Portfolio Management – Page 9

On Long-Term Corporate Investments

Posted on 19 November 201620 November 2016 by David Merkel

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There is a statement commonly made that firms in the US aren’t doing as well as they can in the long-run because the calculation of quarterly earnings inhibits long-term investment. ?I’m not sure that such statements are true or false, but I will try to explain the problem or lack thereof in this post.

Common reasons for alleging the problem

The division between management and ownership means that managements often act in their own interests rather than those of shareholders.
Management incentives are calculated over too short of a period of time.
Quarterly earnings distract from long-term planning.
Accounting methods do not allow for capitalizing certain types of investments, and so they don’t get done to the degree necessary.
Investing for the long-run will create greater returns.
It is easier to simply buy back stock or pay dividends in the short run. ?Investing more?will create greater returns.

I’d like to get rid of a few of these arguments quickly. ?First, there is no evidence that investing more produces greater returns, and there is evidence that stocks that do buybacks and pay dividends tend to outperform. ?There is evidence in specific cases that buying back stock at high prices destroys value, but what?high prices are is often only know in hindsight. ?That said, I encourage corporate boards and managements to have their own conservative estimate of the private market value of their firm, and only to buy back stock when the price is below that estimate.

Second, there is no evidence that long-term investing produces greater returns on average. ?Here’s why: longer investments are less certain than shorter ones, and require longer-term capital to finance them, which is more expensive.

I remember the Japanese making their long-term investments in the 1980s — they were regarded as very farsighted. ?They invested a lot at what seemed like low ROEs, but their stock market kept going up, and they were hailed as geniuses that would bury the barbaric capitalism of the US. ?As it was, the ROEs were low, and in many cases negative.

I liken it to trying to hit a home run in baseball. ?It’s a high-risk, high-return strategy, but tends to lead to worse results than just trying to get on base. ?Many good returning projects for firms are small, and short-term in nature. ?Incremental improvement can go a long way.

Reasons 1-4 have a little more punch in my opinion, but they are all solvable by setting up an alternative accounting basis that facilitates long-term projects, using that as the definition for pro-forma earnings to present to Wall Street, and using it for management performance measurement and compensation.

There is a trick here, though. ?Management and the board have to be intelligent enough to have both:

A long-term investment that they know with high probability will be a success, and
A means of measuring the progress toward the goal over a long period of time.

Both of those are tough. ?Long-term projects can go wrong for a lot of reasons — cultural change, technological change, economic change, competitive change, change in the ability to keep the company as a whole financed, and more.

And, it’s not as if I don’t see project timelines in presentations that managements give to investors and analysts. ?Long-term investing does get done, even if the GAAP or tax accounting treatments don’t favor it in the short run.

As I have mentioned before, corporate valuation depends on free cash flow, and GAAP accounting does not affect that. ?As such, quarterly GAAP earnings should not affect the willingness of companies to take on long-term projects that they think will be winners.

That leaves management incentives, which are always a problem. ?Most good incentive plans are a mix of short and long-run items. ?The mix will depend on the maturity of the industry, and the relative opportunities faced by the firm.

Conclusion

If there is a problem here, boards and managements have adequate tools at their disposal to try to solve the problem, with the added risk that the cure could prove worse than the disease. ?As an example, consider trying to get sleepy pipelines and utilities to innovate on long-term projects that are hard to manage and measure. ?Well, that was Enron, Dynegy and a variety of companies that learned that there aren’t a lot of ways to dramatically improve performance in a mature business.

But there may be no problem here at all. ?The US has been one of the better performing markets in the developed world, and in general, industries that invest a lot do not outperform industries that do less investing. ?We may not need to adjust our methods at all.

Also, we might not need as many tax incentives from the government to promote investing either. ?In my opinion, the good investments will get done. ?Investments that require tax incentives just encourage management teams to do tax farming.

Management teams are less short-term focused than most imagine. ?If they don’t invest a lot for the long-term, it may just be that there aren’t many attractive long-term investments capable of providing returns greater than the cost of longer term capital needed to finance the investments.

Weird Begets Weird

Posted on 9 November 2016 by David Merkel

Photo Credit: Steve Rotman || What could be weirder than President Trump?!

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I have a saying “Weird begets weird.” Usually I use it during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

Well, we can say the same for many aspects of world affairs, including the US election. ?Many people?benefit from free trade, more than get hurt. ?Those who get hurt vote with greater probability. ?Though immigrants are actually a net help to the US economy, because many people think they hurt the economy, they vote accordingly.

After Brexit, there are related effects. ?People are less willing to surrender local advantages for matters that would be larger broad advantages. ?Who knows? ?Maybe the EU will break up next. ?Nah. ?Nothing good happens to continental Europe.

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Tomorrow, I will be a buyer. ?I don’t expect anything good out of Trump, but there is nothing worse from him than Clinton. ?I have 15% cash on hand for clients and me, and I will buy as the market falls.

The Plumbing of Investing

Posted on 25 October 2016 by David Merkel

Photo Credit: Rex Babiera ||Ours is an old house, and its guts reflect that. — Photo Credit: Rex Babiera || Ours is an old house, and its guts reflect that.

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A question?from a reader on my recent post Me Too!:

I recently ran across Ed Thorp?s ?Beat the Market.? I find reasonable his idea that you can take on risks that (almost / essentially) cancel each other out. Find assets that are negatively correlated to buy one long and the other short (he did it with stock warrants in the 60?s but when I started looking into that, well, I?m late to that party, so nevermind).

