Be wary when managements sell their best/safest assets to stay alive.It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.
Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times.Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.
So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.
The same applies to Merrill regarding their stakes in Blackrock and Bloomberg.? Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market.? I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort.? Merrill Lynch has more running room, but even they could face the same fate.
Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits.? It failed when loan underwriting ceased to be done in any prudent way.? Alt-A lending will return, but it is less likely that Indymac will see the light of day again.? Whether in insurance or lending, underwriting is the key to long-term profits.? Foolish lenders/insurers economize on expenses at the cost of losses.
Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer.? My question is whether $15 billion is enough.? It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?
Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.
As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety.? I write this not to sneer at those who have messed this up, because I have done it as well.? Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion.? (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)
I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability.? Many value managers have been hurt from an overallocation to credit-sensitive financials.? They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?
Well, I have made that bet.? Maybe I should not have owned as many insurers, but they should be fine in the long run.? There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here.? Look at companies that can survive moderate-to-severe downturns.? If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.
Readers have suggested some additional tickers for me.? Here they are:
GE, MSFT, BMY, BA, ANAT, KCLI, and DE
Beyond that, there was my country screen — cheap names in Taiwan and Korea that trade in the US?
WF SHG LPL KEP KB IMOS AUO
Then for the industry screen.? Here’s the most recent list of cheap industries; I used the ones labeled “Dig Through”:
Remember, this can be used in momentum mode (red) or value mode (green).? I’m using it in value mode, and it gave me a flood of tickers — remember, in this screen, Price-to-book times Price-to-next year’s earnings must be less than 10.? That’s usually a pretty strict criterion, but this time it turned out 121 tickers:
ABD ABG ACE ACGL AEG AEL AFG AGII AIG AMCP ASI AWH AWI AXA AZ BBI BBW BC BKI BWINA BWINB BWS BZ CAB CHB CINF CMRG CNA CNO CONN CPHL CRH DSITY EBF EIHI FFG FMR FNF GBE GIII GLRE GNW GT HALL HMN HSTX IHC INDM ING INT IP IPCR KGFHY KPPC LFG LGGNY LIZ LNY M MERC MGAM MHLD MIG MIGP MRH MRT MSSR MTE MW MYSZY NP NSANY NSIT NYM OB OSK OXM PAG PCCC PEUGY PL PMACA PNX PSS PTP PTRY RCL RE RNR ROCK RSC RT RUSHA RUSHB RUTH SAH SEAB SEOAY SIGI SMLC SSCC SSI SUR SWCEY SWM THG TI TRH TUES TWGP UFCS UFS UNM UPMKY USMO UTR VOXX VR WHR XL ZFSVY
Well, the quantitative ranking method will have its work cut out when I build the main spreadsheet — it will take some effort to scrub the accounting data, and come to some buy decisions, but that’s my next task.
There are many people calling for a bottom to banking stocks, and I must admit, it is a tempting place to play. I never thought Fifth Third would trade so low. Or Keycorp. Royal Bank of Scotland, sorry, I sold you early in 2008; yes, I thought you would fall. When does the excessive leverage finally eliminate the CEO?
Here’s the challenge for investors: on the one hand, you have declining earnings per share in the near term, from losses and capital raises. But when have equity prices fallen enough to discount the future losses?
I am being cautious here. I own no banks.
Here’s another way to think about it — after all of the bad debts are written off, and bad banks eliminated, what kind of earnings stream will be attractive?
I’ll use the homebuilders as an example here — at troughs, they sometimes trade for half of written-down book value, The question becomes the final side of the book value after the writedowns.
I would still be cautious here, but markets are discounting mechanisms — we are getting closer to a bottom in the banks; we are not there yet.
On Friday, toward the end of the day, I added to my position in Cemex, just to rebalance the portfolio and take advantage of undue weakness in the Mexican stock market.
Earlier in the day, though my timing was good, it could have been better, I swapped my exposure inJapan Smaller Capitalization Fund [JOF] for the SPDR Russell/Nomura Small Cap Japan ETF [JSC]. Given that I like JOF, why did I trade? The premium to NAV got too high — it was 10% on an intraday basis by my calculations, so, I traded. Eventually it will go back to a discount of -5% or so, and I will reverse the trade. I still like Japanese Small caps, but I have my limits when it comes to NAV premiums.
Away from that, I am still considering trading away some/all of my RGA for some MetLife, since I think it will be a cheap way to acquire more RGA. I’m glad the separation has finally come for MetLife and RGA; it was only a question of when. RGA is a unique company; unless Swiss Re, or Munich Re, or Aegon wants to spin out their Life Re business, there are no other pure play life reinsurers out there. Reinsurance of mortality in the present environment is a cozy oligopoly, with one former main player, Scottish Re (spit, spit), badly damaged. (Though I lost badly on Scottish Re, I am still grateful that when I figured out what was going on, I was able to sell at $6+/sh. Current quote: 14 cents/sh, and I hope that MassMutual and Cerberus are enjoying themselves. I took enough lumps for my patronage of Scottish Re, so anyone who sold when I did is at least that much better off.)
