David,
Always enjoy your blog – very thought provoking, and I’ve learned a lot from reading you across a variety of topics. Assuming I haven’t missed this in an older post… one thing you mention as a key investment strategy is finding the right industry at the right time, and I’ve never seen a very good explanation of how one goes about that. In one of Jim Cramer’s recent books he offered a sort of stylized graph outlining a general playbook to that effect – I’ll send it to you if you’d like – but I’d like to get a primer on how you go about industry over/underweights.
Thanks and Best,
JC
It made me think that I should go through my basic principles of industry selection, and explain them.? JC mentions Cramer’s “playbook” — that’s the classical guide to what industries do best in an “ordinary” business cycle.? Personally, I think Cramer’s views on industry selection are more complex than that, largely for the reason that I don’t follow the “playbook” in any strict sense: global demand is more important than US demand alone for many industries.? The old playbook is no longer valid, until we get a totally integrated world economy.? (Side note: we will never get that — some war will upset the globalization — it is the nature of mankind.)
Anyway, I have four basic tenets when looking at industries:
Buy strong companies in weak industries when the industry pricing outlook seems hopeless.
Buy moderate to strong companies in strong industries where the earnings power and duration are underestimated.
Underweight/Ignore/Short industries where pricing power is likely to be negative for several more years, and especially industries that are in terminal decline.
Avoid fad industries.? There are P/E levels that no industry can grow into.
My best example of #1 is the P&C insurance industry in early 2000.? Total gloom.? I bought a lot of The St. Paul then.? Another example: Steel in 2001-2002.? I bought Nucor.
For #2, think of the energy industry — current stock prices embed oil prices far below current levels.? Or, think of the life insurance industry — low P/Es, but the demographic trends are in their favor.
On the third one, think of newspapers, whose richest revenue sources are getting eaten up by the internet.
For the last one, think of the internet/tech bubble 1998-2000.? Very few companies that were hot then are at higher prices now.
I share the results of my industry model once a quarter at minimum.? But I don’t use my model blindly.? For example, lending financials and housing have been cheap for some time, but I have avoided them.? They are cheap for a reason.
My main model uses the Value Line ranking system, and uses the nominal rank, and how it is different from the average historical rank.? It can be used in two ways: highly rated industries can be analyzed to see where the pricing power is not reflected in the stock prices yet.? Low rated industries should be analyzed for the possibility or reversal due to undeserved hopelessness.
But you can create your own model just from a series of index prices.? The idea is to look at industries that either have strong momentum that you think is deserved, or industries with weak momentum where things seem very bad but not terminal.? You can even modify it to look at industries that have bad performance over the past 3-5 years, but have rebounded over the past 6-12 months.
Behind all of that, remember my rule: sharp movements tend to mean-revert, slow, grinding, fitful movements tend to persist.? Things that are too certain tend to disappoint, while those things that are less certain tend to surprise.
One reason I have done well over the past 7+ years is that I have been willing to let my industry selection vary considerably from where the indexes have been.? If you think that you have insight into the longer-term earnings power of industries, then take your opportunity, and deviate from market weightings.
Take some low single-A or high-BBB rated debt, lever it up 15 times.? If spreads back up, lever up more, and buy more at the higher spreads, and hope spreads don’t continue to rapidly widen, such that you have to break the deal and realize the losses.? If spreads tighten enough, de-lever, and declare victory.? That is a great bull market strategy to make money in investment grade credit, but it is not a high quality strategy.
If I created a Collateralized Debt Obligation [CDO] out of similar instruments, with what would be light leverage of 15 times, and it had just two tranches — 94% senior, 6% junior, the senior obligations would get a AAA (probably), but the junior obligations would be rated BB or so — just my back-of-the-envelope guess, but consistent with my experience.
But for Constant proportion debt obligations [CPDOs], they were not rated BB but AAA, because the dynamic portfolio management would allow the structure to survive modest bear markets in credit.? Unfortunately, when a lot of parties lever up credit, the historical statistics on how the credit markets behave at lower leverage levels don’t apply.? The odds of a sharp self-reinforcing bear market in credit rise.
So, it is not a surprise that I was an early bear on CPDO structures.? Here’s a summary piece on what I wrote, and when I wrote it.
Now today it gets revealed in the Financial Times that Moody’s had a mistake in their ratings model for CPDOs that allowed them to offer ratings equivalent to those of S&P.? Needless to say, this is getting a lot of coverage today, from:
There are conflicts of interest in the way that ratings agencies get paid by the issuers, and the CPDO debacle highlights them.? I don’t think you can create a system where the users of ratings carry the full weight of the ratings process.? The issuers have the concentrated interest in a way buyers do not.