I?m uncomfortable with shorting anyway, so what about going long in everything and rebalancing when the assets get out of whack? Aren?t a lot of the price movements of various assets (cash, bonds, stocks, real estate, precious metals) the result of money flowing towards or away from that asset? If people are, on net, selling their stocks, to what type of asset are they sending the proceeds? I can?t predict where people will stash their money next, but if I own a little of everything, I?m both hedged against prolonged depression of one asset class and aware of what?s gotten ?expensive? and what?s ?cheap? now.

Along these same ?indexing? lines, what do you think of using ALL the sector ETFs (Vanguard has 11) to index each sector and then rebalance among them as they change in value? How would that application of your portfolio rule 7 differ than when applied to individual stocks? Also, do you think it would be subject to the same / similar danger as everyone else ?indexing? as you wrote about above?

My, but there is a lot here. ?Let me try to unpack this.

Paragraph 1: All of the easy arbitrages are gone or occupied to the level where the risks are fairly priced. ?Specialists ply those trades now, and for the most part, they earn returns roughly equal to short-term risky debt. ?They tend to get hurt during financial crises, because at those points in time, fundamental relationships get disturbed because of illiquidity and defaults amid demands for liquidity and safety.

Paragraph 2:?First, rebalancing is almost always a good idea, but it presumes the asset classes/subclasses in question is high quality enough that it will mean-revert, and that your time horizon is long enough to benefit from the mean reversion when it happens. ?Also, it presumes that you aren’t headed for an utter disaster like pre-WWII Germany with hyperinflation. ?Or confiscation of assets in a variety of ways, etc.

Then again, in really horrible times, no strategy works well, so that is not a criticism of rebalancing — just that it is useful most but not all of the time.

Aren?t a lot of the price movements of various assets [snip] the result of money flowing towards or away from that asset?

Back to the basics. ?Money does not flow into or out of assets. ?When a stock trade happens, shares flow?from one account to another, and money flows the opposite direction, with the brokers raking off a tiny amount of cash in the process. ?Prices of assets change based on the relative desire of buyers and sellers to buy or sell shares near the existing prior price level. ?In a nutshell, that is how secondary markets work.

Then, there is the primary market for assets, which is when they were originally sold to the public. ?In this case, corporations offer stocks, bonds, etc. to individuals and institutions in what are called initial public offerings [IPOs]. ?The securities flow from the companies to the accounts of the buyers, and the money flows from the accounts of the buyers to the companies. ?The selling prices of the assets are typically set by syndicates of investment bankers, who rake off a decent-sized chunk of the money going to the companies. ?In this case, yes, the amount of money that people are willing to pay for the assets will dictate the initial price, unless the deal is received so poorly that it does not take place. ?After that, secondary trading starts. ?(Note: this covers 95%+ of all of the ways that assets get to public markets; there are other ways, but I don’t have time for that now. ?The same is true for how securities get extinguished, as in the next paragraph.)

The same thing happens in reverse when companies are bought in entire, either fully and partially for cash, and in the process, cease to be publicly traded. ?The primary and secondary markets complement each other. ?Corporations and syndicates take pricing cues from the levels securities trade at in the secondary markets in order to price new securities, and buy out existing securities. ?Value investors often look at primary markets to estimate what the assets of whole companies are worth, and apply those judgments to where they buy and sell in the secondary markets.

Trying to guess where market players?will raise their bids for assets in secondary trading is difficult. ?There are a few hints:

Valuation: are asset cheap or rich relative to where normalized valuation levels would be for this class of assets?
Changes in net supply of assets: i.e., the primary markets. ?Streaks in M&A tend to persist.
Price momentum: in the short-run (3-12 months), things that rise continue to rise, and vice versa for assets with?falling prices.
Mean-reversion: in the intermediate term (3-5 years), things that currently rise will fall, and vice-versa. ?This effect is weaker than the momentum effect.
Changes in operating performance: if you have insight into companies or industries such that you see earnings trends ahead of others, you will have insights into the likely future performance of prices.

All of these effects vary in intensity and reliability, both against each other, and over time. ?If you own a little of everything, many of these effects become like that of the market, but noisier.

Paragraph 3:?If you want to apply rule 7 to a portfolio of sectors, you can do it, but I would probably decrease the trading band from 20% to 10%. ?Ditto for a portfolio of country index ETFs, but size your trading band relative to volatility, and limit your assets to developed and the largest emerging?market countries. ?With a portfolio of 35 stocks, the 20% band has me trade about 4-5 times a month. ?With 11 sectors your band should be sized to trade 1-2 times a month. ?20 countries, around 3x/month. ?If it is a taxable account set the taxation method to be sell highest tax cost lots first.

Remember that portfolio rule 7 is meant to be used over longer periods of time — 3 years minimum. ?There are other rules out there that adjust for volatility and momentum effect that have done better in the past, but those two effects are being more heavily traded on now relative to the past, which may invalidate the analogy from history to the future.

Using portfolio rule 7 overweights smaller companies, industries, sectors, or countries vs larger ones. ?It will not be as index-like, but it is still a diversified strategy, so it will still be somewhat like an indexed portfolio.

Finally, even if we get to the point where active management outperforms indexing regularly, remember that indexing is still likely to be a decent strategy — the low cost advantage is significant.

That’s all for now, and as always, comments and questions are welcome.

Me Too!

Posted on 22 October 201623 October 2016 by David Merkel

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I have sometimes said that it is common for many people to imitate the behavior of others, rather than think for themselves. ?There are several reasons for that:

It”s simple.
It’s fast.
And so long as you don’t run into a resource constraint it works well.

People generally have a decent idea who their smartest friends are, and who seems to give good advice on simple issues. ?If your neighbor says that the new Chinese food place is excellent, and you know he knows his food, there is a very good chance that when you go there that you will get excellent Chinese food as well.

You might even tell your friends about it; after all, you want to look bright as well, and its neighborly to share good information. ?That works quite well until the day that Yogi Berra’s dictum kicks in:

Nobody goes there anymore. It?s too crowded.

The information indeed was free, but space inside the restaurant was not, even if patrons weren’t paying to get in. ?And even if they have carryout, the line could go around the block… a hardship for many even if?you are getting the famous Ocean Broccoli Beef. ?(Warning: Hot in every way.)

Readers of my blog know that the same thing happens in markets. ?Imitation was a large part of the dot-com bubble and the housing bubble. ?When a less knowledgeable friend is making what is seemingly free money, it is very difficult for many people to resist the temptation to imitate, because if it works for him, it ought to work better for the more knowledgeable.

As such, prices can get overbid, and the overshoot above the intrinsic value of the assets can be considerable. ?It all ends when the cost of capital to finance?the asset is considerably higher than the cash flow that the asset throws off. ?And as with all bubbles, the end is pretty ugly and rapid.

But what if you had a really big and liquid strategy, one that threw off decent cash flow. ?Could that ever be a bubble? ?The odds are low but the answer is yes. ?It is possible for any strategy to distort?relative prices such that the assets inside a strategy get significantly above intrinsic value — to the point where they discount negative future returns over a 5-10 year horizon. ?(As an aside, negative interest rates are by definition a bubble, and the instruments traded there are in big liquid markets. ?The severity of that bubble collapsing is likely to be limited, though, unless there is some sort of payments crisis. ?The relative amount of overvaluation is small, and has to be small.)

Indexing as Imitation

Today, indexing is a form of imitation in two ways. ?The first way is not new — it is a way of saying “I want the average result, and very low fees.” ?It’s a powerful idea and generally a good idea. ?If used for long-term investment, and not short-term speculation, it allows capital to compound over long periods of time, and keeps people from making subpar investment decisions through panic and greed.

Then there is the second way of imitation: indexing because it is now the received wisdom — all your friends are doing it. ?This is a momentum effect, and at some point even indexing through a large index like the S&P 500 or Wilshire 5000 could become overdone. ?The effects could vary, though.

You could see more larger private corporations go public because the advantage of cheap capital overwhelms the informational and other advantages of remaining private.
You could see corporations reverse financial engineering, and issue more cheap stock to retire expensive debt. ?On the other hand, it would be more likely that credit spreads would tighten significantly, leaving debt and equity balanced.
You would see pressure on corporations with odd capital structures like?multiple share classes to simplify, so that all of the equity would trade at high multiples.
Corporations could dilute their stock to pay for resources — labor, land, intellectual capital and physical capital. ?Or, buy up competitors. ?If you think that is farfetched, I remember the late ’90s where it was cool for executives to say, “Let the stock market pay your employees.”
People could borrow against their homes to buy more stock, or just margin up.

If you see what I am doing — I’m trying to show what a distorted price for publicly traded stocks in an big index could do — and I haven’t even suggested the obvious — that an unsustainable price will correct eventually, and maybe, in a dramatic way.

I’m not saying that indexing is a bubble presently. ?I’m only saying it could be one day. ?Like the imitation illustrations given above, when a lot of people want to do the same thing without bringing additional information to the process, shortages develop, and in some cases prices rise as a result.

One final note: active management would get more punch at some point, because informationless index investing would lead to some degree of mispricing that active managers would take advantage of. ?At the rate money is currently exiting active management and going into indexing, that could be five years from now (just a guess).

As with all things in investing, the proof will be seen only in hindsight, so take this with a saltshaker of salt. ?As for me, I will continue to pick stocks. ?It has worked well for me.

Watch Net Income Double in Two Years, Not

Posted on 20 October 2016 by David Merkel

Data Source: Media General || Note: Do not cite or republish this graph without publishing the limitations paragraph below. — Data Source: Media General || **Note: Do not cite or republish this graph without publishing the limitations paragraph below.**

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Before I start this evening, I want to state again that I welcome comments at this blog. It may not seem so from the last few months, but I have shaken the bugs out of the software that protects my blog, which was hypersensitive on comments. The only thing I ask of commenters is that you be polite and clean in your speech. Disagree with me as you like — hey, even I have doubts about my more extreme positions. 😉

Limitations

The graph above and the text explaining it could very easily be misused, so I am giving a detailed explanation of how I calculated the figures so that people looking at them can more easily critique them and perhaps show me where they are wrong. ?Please use the above figures with care.

I summed up the net income data for 2706 firms in the Media General database used in the AAII Stock Investor Pro screening software. ?Those firms had:

Seven years of historical earnings data (2009-2015)
Earnings estimates that go out to 2018, and
An estimate of the diluted common shares of each

In short, it is all of the firms trading on US exchanges (that Media General covers) that have seven years of earnings history, and significant analyst coverage extending out for two years. ?Please note that not all fiscal years are equivalent, and that the historic data is on fiscal years, aside from 2016YTD, which is a trailing twelve months figure. ?That means 2016YTD is largely from the first half of calendar 2016 and the last half of calendar 2015.

Note that companies that went out of existence between 2009 and today are not reflected in these figures. ?They represent only the companies that exist as publicly traded firms today. ?Also note that foreign firms trading on US exchanges are in these figures.

The projected Non-GAAP earnings are the product of average sell-side earnings estimates and the most recent estimate of fully diluted common shares. ?2016, 2017 & 2018 are the current, next year, and two years ahead estimates of adjusted earnings, which are?Non-GAAP.

Remember that sell-side estimates are designed (in theory) to eliminate transitory factors and provide an estimate of run rate earnings for the future. ?Whether that is true in practice is another matter, as we may see here.

There is one more piece of data that you need before you can interpret the above graph: because of foreign firms that are included, the total market capitalization underlying the graph is $28.8 Trillion.

Analysis

After my recent piece?Practically Understanding Non-GAAP Earnings Adjustments, I felt there was something more to say, because regularly I would see earnings estimates that were higher than historic earnings by a wide margin, which would make me say “How does it get from here to there?” ?The answer is simple. ?It doesn’t.

Why? ?We’re comparing apples and oranges. ?GAAP earnings deduct many expenses out that were incurred in prior periods, but deferred. ?GAAP earnings also have?unusual and extraordinary charges that are expected not to occur. ?Non-GAAP earnings exclude those (among other things, sometimes excluding interest and taxes). ?As such, they are considerably higher than GAAP earnings.

Take a look at this table of price-earnings ratios.

Year	2009	2010	2011	2012	2013	2014	2015	2016YTD	2016	2017	2018
P/E	36.61	24.84	22.13	23.26	21.01	21.70	29.69	30.68	18.68	16.02	14.06

Note: the same warning on the graph applies to this table.

Note that the current market capitalization is being applied against historic net income 2009-2016YTD. ?2016-2018 are on projected non-GAAP net income estimated by the sell-side. ?Obviously, in 2009 the market capitalization was much lower, and so the P/E then would have been higher. ?Survivorship bias will have some impact here, but I’m not sure which way it would go.

See how much lower the P/Es are for the sell-side estimates (these would be bottom-up, not top-down). ?Figures like this get cited by pundits who say the market isn’t that expensive.

Also, note how GAAP earnings have shrunk since 2014, and haven’t grown much since 2009. ?I know only the media compares actual to prior, which is an anachronism, but maybe we need to do that more.

Summary

That leaves us with a few sticky questions:

Which is a better measure for growth in value? ?GAAP or non-GAAP earnings? ?(I think the answer varies by industry, and how long of a period you are considering.)
Should we allow non-GAAP earnings to be published? (Yes, after all management is going to explain the non-GAAP adjustments orally as they explain why the quarter was good or bad.)
Does this mean that the market is overvalued? ?(Not necessarily. ?Rational businessmen are still buying some firms out, which partially validates current levels. Also, free cash flow is not affected by accounting rules, so questions of overvaluation should not rely on accounting methods. ?If it is overvalued on one, it should be overvalued on all, etc.)
Should we create a fifth main statement for GAAP accounting, that formalizes non-GAAP and gives it real rules? (Probably, but like most of GAAP, there will be some flexibility and industry-specific rules.)

As for me, this will give me a little help in making adjustments to earnings estimates as I try to think through valuation issues, and give me some rough idea as to whether the hockey stick that the sell side illustrates is worth considering or not, or to what degree.

Again, comments are welcome. ?Please note that my findings are tentative here.

Practically Understanding Non-GAAP Earnings Adjustments

Posted on 14 October 2016 by David Merkel

Photo Credit: Constanza || Well, aren't many efforts at adjusting earnings patch jobs?? — Photo Credit: Constanza || Well, aren’t many efforts at adjusting earnings patch jobs??

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Over the years, I’ve written a lot about earnings adjustments and non-GAAP earnings. ?There are several basic questions to answer:

1) Which matters more? ?GAAP earnings or non-GAAP earnings?

In the short-run, non-GAAP earnings matter more for two reasons: a) the non-GAAP earnings attempt in principle to eliminate special factors and estimate the change in run-rate earnings or free cash flow. ?If done properly, it is a very valuable exercise. ?If done wrong, it’s just an advanced form of chicanery, where companies attempt to keep the stock price higher than it deserves to be, before gravity catches up with them. ?Gravity will catch up regardless and eventually, because fooling Ben Graham’s weighing machine invites a rude payback with compound interest. ?Ask Enron.

b) the second reason is a weaker one, but the sell-side performs a service by estimating earnings, and they use non-GAAP earnings. ?It is a control mechanism that allows investors to measure the progress of companies in the short-run. ?Note that this does not encourage short-termism unless the non-GAAP adjustments are done wrong. ?It’s fine to talk about the long-run, but what progress are you making toward it? ?If the non-GAAP metric does not reflect the best efforts of the management team to create the long term value, then they need to adjust their non-GAAP earnings metric to reflect what maximizes long-run value creation. ?After that, educate the sell-side on why you are right, and let the buy-side quietly consider whether they can improve on it.

