly.  2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow.  The cost of capital normalized, and many dot-coms could no longer get financing at any price.

Another Example

Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises.  They might think: “Why should the stock market rise?  Doesn’t everyone know that business conditions are lousy?”

Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks?  Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has swung to stocks, and the prices rise.

I can give more examples, and maybe this should be a series:

  • The Fed tightens policy and bonds rally. (Rare, but sometimes…)
  • The Fed loosens policy, and bonds fall. (also…)
  • The rating agencies downgrade the bonds, and they rally.
  • The earnings report comes out lower than last year, and the stock rallies.
  • Etc.

But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets.  Why?  Markets are composed of people, that’s why.  We’re not always predictable, and we don’t predict better when you examine us as groups.

That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.”  Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:

“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”

So be aware of the tone of the market.  Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected.  Good news may imply that there are other places to attract money away from stocks.

Ideas for this topic are welcome.  Please leave them in the comments.

When Will the FOMC Tighten the Fed Funds Rate?

Photo Credit: Moon Lee || When is this train going to arrive?

Photo Credit: Moon Lee || When is this train going to arrive?

There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better.  Don’t assume the FOMC:

  • Shares your view of how economies work.
  • Cares about the politics of the situation.
  • Knows what it really wants, aside from magic.
  • Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
  • Cares about the reasoning of dissenters on the committee.
  • Understands what is actually happening in the economy, much less what its policy tools will really do.

But you can assume the FOMC:

  • Cares about the health of the banks, at least under extreme conditions
  • Wants to do something good, even if their minds are poisoned by neoclassical economics
  • Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact desired on the markets and economy.
  • Will act in the manner that most protects its continued existence and privileges.

So if we want to guess when the FOMC will tighten, we can do three things:

  1. Look at market opinion
  2. Look at the FOMC’s own opinions, or
  3. Something else ;)

Let’s start with market opinion.  At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter.  Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well.  So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.

Okay, so what does the FOMC think?  Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:

central tendency_10374_image001 GDP

In general, they have been overly optimistic about growth in the US economy.  They probably still are too optimistic.

 

 

Unemp

They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.

PCE

 

In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.

FF

 

And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market.  Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be.  Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015″ since September 2012.  The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.

So, where does this leave us, but with a view that the FOMC will tighten policy next year.  But what if the monetary doves on the FOMC remain dominant?  After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate.  That leaves me with this, which reflects the influence of the doves better:

Tighten

 

This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.

The drift has happened because the economy has not strengthened the way the FOMC expected it would.  If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected.  After all, labor conditions are soft, and inflation as they measure it is not roaring ahead.  (Please ignore the asset price inflation that aids the non-existent wealth effect.)

As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE.  They are still waiting for their grand sign to act on Fed funds, and it has not come yet.

Summary

Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015.  Prior expectations of FOMC action have signaled much earlier action than what has actually happened.  From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus earlier than then.  The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.