But maybe there is a way to re-align matters.? What if the ratings agencies received half of their fee by receiving interests in the juniormost class?? (For non-structured deals, make that a subordinated interest strip.)? My, but I think that subordination levels would rise.? Also, I think the ratings agencies would become more generally cautious.
From my angle, though, the CPDO debacle is more egregious than other rating failures, because the agencies deviated from their normal way of rating debt, seemingly just to make more money.? Well, they made the money, but how much is a reputation for quality ratings worth?? In the long run, the CPDO deals will be net losers for Moody’s and S&P, and a net win for skeptics like Fitch and Dominion.
We haven’t quite made it back to the highs made in July or October. But the VIX has normalized:
And the spread between A2/P2 commercial paper and the two-year Treasury has narrowed as well. Normalcy has returned to the lending markets?
Well, sort of. The question remains as to what happens when the Fed ends their new lending programs, that is, if they can end them. As with many government programs, they take on a life of their own, and they are difficult to end. If the Fed can’t end the new facilities, can they really say that they have ended the crises?
As for market sentiment, consider this graph:
This is a knockoff of the oscillator that Cramer cites. How accurate is it? Over +/- 500, Cramer comments that there are extreme readings. But as for now we are near zero — this indicator tells us nothing here.
So, what am I saying? We have rallied a great deal, and a lot of fear has come out of the markets, but we still have not eclipsed the highs of July or October. My sense is that we will muddle from here and not do much on net for the next three months. Fear has ended too quickly.
Aside from Abnormal Returns (one of my favorites, good to see him back), my comments on AIG were also cited by Felix Salmon at Market Movers.? I tried to post this comment there, but the software would not let me, and I have no idea why:
Thanks, Felix.? With the Wells Notice served to Hank Greenberg, this chapter of the AIG story is not over yet.
Sometime in the future, I’ll find and post a copy of the memo where Hank Greenberg discovered the massive under-reserving at ALICO Japan, giving his response to the problem… but given the billion dollar hole, it was amazing that AIG did not miss earnings that quarter, because it was much larger than their quarterly earnings.
And some of my insurance analyst friends wonder why I don’t find AIG to be cheap…
As I mentioned at RealMoney back when Greenberg left AIG, my experience in my three years inside AIG was that we (the small actuarial unit that I was in in Wilmington, Delaware) found five reserve errors worth more than $100 million, but none of them ever upset AIG’s quarterly earnings.? That is why I remain a skeptic on AIG.
It’s that time again. As WordPress counts, this is post 700 on my blog, though the actual number is more like 80% of that. I take this time to write a post about the blog itself, rather than the things I ordinarily write about.
My blog is a tough one in some ways. I admire many narrowly focused blogs, because they do such a good job at their narrow tasks. Many of them are in my blogroll. I read my blogroll daily; that’s what is in my RSS reader.
But I care about a wide range of topics in economics, finance and investments. Anytime I focus on one narrow area for a time, I get negative e-mail saying that I’m not writing about what he wants to read. Well, I’m sorry. My interests are broad, and you will get a melange when you read me. I felt the same way at RealMoney, because I was one of the few writers that you could not predict what area I would write about next.
The markets have calmed down, and my equity portfolio has done well, but I do not think we are past the troubles yet:
We still have an oversupply of houses.
Investment banks are still overlevered in their swap books.
Commercial property prices are beginning to fall, and that will have negative effects on the equityholders, and those who finance them.
As for my business life, I am busy preparing to pitch my equity management methods to institutional investors. I have been on the other side of the table in my life. Hopefully that will help me meet their needs.
In closing, I want to thank Abnormal Returns, The Big Picture (thanks, Barry), Alea (thanks, jck), FT Alphaville, The Kirk Report, Seeking Alpha, and Newsflashr for their support. I also want to thank the many small blogs that like me and have me on their blogroll. That means something to me; I thank you for your support. I also thank the TSCM/RealMoney fraternity for their support. TSCM has done the world a service by training young financial journalists, and bringing talented investors into writing for the public.
I have a list of thing to write about next, and it is long. If you have opinions about what you want me to cover e-mail me here. I am horrendously behind on my mail, but I read everything that gets written to me.
Again, many thanks for reading me. I appreciate all who take their valuable time to read my blog.
I worked for AIG for three years of my life 1989-1992.? In general, though I learned a ton while working there, I did not like the experience.? As my boss at Provident Mutual said to me, “My greatest doubt about you was that you survived there for three years; it made me wonder about your character.”
That’s probably a bit severe, but turnover was high among employees in the first five years; after that, there were many who would “lifers.”? Turnover would be low after five years.