That said, GAAP earnings are more important for the long run. ?Even more important is the growth in book value plus accrued dividends. ?These measures take into account the one-time adjustments. ?The many one time adjustments. ?THE CONSTANT ONE TIME ADJUSTMENTS!! ?

(Ahem.)?Management is responsible over the long haul for all of the things that they never anticipated, because they are supposed to be prepared for them on average. ?It’s fine to complain about weather affecting sales or margins for one quarter, but to complain about it more than twice in a decade means you aren’t prepared as a management team. ?The same applies to writing down goodwill and other asset values. ?One surprise every now and then is fine, but if it becomes annual then it should be planned for… perhaps the recoverability estimates aren’t very good at all, and you need to write down ten years of a lack of expected profitability now, rather than eating the elephant of subpar decisions?one bite at a time.

2) What should we look for in?earnings surprises?

a) Be wary of companies that always beat estimates. ?Those that do are one of two things — stupendous, or manipulators. ?Earnings should be somewhat ragged, even for a growth company. ?I actually like my companies to miss estimates every now and then, because it proves genuineness.

b) Be wary of companies that beat positive estimates frequently, but never seem to have GAAP earnings or book value that grows. ?What that means is that the non-GAAP metric may not truly represent what is building value for the firm.

c) Be wary of companies that beat positive estimates frequently, and yet have to raise a lot of capital because the business isn’t throwing off a lot of cash that can be reinvested in the business. ?Non-GAAP metrics should be strongly related to free cash flow, which should reduce financing needs.

d) For companies with negative forecast earnings, watch the date closely for when earnings are supposed to go positive. ?If you see that date extended more than once, you might want to sell.

e) If a?stock trades at a low valuation, don’t make too much out of missing earnings if the book value grows at a decent rate.

3) What else should we know?

a) Earnings misses and beats are frequently overestimated in importance. ?Business has irregularities; get used to it, and don’t panic off of one or two bad numbers.

b) But repeated?misses probably should be sold, unless the valuation is so cheap that an activist would have an easy time with the stock.

c) If a management is good at managing capital, and honest, an earnings miss can be a great opportunity to buy. ?Remember that not all value is driven through short-term earnings. ?Clever use of free cash flow to do small acquisitions that can be grown organically can be underestimated. ?During times of crisis, a genuinely clever management team can occasionally do amazing things as conditions seem to be falling apart, by buying cheap assets from mis-financed sellers who need quick cash.

d) Stocks with high valuations should use excess cash to pay dividends; those at low valuations should buy back stock.

e) The height of the stock market tends to be determined by long-term estimates of unadjusted future earnings or free cash flow, rather than the current period expected earnings. ?As with everything in investing, don’t get too excited about anything. ?This is a business, and not primarily a game, though many things are game-like.

f) Situations where M&A are involved are always more complex, and require special handling. ?I can’t give a simple general answer there.

g) Actual GAAP earnings and non-GAAP earnings do not live on the same planet on average. ?At some point, I will put out a post showing how inflated non-GAAP earnings are on average versus GAAP earnings. ?I have the study design ready to go, and just have to run the calculations. ?If you look at past earnings, and compare them to forecast earnings, the naive will say, “Wow, what growth!” ?The experienced will say, “There are things in the non-GAAP earnings that will not factor into long-term growth in value.”

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That’s all for now. ?Your quality thoughts in response are always welcome, though I can’t answer every comment.

Estimating Future Stock Returns, June 2016 Update

Posted on 21 September 2016 by David Merkel

This is my quarterly update on how much the market is likely to return over the next 10 years. ?At the end of the last quarter, that figure was around 6.54%/year. ?For comparison purposes, that is at the 77th percentile of outcomes — high, but not nosebleed high, which to me, is when the market is priced to?return 3% or less. ?That’s when you run.

Adding in quarter to date movements, the current value should be near 6.3%/year (79th percentile).

With all of the hoopla over how high the market is, why is this measure not screaming run? ?This is because average investors, retail and institutional, are not as heavily invested in the equity markets as is typical toward the end of bull markets. ?There are many articles calling for caution — I have issued a few as well.

From an asset-liability management standpoint, bull markets get particularly precarious when caution is thrown to the wind, and people genuinely believe that there is no alternative to stocks — that you are missing out on “free money” if you are not invested in stocks.

We aren’t there now. ?So, much as I am not crazy about the present state of the credit cycle (debts rising, income falling), there is still the reasonable possibility of more gains in the stock markets.

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For more on this series, see the first four articles in this search, which describe the model, and its past estimates.

Dead as a Severed Horse’s Head

Posted on 15 September 2016 by David Merkel

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Six years ago, I reviewed a book?The Club No One Wanted To Join. ?It was a poorly done book written by a bunch of people who were swindled by Bernie Madoff. ?Now, I?didn’t want to be unsympathetic — after all, they were cheated. ?But they missed many signals that tipped off others, and could have tipped off them to the fraud. ?Worse, they tried to argue that since many top-performing mutual funds had total returns similar to that of Madoff, there was no way anyone could have figured out that it was a scam. ?They neglected to note that Madoff’s returns were ultra-smooth, while the returns of the mutual funds were not. ?Big difference.

There’s one more thing: many of them gave in to the idea that they had found a hole in the system. ?Far from it being “The Club No One Wanted To Join,” rather, it was their own secret private club that they were smart enough to join when fate smiled on them, and they got their opportunity.

Tonight, I am talking about a different sort of scam that sucked in a different class of people. ?This scam was a corporation where the management took a?firm into bankruptcy that could easily pay its debts, at least in the short-run. ?The management likely conspired with the bondholders against its shareholders, seemingly in an effort to gain a greater reward from the bondholders who would own the firm post-bankruptcy than they could from operating the firm outside of bankruptcy. ?The name of this firm is Horsehead Holdings [ZINCQ].

For background, you can read this?article in the New York Times. ?For the ultimate result of the bankruptcy, you can read this article in the Wall Street Journal:?Zinc Producer Horsehead Cleared to Exit Bankruptcy.

I’m not writing about?this to give a blow-by-blow description of how the bondholders and management cheated shareholders out of their ownership interests, though I will touch on that at points. ?I am writing about this to respond to those who wrote to me in the midst of the bankruptcy trial to try to gain some coverage of what was going on.

Over 20 people wrote to me and almost 100?journalists/media in an attempt to create “viral” coverage of the trial, and if nothing else, bring public attention to the travesty that was the bankruptcy process. ?As it is, I wrote one paragraph on the matter, but I didn’t see anything from any major publication until after the trial completed. ?I did mention to a number of the writers that efforts to get coverage would not affect the outcome of the bankruptcy court; it is relatively insulated from public opinion, as it should be.

(As an aside: if you write such a letter to journalists, or me, try to stay on topic. ?It is not relevant to call the bondholders “greedy,” that they are a hedge fund, or talk about their prior dealings with Collateralized Debt Obligations that failed during the recent financial crisis.)

Aleph Blog is mostly about risk control. ?As I read the letters from the shareholders who were watching their ownership rights be destroyed, I noted a few things that might have enabled some of them to avoid much of the unfavorable outcome:

Buying a levered highly cyclical company.
Relying on the insights of bright investors who buy concentrated stakes ?in a few companies.
Not diversifying enough.

Let me take these in order:

Buying a levered highly cyclical company

If you look at the risk of owning a single company, there are two ways where a company can affect the degree to which a change in sales can raise the profits of the company. ?The first way is to choose a production method that has high fixed costs and low variable costs, which is typically true of cyclical companies. ?The second way is to borrow money. ?Both methods magnify returns, right or wrong.

Typically, you only do one at a time. ?Supermarkets are stable, so they often borrow more to lever up returns. ?Mining companies, among other industries that require heavy capital investment, are anything but stable booms and busts are common and follow product prices.

Horsehead Holdings had a high degree of leverage from both debt and being in a cyclical industry. ?It ran into a scenario where the price of its main product, zinc, fell hard. ?At the time before they filed for bankruptcy, management could legitimately say to themselves, “If the price of zinc remains this low we will shortly be insolvent, particularly if our new processing plant doesn’t work out.”

Now, the bankruptcy code is a rather flexible beastie. ?It allows for a management team to file before things are at their worst so that they can try to preserve a better outcome for the company. ?My suspicion is that management’s motives were mixed when they filed — they wanted the best deal they could get for themselves, but may have assumed that there wasn’t much life left to the equity anyway. ?Who could have predicted that the price of zinc would rally back so much, such that the company could have survived in its pre-bankruptcy state?

Now, has this ever happened to me? ?Not exactly, but there are other ways that managements can dispose of a company to the detriment of the stockholders. ?I lost money on C. Brewer Homes when management did a leveraged buyout when the stock price was unduly depressed. ?Enough stock was in the hands of arbs that the deal went through. ?Oh, and if you want another one, there was the loss on National Atlantic Holdings which I described in ugly detail in this article.

The main point is this: don’t assume that management will act in the interests of stockholders, particularly in a stressed situation. ?The leverage and cyclicality of Horsehead Holdings set up the possibility of that occurrence, and the fall in the price of zinc triggered it.

Relying on the insights of bright investors who buy concentrated stakes ?in a few companies

I respect both Mohnish Pabrai and Guy Spier. ?They are bright guys, and from what I can tell at a distance, ethical too. ?They were big holders of Horsehead Holdings, and I’m sure they had good reasoning behind their decisions. ?But, even excellent investment managers aren’t infallible. If you are just picking one of their ideas, that could be a rocket to the sky — or the ground, while their portfolio as a whole might do well.

Also, they will make their decisions with some lead time over you if the data shifts. ?Any investment advisor you mimic is not required to tell you when they change their mind, aside from required filings with the SEC… which are delayed, and sometimes don’t cover everything.

Has this happened to me? ?Yes it has. ?I have sometimes invested partly ?on who is invested in a company, though never to the point of not?doing my “due diligence.” ?But aside from some early failures 20+ years ago, it never hurt me much because I was never guilty of:

Not Diversifying Enough

A number of the people emailing me said they put more than half their savings into Horsehead Holdings. ?If you are going to engage in such risky behavior, you need to know more than everyone else investing in the stock. ?No exceptions. ?I agree with investing in a concentrated way, but?my view of that for average people is no positions larger than 5% of your capital. ?That is plenty concentrated enough.

I have one holding that is 13% of my assets — a private company that I know exceptionally well. ?My house is another 13%. ?After that, my next largest holding is 3% of my assets. ?I believe in the assets that I buy, but I concentrate enough by only owning individual stocks, and very little in the way of pooled investment vehicles.

With 75% of my assets in risk assets, I take enough risk. ?I don’t have to amplify that by taking disproportionate security-specific risk. ?(The stock portfolios that I provide for clients have 35 or so stocks in them… given that I tend to concentrate in a few industries, that takes reasonable rsk.)

Summary

Again, my sympathies to those who lost on Horsehead. ?I can’t do anything about those losses. ?At least you have the opportunity to sue the?management of the company. ?It certainly seems like the management team cheated the stockholders, though I can’t say for sure.

What I can help are future investors, and my counsel is this: Diversify! ?You are your own best defender, so don’t merely mimic bright investors; do your own due diligence. ?Be wary of investing in cyclical companies with high debt levels. ?Don’t implicitly trust that management teams will act in your interest. ?And finally, diversify, as it protects against failures in other areas.

PS — I looked through my notes of the past. ?I did look at Horsehead Holdings, and I passed on it. ?That said, I don’t know why… hopefully it was for a good reason, though I expect that I didn’t have room for another cyclical company, and not another one in base metals.

The Cash Will Prove Itself

Posted on 1 September 2016 by David Merkel

Photo Credit: Renegade98 || What was it that Buffett said 'bout swimmin' naked? — Photo Credit: Renegade98 || What was it that Buffett said ’bout swimmin’ naked?

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It?s only when the tide goes out that you learn who has been swimming naked.

— Warren Buffett, credit Old School Value

When I was 29, nearly half a life ago, Donald Trump was a struggling real estate developer. ?In 1990, I was still trying to develop my own views of the economy and finance. ?But one day heading home from work at AIG, I was listening to the business report on the radio, and I heard the announcer say that Donald Trump had said that he would be “the king of cash.” ?My tart comment was, “Yeah, right.”

At that point in time, I knew that a lot of different entities were in need of financing. ?Though the stock market had come back from the panic of 1987, many entities had overborrowed to buy commercial real estate. ?The major insurance companies of that period were deeply at fault in this as well, largely driven by the need to issue 5-year Guaranteed Investment Contracts [GICs] to rapidly growing stable value funds of defined contribution plans. ?Outside of some curmudgeons in commercial mortgage lending departments, few recognized that writing 5-year mortgages with low principal amortization rates against long-lived commercial properties was a recipe for disaster. ?This was especially true as lending yield spreads grew tighter and tighter.

(Aside: the real estate area of Provident Mutual avoided most of the troubles, as they sold their building that they built seven years earlier for twice what they paid to a larger competitor. ?They also focused their mortgage lending on small, ugly, economically necessary properties, and not large trophy properties. ?They were unsung heroes of the company, and their reward was elimination eight years later as a “cost saving move.” ?At a later point in time, I talked with the lending group at Stancorp, which had a similar philosophy, and expressed admiration for the commercial mortgage group at Provident Mutual… Stancorp saw the strength in the idea, and still follows it today as the subsidiary of a Japanese firm. ?But I digress…)

Many of the insurance companies making the marginal commercial mortgage loans had come to AIG seeking emergency financing. ?My boss at AIG got wind of the fact that I was looking elsewhere for work, and subtly regaled me of the tales of woe at many of the insurance companies with these lending issues, including one at which I had recently interviewed. ? ?(That was too coincidental for me not to note, particularly as a colleague in another division asked me how the search was going. ?All this from one stray comment to an actuary I met coming back from the interview…)

Back to the main topic: good investing and business rely on the concept of a margin of safety. ?There will be problems in any business plan. ?Who has enough wherewithal to overcome those challenges? ?Plans where everything has to go right in order to succeed will most likely fail.

With Trump back in 1990, the goal was admirable — become liquid in order to purchase properties that were now at bargain prices. ?As was said in the Wall Street Journal back in April of 1990, the article started:

In a two-hour interview, Mr. Trump explained that he is raising cash today so he can scoop up bargains in a year or two, after the real estate market shakes out. Such an approach worked for him a decade ago when he bet big that New York City’s economy would rebound, and developed the Trump Tower, Grand Hyatt and other projects.

“What I want to do is go and bargain hunt,” he said. “I want to be king of cash.”

That’s where?Trump said it first. ?After that he received many questions from reporters and creditors, because his businesses were heavily indebted, and?property values were deflated, including the properties that he owned. ?Who wouldn’t want to be the “king of cash” then? ?But to be in that position would mean having sold something when times were good, then sitting on the cash. ?Not only is that not in Trump’s nature, it is not in the nature of most to do that. ?During good times, the extra cash that Buffett keeps on hand looks stupid.

Trump did not get out of the mess by raising cash, but by working out a deal with his creditors in bankruptcy. ?Give Trump credit, he had convinced most of his creditors that they were better off continuing to finance him rather than foreclose, because the Trump name made the properties more valuable. ?Had the creditors called his bluff, Trump?would have lost a lot, possibly to the point where we wouldn’t be hearing much about him today.

Trump escaped, but most other debtors don’t get the same treatment Trump did. ?The only way to survive in a credit crunch is plan ahead by getting adequate long-term financing (equity and long-term debt), and keep a “war kitty” of cash on the side.

During 2002, I had the chance to test this as a bond manager. ?With the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, ?The market is offered without bid.? We?ve never seen it this bad.? What do you want to do??? I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked.? By noon, I had used up all of my liquidity, but the market was turning.? On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.

That’s tough to do, and my client pushed me on the “extra cash sitting around.” ?After all, times are good, there is business to be done, and we could use the additional interest to make the estimates next quarter.

To give another example, we have the visionary businessman Elon Musk facing a?cash crunch?at Tesla?and?SolarCity. ?Leave aside for a moment his efforts to merge the two firms when stockholders tend to prefer “pure play” firms to conglomerates — it’s interesting to look at how two “growth companies” are facing a challenge raising funds at a time when the stock market is near all time highs.

Both Tesla and Solar City are needy companies when it comes to financing. ?They need a lot of capital to grow their operations before the day comes when they are both profitable and cash flow from operations is positive. ?But, so did a lot of dot-com companies in 1998-2000, of which a small number exist to this day. ?Elon Musk is in a better position in that presently he can ~~dilute~~?issue shares of Tesla to finance matters, as well as buy 80% of the Solar City bond issue. ?But it feels weird to have to finance something in less than a public way.

There are other calls on cash in the markets today — many companies are increasing dividends and buying back stock. ?Some are using debt to facilitate this. ?I look at the major oil companies and they all seem to be levering up, which is unusual given the recent trajectory of crude oil prices.

We are in the fourth phase of the credit cycle now — borrowing is growing, and profits aren’t. ?There’s no rule that says we have to go through a bear market in credit before that happens, but that is the ordinary?way that excesses get purged.

That is why I am telling you to pull back on risk, and review your portfolio for companies that need financing in the next three years or they will croak. ?If they don’t self finance, be wary. ?When things are bad only cash flow can validate an asset, not hopes of future growth.

With that, I close this article with a poem that I saw as a graduate student outside the door of the professor for whom I was a teaching assistant when I first came to UC-Davis. ?I did not know that is was out on the web until today. ?It deserves to be a classic:

Quoth The Banker, ?Watch Cash Flow?

Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
Some new tax loophole,
Suddenly I heard a knock upon my door,
Only this, and nothing more.

Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I?d often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
?Cash flow,? the banker said, and nothing more.

I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, ?No.
Your receivables are high, mounting upward toward the sky;
Write-offs loom.? What matters is cash flow.?
He repeated, ?Watch cash flow.?

Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a might oath
He waved his arms and shouted, ?Stop!? Enough!
Pay the interest, and don?t give me any guff!?

Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I?d held depreciation back,
And my banker said that I?d done something rash.
He quivered, and his teeth began to gnash.

When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he?d insist on some security?
All my assets plus the scalp upon my pate.
Only this, a standard rate.

Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain?unremitting woe!
And I hear the banker utter an ominous low mutter,
?Watch cash flow.?

Herbert S. Bailey, Jr.

Bumped Against My Upper Cash Limit

Posted on 20 August 2016 by David Merkel

Photo Credit: Wayne Stadler || Most of us have limited vision, myself included

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In the time I have been managing money for myself and others in my stock strategy, I set a limit on the amount of cash in the strategy. ?I don’t let it go below 0%, and I don’t let it go over 20%.

I have bumped against the lower limit six or so?times in the last sixteen years. ?I bumped against it around five times in 2002, and once in 2008-9. ?All occurred near the bottom of the stock market. ?In 2002, I raised cash by selling off the stocks that had gotten hurt the least, and concentrating in sound stocks that had taken more punishment. ?In September 2002, when things were at their worst, I scraped together what spare cash I had, and invested it. ?I don’t often do that.

In 2008-9 I behaved similarly, though my household cash situation was tighter. ?Along with other stocks I thought were bulletproof, but had gotten killed, I bought a double position of RGA near the bottom, and then held it until last week, when it finally broke $100.

But, I had never run into a situation yet where I bumped into the 20% cash limit until yesterday. ?Enough of my stocks ran up such that I have been selling small bits of a number of companies for risk control purposes. ?The cash started to build up, and I didn’t have anything that I deeply wanted to own, so it kept building. ?As the limit got closer, I had one stock that I liked that would serve as at least a temporary place to invest — Tesoro [TSO]. ?Seems cheap, reasonably financed, and refining spreads are relatively low right now. ?I bought a position in Tesoro yesterday.

I could have done other things. ?I could have moved the position sizes of my portfolio up, but I would have had to increase the position sizes a lot to have some stocks hit the lower edge of the trading band,?but that would have been more bullish than I feel now. ?As it is, refiners have been lagging — I can live with more exposure there to augment Valero, Marathon Petroleum and PBF.

I also could have doubled a position size of an existing holding, but I didn’t have anything that I was that?impressed with. ?It takes a lot to make me double a position size.

As it is, my actions are that of following the rules that discipline my investing, but acting in such a way that reflects my moderate bearishness over the intermediate term. ?In the short run, things can go higher; the current odds even favor that, though at the end the market plays for small possible gains versus a larger possible loss.

The credit cycle is getting long in the tooth; though many criticize the rating agencies, their research (not their ratings) can serve as a relatively neutral guidepost to investors. ?Corporate debt is high and increasing, and profits are flat to shrinking… not the best setup for longs. ?(Read John Lonski at Moody’s.)

I will close this piece by saying that I am looking over my existing holdings and analyzing them for need for financing over the next three years, and selling those that seem weak… though what I will replace them with is a mystery to me.

Bumping up against my upper cash limit is bearish… and that is what I am working through now.

Full disclosure: long VLO MPC PBF and TSO