Pricing power isn’t anything amazing here, because the life insurers in general have enough capital, and are not ceding as much business to the reinsurers. But it is a steady business, and one with barriers to entry — ACE and XL will try to get into the business, and Scor will try to improve its position, but RGA, Swiss Re and Munich Re will be tough to dislodge.
I am looking forward to the next reshaping, and considering industry trends… I’m really not sure which way the portfolio will go, but I am gathering tickers and industry data, and preparing for the next change.
One last note: did you know that I am overweight financials? Yes, but only insurance companies, and Alliance Data Systems. (I still don’t trust the banks, and particularly not the investment banks.) The insurers that I own are cheap to the point where earnings don’t need to grow much to give me good value over the long run, and are largely insulated from any hurricane activity this year. Now, if the winds blow, you can expect that I will do a few trades to take advantage of mispricing among reinsurance companies. That said, Endurance, Aspen, Flagstone, and PartnerRe look cheap to me at present. Endurance looks very cheap… I have owned all four in the past, and will probably own some of them again in the future. But, no major commitments until the wind starts blowing (hurricanes), or if we get to the middle of the hurricane season (say, mid-September), and nothing has happened. Then it would be time to buy. Damage from windstorm tends to be correlated within years — bad years start early, and are very bad. Good years are quiet, and continue quiet with a few storms doing low levels of damage.
Anyway, that’s what I am up to. Got other ideas? Share them with my readers!
Of the 35 stocks in my portfolio, only 4 lost money for me in May: Magna International, Group 1 Automotive, Reinsurance Group of America, and Hartford Insurance.? My largest gainer, OfficeMax, paid for all of the losses and then some.
I am only market-weight in energy, so that was not what drove my month.? Almost everything worked in May: company selection, industry selection, etc.? My other big gainers were: Charlotte Russe, Helmerich & Payne, Japan Smaller Capitalization Fund, and Ensco International.? I have often said that I am a singles hitter in investing — this month is a perfect example of that.
Now, looking at the year to date, I am not in double digits yet, but I am getting close — I am only 3.6% below my peak unit value on 7/19/07.? My win/loss ratio is messier: 15 losses against 32 wins.? It takes the top 5 wins to wipe out all of the losses.? The top 5: National Atlantic, Cimarex, Helmerich & Payne, Arkansas Best, and Ensco International.? Energy, Trucking, and a lousy insurance company that undershot late in 2007.
The main losers: Deerfield Triarc (ouch), Valero, Royal Bank of Scotland, Avnet, and Deutsche Bank.
I much prefer talking about my portfolio than individual stock ideas, because I think people are easily misled if you offer a lot of single stock ideas.? I have usually refused to do that here; I am not in the business of touting stocks.? I do like my management methods, though, and I like writing about those ideas.? If I can make my readers to be erudite thinkers about investing; I have done my job.
So, with that, onto the rest of 2007.? I don’t believe in sitting on a lead — I am always trying to do better, so let’s see how I fail or succeed at that in the remainder of 2007.
PS — When I have audited figures, I will be more precise.? You can see my portfolio, for now, at Stockpickr.com.
Full disclosure: long VLO AVT NAHC XEC HP ESV MGA GPI RGA HIG OMX CHIC JOF
Time for another dose of my industry ranks.? Here’s the list, complete with the ideas that are most attractive for me to investigate:
Remember, this uses the Value Line Industries, and it can be used in Value mode (green industries), or Momo mode (Red industries)? I look to buy from the green list, but I have a tendency to let companies that I own that are on the red list hang around.? Momentum tends to persist in the short run, and I have usually trimmed exposure due to my rebalancing discipline.
My next reshaping is not until early July, but I expect that it will be a doozy, because I will redeploy proceeds from National Atlantic, as well as a new slug of cash that I have received.? I’m running at 12% cash now, but if you count in National Atlantic, it is more like 18%.? That has to come down, so in a month or so, I will have to deploy cash.? I’m looking for a downdraft to do it in, but those don’t always come on schedule.
This is a bit dated, but bear with me. Last week, Jevic Transportation closed down. It looks like it is liquidating. On the next day, trucking stocks fell as a result. Are things tough in the trucking industry? You bet. Volumes are low, and fuel costs are high.
Now, Jevic wasn’t that big, but if I see a few more large-ish Truckers disappear, I will move to a major overweight in trucking stocks. Why? Pricing power will return to the remaining trucking firms, and after a time, the stocks will rebound. That’s what happened to steel in 2002. I owned Nucor, and did quite well, though, I sold too soon.