Now, my stylized history of AIG takes it through the glory days of the 1980s, where return on assets [ROAs] was high, and financial leverage low.? ROA is a much better way to measure insurance company performance than return on equity [ROE].? Earning a spread between assets and liabilities is tough.? Earning an underwriting profit is tough.? Borrowing money to buy back stock is easy.? From the early 90s to the present, AIG became increasingly more levered.? ROE stayed near 15%, but it was less and less ROA, and more and more leverage.
I was never a great fan of my former employer, but I convinced the hedge fund that I worked for to buy some AIG when it was cheap.? We sold around $76, on the day it went into the DJIA.? It hasn’t seen that level since.
When AIG had their big problems, and ejected Greenberg, I wrote a lot at RealMoney about the situation.? The possibilities of accounting manipulation did not surprise me; my own experience there was that we played it to the edge.? AIG has been downgraded by the ratings agencies since then, but because they were big, they delayed the downgrading.? It should have happened years earlier, but Hank intimidated the ratings agencies.
It also does not surprise me that Hank is going after present AIG management regarding their recent disappointing earnings.? What does surprise me is the thought that International Lease Finance wants to go its own way.? When the deal originally was done, there was some skepticism inside AIG, but the word was that the tax benefits made the deal work on its own.??? My skepticism today is that AIG will not want to let go of a successful division.? It doesn’t make sense.
Now, Hank can fight AIG management as much as he wants.? (One, two, three.)? My opinion is that poor Martin Sullivan is not capable of managing such a large enterprise, and that it would be better if AIG were broken up.? (Okay, ILFC, see if you can survive on your own.)? Create a US life company, an international life company, a US P/C insurer, one for the foreign P/C business, and one more company to hold everything else.
Hank can complain, but the problems are bigger than the current management team, or Hank, can deal with.? AIG needs to shrink– reduce leverage, focus on underwriting profitability, exit unprofitable lines, as AIG did back in the 80s.? Give up market share, shed employees, become more profitable.? Essentially, they need to undo a lot of what Hank did.? The synergies of the combined enterprise are small, so break up AIG and let new managers focus more intensely on their less diverse enterprises.
To start, let me gather together my conclusions from the prior articles, and add one more:
Get the right industry.
Get a bright management team.
Don?t panic over small setbacks. Buy more.
Rebalance your portfolio regularly to fixed weights.
Dividends matter.
Buy cheap.
Trade away for better opportunities when you find them.
Don?t play with companies that have moderate credit quality during times of economic stress.
Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
Spend more time trying to see whether management teams are competent or not.
Cut losses when your estimate of future profitability drops to levels that no longer justify holding the asset.
Diversify, diversify, diversify!
Okay, take another look at the graph above, and see that my gains are bigger and more frequent then my losses. Nonetheless, I took some significant losses. How could I bear those losses? Diversification. No position has ever been more than 7% of my portfolio, and the normal position is 2.9% in my 35 stock portfolio. I can take some whacks on individual positions if my overall investing is working.
My key question in deciding whether to sell a stock is whether I think its future returns are likely to be less than alternative investments. That is the only good reason to sell a stock, but few investors follow that rule. I may get my estimates of future value wrong, but if I do it consistently, my results should be good.
You can review my eight rules here. From my prior articles, you can see how my rebalancing trades have added value overall, even though on my losing trades, they added to the losses. Value works, Momentum works, and industry rotation works if it is done right.
My focus on accounting integrity, similar to to the work done by Piotorski, helps value investing work by avoiding value traps. I don’t miss every trap, but if I miss enough of them, I end up doing well.
Finally, our minds are not geared to make decisions where the dimensions of the decision are large. My methods compress the dimensions of the decision, and turn the decision into a swap transaction, where you trade something worse for something better.
That’s what I do in investing, and perhaps in the near term, I will gain my first sizable external clients. In closing, here is a list of all of my trades over the past 7.7 years:
I’m going to go in reverse order here. These were my best investments in the Broad Market Portfolio over the past 7.7 years measured by total dollars gained. After this post, I should have one or two more to wrap up the series, to try to explain why I think my methods work, and flesh out the lessons that I have learned. I am a generalist, but if I have a core skill, I think it is being a portfolio manager, especially regarding risk control, though as I have admitted, I have had some real losers.
Drumroll, and here goes:
10) Anglo American plc
When I bought it originally, it was the cheapest of the diversified miners. I wanted some base metal mining exposure, because I felt it was an industry trend that was underdiscounted. The metal prices were ahead of the stock prices. (And, I wish I had never sold Cleveland Cliffs… then again, for many of the names on this post, I wish I had never sold a share, but discipline in risk taking gives you the confidence to take risks.)
The trading of this one was simple — one rebalancing buy in 2006 during a small metals panic, but aside from that, the thesis was perfect, and I kept selling as the price kept rising. As is common for me with big gainers in my taxable account, I gave away the last bit to charity. If you are charitable, giving away appreciated stock is a wonderful way to do it, and the Fidelity Charitable Gift Trust makes it sooooo easy.
9) Ameron International
You ever heard of Ameron International? I’m not sure to this day where I first heard of it. For much of the time that I owned it, it was one of the larger stocks with no analytical coverage. Ameron International is a multinational manufacturer of engineered products and materials for the chemical, industrial, energy, transportation and infrastructure markets.
Anyway, I bought some, and then Chris Edmonds, who at that time wrote for RealMoney, separately picked it for one of his Holiday Portfolios. I e-mailed my hearty assent.
Ameron didn’t do much for the first three years that I owned it, but I kept clipping the dividend, and doing rebalancing trades, while the internal value of the business grew. Finally, some institutional investor(s) realized what a gem this company is, and the price exploded. I gave the final slug to charity. Would that I had held on, but I have had other good stocks since then.
8 ) SPX Corp
SPX Corp is a diversified industrial corporation that fell on hard times. I looked at it as a turnaround, with global growth as a tailwind that would eventually drive the stock up. In the fall of 2004, I felt pretty dumb about my purchases, but I persevered, thinking that there was value to be unlocked through intelligent management.
Many companies that I own have significant declines for no good economic reason. SPX was one of them. It is difficult to tell apart those that will disappoint versus those that will persevere, but my experience is that more of mine persevere than fail.
Again, another company that in hindsight it would have been better not to sell, but it was outside my valuation boundaries, and as I would say along with Lord Rothschild, “I always sell too soon.”
7) Helmerich & Payne
I still own Helmerich & Payne, and have sold once more in May. As the oil price kept going higher, I looked for related entities that had not gone crazy and would benefit from the higher prices. HP was one of them. (And, as I wanted to say to my pal Cody Willard — “Hey, Cody, I own HP, but it’s the right HP.”)
Contract drilling is a great place to be, when oil prices are so high. During the rise in energy prices, I moved more of my exposure into services, because even if oil would not be found, still those that were aiding the attempt to find it would get paid.
6) Cemex SA
Cemex is the company that I have held the longest. I have long been a fan of the cement industry, because it is the cheap way to facilitate global growth, and catch up on delayed infrastructure investment in the US. My first article for RealMoney was on the cement industry, and I owned three companies in it at that time, a massive overweight that paid off.
It was not a popular idea to buy Cemex when I did. They had problems with derivatives and mis-hedging in recent memory, but the stock was cheap enough that I thought it was worth the risk. For the next year it got cheaper, and I bought more. Most investors would have assumed that they had gotten it wrong, and bailed out. That’s not my way.
As you can see, though the price of Cemex rose, it rose in a volatile way, and my rebalancing discipline captured a lot of extra value in the process. I still own Cemex, and still think that it is cheap, and that management is pretty bright. I’m getting close to another rebalancing sale. This is a gift that keeps on giving.
5) Valero Energy
I own Valero today, but I sold out of it in entirety in 2005. I also owned Premcor during the best part of the run, and through the acquisition by Valero. At the end, I sold some and gave the rest away. If I added Valero and Premcor together, they would be my #1 gainer.
When I bought Valero, I felt that refining was in short supply, and would get rewarded. I don’t expect to be right that fast, but it is gratifying when it happens.
Now, after Hurricane Katrina, I felt that the price rises were overdone for refining stocks, so I sold, and gave the rest away.
4) Lyondell Chemical
Lyondell was an idea that I grabbed from that grand old man, John Neff. He is a humble guy, so you won’t hear him tooting his horn. My idea was that they owned half of a refinery with Citgo, and the rest of their business I was getting for the price of the refinery.
As it was, Venezuela needed cash because of the self-aggrandizing goals of Chavez, and they sold their half of the refinery cheaply to Lyondell. There was some confusion in the process and the rating agencies had their doubts, but Lyondell managed it well, until selling out to Basell, a Russian company. I gave the remainder away to charity.
3) Conoco Phillips
I have owned Conoco for a long time. It is my second longest holding, and it has rewarded me well. It looked cheap when I bought it, and on an earnings basis, it doesn’t look much different now. I have had a few rebalancing buys, but on the whole, the mix of exploration and refining has done admirably.
2) Plum Creek Timber
There is a small complexity in this investment. When Plum Creek bought The Timber Company [TGP], I swapped my holdings of Plum Creek for the Timber Company. When the deal closed, I had more Plum Creek shares. Even after that, to mid-2002, I bought more Plum Creek, making it a triple-weight in my portfolio. I felt that timber assets were undervalued, and I was happy to clip dividends while the market caught up with me.
In late 2004, I began the process of scaling out of the position, moving from a triple weight to a double, single, and then zero weight. I like the management of Plum Creek, but there are price levels that I can’t pay, and I must sell.
1) Companhia de Saneamento Basico do Estado de Sao Paulo — SABESP
What a company; this was an idea from Cramer (yes). I have long believed the thesis that potable water is scarce, and that companies that facilitate fresh water will be rewarded. SABESP is one of the few companies that was cheap enough to buy in 2005, and remains so today. Demand for water remains high, particularly in Sao Paulo, Brazil. I have sold many times, but not bought because there haven’t been any pullbacks; what a happy problem to have.
So, there are my top ten. They are a mix of:
Get the right industry.
Get a bright management team.
Don’t panic over small setbacks. Buy more.
It is worth noting that the top 11 companies that I have owned covered all of my losses. The gains have been bigger than my losses by a wide margin , and I have had three gains for every loss. In my next post or two, I will wrap up this series, and try to explain underlying ideas that helped me do so well.
Finishing off the average 10, the slightly better 5…
Deltic Timber
Deltic Timber was an idea that I gleaned from Jim Grant.? They have a lot of timberland in the Southern US, a decent amount of which is next to Little Rock, Arkansas.? The land near Little Rock, once developed, could be quite valuable in a bull market for residential real estate.? I ended up selling because I lost confidence in the residential housing market.
Honda Motors
I still own Honda.? Does the world need cars?? Does the world need small cars?? Yes!? Is Honda cheaply valued?? Yes.? Can they beat the cost levels of Ford, GM, and Chrysler?? Yes.? I like Toyota as well, and have owned it in the past.? I have owned American auto part manufacturers, but never the automakers themselves; their credit quality is too low.
Mueller Industries
This is a case where I found a cheap industrial, bought it, and waited.? The price rose, and I concluded that I had cheaper opportunities, so I sold.? Also, their raw materials prices were going to rise…
American Power Conversion
American Power Conversion was a cheap tech stock with products that are difficult to obsolete.? Eventually I had cheaper investments to buy, and I sold.? This is another example of how the rebalancing discipline can turn a flat stock into extra profits.
Australia & New Zealand Banking
This seemed to be a cheap, well-run foreign bank so I bought some.? As with many of my average investments, I sold it to fund other more promising investments.
Summary of Part II
Rebalance your portfolio regularly to fixed weights.
Dividends matter.
Buy cheap.
Trade away for better opportunities when you find them.
It is important in investing to have something to compare investments against.? Make them compete against each other for your dollars, and be rigorous about it.? Don’t invest because “That sounds like a good idea,” rather, is it better than what you currently have?? Keep improving the quality of your portfolio, in terms of cheapness, quality, and future prospects.
Okay, same drill as my pieces for my worst losses, but this time I chose the ten most average investments of mine in terms of dollars earned. Remember, one of my key disciplines is rebalancing.
Honeywell
Honeywell was short and simple. I felt it was out of favor, and I bought some. Six months later, I had cheaper stocks to buy, so Honeywell was gone.
Stone Energy
Stone Energy was a weird one. As you will note, the initial purchase and final sale prices aren’t that much different. Interim trading made a difference to the total return.
The stock popped after hurricane Katrina, and sagged quickly thereafter on an audit of proven reserves that came up light. The rebalancing discipline was a big help here.
Dow Chemical
Dow Chemical has two stories. First, dividends are valuable. Second, rebalancing adds value. Dow was a cheap stock that did not get respect, but I still made decent money off of its gyrations, and dividends.
Universal American Financial Corporation
This one is too early to tell. I still own it. Sometimes investments make significant money out of the gate. That is not often, in my experience. This is a little individual and group healthcare company that has gotten smashed over the merger integration. That is a relatively stable business, but small healthcare players have been harmed in the past. Insider buying here is a plus.
Aspen Insurance Holdings
Aspen was a relatively cheap reinsurer. I bought some and sold a chunk into a runup, and sold the rest as I concluded that I had better places to put money.
Summary of Part I
Rebalance your portfolio regularly to fixed weights.
Dividends matter.
Buy cheap.
If done consistently, these principles will raise your overall return, and reduce overall risk. Pretty good performance from a bunch of average stocks.