When my next reshaping comes up, I will toss some of the highest quality trucking stocks into the mix. The idea is that if the industry weakens further, they will remain among the survivors, but if pricing power comes back, I will make more than adequate profits.
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Now, if you have read me for a while, you know I like to rotate sectors within a value discipline. I do well at it. But who is the best of them all? Ken Heebner. Now, that’s a guy I would love to learn from. I deliberately don’t let sector rotation become the whole strategy because I am trying to limit risk. I also don’t trade like a maniac, because I can’t do that well. But I do more than adequately, and all of us could learn from the expertise of Ken Heebner. Unlike Peter Lynch, who was totally bottoms up, there are real advantages that come through analyzing the economy, particularly individual industries. But, if most investors ignore economics, or, if they only focus on broad macroeconomics, that’s fine with me. I will focus on the economics of industries, and that will help me invest well.
Maybe there is something different about the way that neoclassical economists and historians approach things. I am a bit of a generalist, so I try to look at things from many angles. The two books that I cited in my recent book review on bubbles were written by historians, not economists. Let me cite my summary of Kindleberger’s paradigm:
Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies of those that borrowed to finance the assets
A lender of last resort appears to end the cycle
That’s not the way a neoclassical economist views the world. Either men are rational, or, their errors tend to cancel each other out in the short run. Certainly there are never destabilizing feedback loops. Errors on the part of one person don’t lead others to make the same errors.
It is said that neoclassical economics cannot explain the existence of marketing and financial markets, without relaxing their rationality assumptions significantly. As an economist trained in the neoclassical school, I think we forget that these are assumptions that are made in order to get the math to work, not the way things actually work in the world. People are influenced by other people, and they do stupid things as a result, even when there is money on the line. (Maybe, especially when there is money on the line, due to the effects of fear and greed.)
Don’t they effectively borrow to finance the oil futures market?
Was the internet a bubble?
Isn’t housing unique, in that the speculators can walk away so easily?
In an attempt to answer these questions, “What’s the definition of a bubble? When does something become a bubble? Was the internet a bubble?” consider this piece from RealMoney’s Columnist Conversation:
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:
1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?
This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.
To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.
Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.
It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.
In the internet bubble, there wasn’t that much debt, aside from vendor financing. Some faced the obligations of paying taxes on employee stock options, without having the cash to do so. Others speculated on margin, favoring the long side, of course. The real bubble was the low cost of equity capital, which led to the creation of dubious businesses, and weird stock price movements at IPOs. Say what you want about the present era, the IPO market is relatively calm, and the few deals getting done seem to have some quality.
Regarding the oil futures markets, yes, many participants are levered, but the commodity funds which are huge typically are not. Most of the selling to them comes from the oil companies, which find it profitable to lock in prices at $60, $70, $80…. $130, you get it. In that sense, I don’t think the majority of the activity is coming from levered players that are active investors — the commodity funds are passive hoarders, and the oil companies have a commercial interest.
For another example, consider the silver bubble in the late 70s / early 80s. The Hunt brothers tried to corner the silver market. In the process, the price of silver touched $54/ounce. What stopped them?
COMEX limited their ability to hold silver futures.
The Fed tightened monetary policy.
Silver came from everywhere to meet demand. People sold the family silver, mines that were closed reopened, mines that were marginal began producing like the was no tomorrow.
That last point is why I think it is very hard to corner any commodity, and why bubbles don’t last. Supply overwhelms speculative demand. The speculative demand in this environment is coming from a bunch of nerds who advise pension funds. This isn’t hot money.
This brings me to the last point, regarding housing: “When did housing become a bubble? Who identified it? Isn’t housing unique, in that the speculators can walk away so easily?”
Housing became a bubble when lenders loosened underwriting standards and offered lending terms that were atrocious — what lender in his right mind would ignore equity, recourse, and amortization? Yet in a mania to earn current profits, many lenders did. The bubble started in 2003, and crested in 2005. I posted on this for four years 2003-2007. I posted at RealMoney as it was cresting, with my main article in May 2005, and several more through the remainder of the year.
There were many others who also pointed at the bubble, but as with all bubbles, the naysayers are at the fringe. It can’t be otherwise.
Regarding the ability of the housing speculators to walk away, I like Tanta’s line at Calculated Risk that there aren’t many true walk aways. Most people abandoning their former homes have tried to keep them, and have lost a lot in the process. Away from that, the lenders do screen delinquencies for likely ability to pay. If there are significant assets in a state that allows for recourse, you can bet the lawyers are active.
In closing, I think the concept of a bubble is meaningful. It is a series of two self-reinforcing cycles, one positive, and one negative. These cycles occur because market players chase past performance, suffering from greed as prices rise, and fear as they fall. Any lending to finance the speculation intensifies the size and the speed of the event.
PS — if it helps at all, my equity investing methods borrow from these ideas. I am always trying to analyze industry cycles, to make money and avoid losses. So far it has worked well.
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.
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:
