The Z.1 report came out yesterday, giving an important new data point to the analysis. ?After all, the most recent point gives the best read into current conditions. ?As of March 31st, 2016 the best estimate of 10-year returns on the S&P 500 is 6.74%/year.
The sharp-eyed reader will say, “Wait a minute! ?That’s higher than last time, and the market is higher also! ?What happened?!” ?Good question.
First, the market isn’t higher from 12/31/2015 to 3/31/2016 — it’s down about a percent, with dividends. ?But that would be enough to move the estimate on the return up maybe 0.10%. ?It moved up 0.64%, so where did the 0.54% come from?
The market climbs a wall of worry, and?the private sector has been holding less stock as a percentage of assets than before — the percentage?went from 37.6% to 37.1%, and the absolute amount fell by about $250 billion. ?Some stock gets eliminated by M&A for cash, some by buybacks, etc. ?The amount has been falling over?the last twelve months, while the amount in bonds, cash, and other assets keeps rising.
If you think that return on assets doesn’t vary that much over time, you would?conclude that having a smaller amount of stock owning the assets would lead to a higher rate of return on the stock. ?One year ago, the percentage the private sector held in stocks was 39.6%. ?A move down of 2.5% is pretty large, and moved the estimate for 10-year future returns from 4.98% to 6.74%.
Summary
As a result, I am a little less bearish. ?The valuations are above average, but they aren’t at levels that would lead to a severe crash. ?Take note, Palindrome.
Bear markets are always possible, but a big one is not likely here. ?Yes, this is the ordinarily bearish David Merkel writing. ?I’m not really a bull here, but I’m not changing my asset allocation which is 75% in risk assets.
Postscript for Nerds
One other thing affecting this calculation is the Federal Reserve revising estimates of assets other than stocks up prior to 1961. ?There are little adjustments in the last few years, but in percentage terms the adjustments prior to 1961 are huge, and drop the R-squared of the regression from 90% to 86%, which also is huge. ?I don’t know what the Fed’s statisticians are doing here, but I?am going to look into it, because it is?troubling to wonder if your data series is sound or not.
That said, the R-squared on this model is better than any alternative. ?Next time, if I get a chance, I will try to put a confidence interval on the estimate. ?Till then.
Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic,, would not have been a bad decision.
I’m here to write about a related issue this evening. ?To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not. ?Take the “Fed Model” as an example. ?You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole.
Now with interest rates so low, belief in the Fed Model?is tantamount to saying “there is no alternative to stocks.” [TINA] ?That should make everyone take a step back and say, “Wait. ?You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?” ?Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations.
Here’s why: in my?prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model. ?With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital.
Now that’s a basic idea that makes sense, particularly when consider how corporations work. ?If a corporation can issue cheap debt capital to?retire stock with a higher yield on earnings, in the short-run it is a plus for the stock. ?After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards. ?If true for corporations, it should be true for the market as a whole.
The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries — rather, the firm’s cost of capital is the tradeoff. ?My proxy for the cost of capital?for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data. ?It’s not perfect, but here are some reasons why it is a reasonable proxy:
Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity.
The Baa bonds are on the cusp of investment grade. ?The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average. ?You could tranche?off a pseudo-debt interest in a way akin to the old Americus Trusts, and the cash flows would price out much like corporate debt or a preferred stock interest.
The debt ratings of most of the S&P 500 would be strong investment grade. ?Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference.
As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model. ?That’s a better pair to compare against one another.
A new take on the Equity Premium!
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That brings up another bad binary comparison that is common — the equity premium. ?What do?stock returns?have to with the returns on T-bills? ?Directly, they have nothing to do with one another. ?Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed — those of maturity risk, credit risk and business risk. ?(And the last of those should be split into a economic earnings ?factor and a valuation change factor.)
This is why I’m not a fan of the concept of the equity premium. ?The concept relies on the idea that equities and T-bills?are a binary choice within the beta calculation, as if only the risky returns trade against one another. ?The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate. ?At certain points lending long is attractive, or taking credit risk, or raising capital to start a business. ?Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere.
Summary
When looking at investment analyses, ask “What’s the comparison here?” ?By doing that, you will make more intelligent investment decisions. ?Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock. ?(That’s why I prefer swap transactions.) ?People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result.
This post is a little different from the first three articles, because I got the data to extend the beginning of my study from 1950 to 1928, and I standardized my turning points using the standard bull and bear market definitions of a 20% rise or fall from the last turning point. ?You can see my basic data to the left of this paragraph.
Before I go on, I want to show you two graphs dealing with bear markets:
As you can see from the first graph, small bear markets are much more common than large ones. ?Really brutal bear markets like the biggest one in the Great Depression were so brutal that there is nothing to compare it to — financial leverage collapsed that had been encouraged by government policy, the Fed, and a speculative mania among greedy people.
The second graph tells the same story in a different way. ?Bear markets are often short and sharp. ?They don’t last long, but the intensity in term of the speed of declines is a little more than?twice as fast as the rises of bull markets. ?If it weren’t for the fact that bull markets last more than three times as long on average, the sharp drops in bear markets would be enough to keep everyone out of the stock market.
Instead, it just keeps many people out of the market, some entirely, but most to some degree that would benefit them.
Oh well, on to the gains:
Like bear markets, most bull markets are small. ?The likelihood of a big bull market declines with size. ?The current bull market is the fourth largest, and the one that it passed in duration was the second largest. ?As an aside, each of the four largest bull markets came after a surprise:
(1987-2000) 1987: We knew the prior bull market was bogus. ?When will inflation return? ?It has to, right?
(1949-56) 1949: Hey, we’re not getting the inflation we expected, and virtually everyone is finding work post-WWII
(1982-7) 1982: The economy is in horrible shape, and?interest rates are way too high. ?We will never recover.
(2009-Present) 2009: The financial sector is in a shambles, government debt is out of control, and the central bank is panicking! ?Everything is falling apart.
Sometimes you win, sometimes you lose…
Note the two dots stuck on each other around 2800 days. ?The arrow points to the lower current bull market, versus the higher-returning bull market 1949-1956.
Like bear markets, bull markets also?can be short and sharp, but they can also be long and after the early sharp phase, meander upwards. ?If you look through the earlier articles in this series, you would see that this bull market started as an incredibly sharp phenomenon, and has become rather average in its intensity of monthly returns.
Conclusion
It may be difficult to swallow, but this bull market that is one of the longest since 1928 is pretty average in terms of its monthly average returns for a long bull market. ?It would be difficult for the cost of capital to go much lower from here. ?It would be a little easier for corporate profits to rise from here, but that also doesn’t seem too likely.
Does that mean the bull is doomed? ?Well, yes, eventually… but stranger things have happened, it could persist for some time longer if the right conditions come along.
But that’s not the way I would bet. ?Be careful, and take opportunities to lower your risk level in stocks somewhat.
The historical analogue that matches well with these conditions is 1990. There was a 19.9% drop in the S&P 500, lasting a bit under three months. But the damage to foreign stocks, small-caps, cyclicals, and value stocks in that cycle was considerably more. Both the Russell and the Nasdaq were down 32% to 33%. You might remember United Airlines? failed buyout bid; the transports were down 46%. Foreign stocks were down about 30%.
And then Saddam Hussein invaded Kuwait.
That might have been the final trigger. The broad market top was in the fall of 1989, and most stocks didn?t bottom until Oct. 11, 1990. In the record books, it was a shallow bear market that didn?t even officially meet the 20% definition. But it was a damaging one that created a lot of opportunity for the rest of the 1990s.
FWIW, I remember the fear that existed among many banks and insurance companies that had overlent on?commercial properties in that era. ?The fears led Alan Greenspan to encourage the FOMC to lower rates to… (drumroll) 3%!!! ?And, that experiment together with the one in 2003, which went down to 1.25%, practically led to the idea that the FOMC could lower rates to get out of any ditch… which is now being proven wrong.
Every now and then, you will run across a mathematical analysis where if you use a certain screening, trading, or other investment method, it produces a high return in hindsight.
And now, you know about it, because it was just published.
Now, luck can simply be a question of timing… think of my recent post:?Think Half of a Cycle Ahead. ?What would happen to value investing if you tested it only over the last ten years?
It would be in the dustbin of failed research.
Just published… well… odds are, particularly if the data only goes back a short distance in time, it means that there was likely a favorable macro backdrop giving the idea a tailwind.
There is a different aspect to luck though. ?Perhaps a few souls were experimenting with something like the theory before it was discovered. ?They had excellent returns, and there was a little spread of the theory?via word of mouth and unsavory means like social media and blogs.
Regardless, one of the main reasons the theory worked was that the asset being bought by those using the theory were underpriced. ?Lack of knowledge by institutions and most of the general public was a barrier to entry allowing for superior returns.
When the idea became known by institutions after the initial paper was published, a small flood of money came through the narrow doors, bidding up the asset prices to the point where the theory would not only no longer work, but the opposite of the theory would work for a time, as the overpriced assets had subpar?prospective returns.
Remember how dot-com stocks were inevitable in March of 2000? ?Now those doors weren’t narrow, but they were more narrow than the money that pursued them. ?Such is the end of any cycle, and the reason why average investors get skinned chasing performance.
Now occasionally the doors of a new theory are so narrow that institutions don’t pursue the strategy. ?Or, the strategy is so involved, that even average quants can tell that the data has been tortured to confess that it was born in a place where the universe randomly served up a royal straight flush, but that five-leaf clover got picked and served up as if it were growing everywhere.
Sigh.
My advice to you tonight is simple. ?Be skeptical of complex approaches that worked well in the past and are portrayed as new ideas for making money in the markets. ?These ideas quickly outgrow the carrying capacity of the markets, and choke on their own success.
The easiest way to kill a good strategy is to oversaturate it too much money.
As such, I have respect for those with proprietary knowledge that limit their fund size, and don’t try to make lots of money in the short run by hauling in assets just to drive fees. ?They create their own barriers to entry with their knowledge and self-restraint, and size their ambitions to the size of the narrow doors that they walk through.
To those that use institutional investors, do ask where they will cut off the fund size, and not create any other funds like it that buy the same assets. ?If they won’t give a firm answer, avoid them, or at minimum, keep your eye on the assets under management, and be willing to sell out when they get reeeally popular.
If it were easy, the returns wouldn’t be that great. ?Be willing to take the hard actions such that your managers do something different, and finds above average returns, but limits the size of what they do to serve current clients well.
Then pray that they never decide to hand your money back to you, and manage only for themselves. ?At that point, the narrow door excludes all but geniuses inside.
This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. ?First, I don’t like infographics or video. ?I want to learn things quickly. ?Give me well-written text to read. ?A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.
Here’s the problem. ?Do you want to reduce?the volatility of your asset portfolio? ?I have the solution for you. ?Buy bonds and hold some cash.
And some say to me, “Wait, I want my money to work hard. ?Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” ?In a word the answer is “no,” though some will tell you otherwise.
Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. ?Those buying stocks stuck to well-financed “blue chip” companies.
Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:
Growth stocks
Midcap stocks (value & growth)
Small cap stocks (value & growth)
REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
Developed International stocks (of all kinds)
Emerging Market stocks
Frontier Market stocks
And more…
And initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.
Now, was there no diversification left? ?Not much. ?The diversification from investor behavior is largely gone (the liability side of correlation). ?Different sectors of the global economy don’t move in perfect lockstep,?so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?
Why do I hear crickets? ?Hmm…
Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:
Timberland
Real Estate
Private Equity
Collateralized debt obligations of many flavors
Junk bonds
Distressed Debt
Merger Arbitrage
Convertible Arbitrage
Other types of arbitrage
Commodities
Off-the-beaten track bonds and derivatives, both long and short
And more… one that stunned me during the last bubble was leverage nonprime commercial paper.
Well guess what? ?Much the same thing happened here as happened with non-“blue chip” stocks. ?Initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.
Now, was there no diversification left? ?Some, but less. ?Not everyone was willing to do all of these. ?The diversification from investor behavior was reduced?(the liability side of correlation). ?These don’t move in perfect lockstep,?so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are some?that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. ?Many of those blew up last time. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?
Why do I hear crickets again? ?Hmm…
That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. ?Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.
But beyond that, hold dry powder. ?Think of cash, which doesn’t earn much or lose much. ?Think of some longer high quality bonds that do well when things are bad, like long treasuries.
Remember, the reward for taking business risk in general varies over time. ?Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). ?This isn’t a call to go nuts and sell all of your risky asset positions. ?That requires more knowledge than I will ever have. ?But it does mean having some dry powder. ?The amount is up to you as you evaluate your time horizon and your opportunities. ?Choose wisely. ?As for me, about 20-30% of my total assets are safe, but I?have been a risk-taker most of my life. ?Again, choose wisely.
PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. ?You will have to wait for those ideas to be forgotten. ?Wait to see a few fund closures, and a severe reduction in AUM for the leaders…
I was looking through an article to see if it had any decent stock ideas, and noted that most of the companies featured were growth stocks. ?As such, my first pass for analysis is the PEG ratio, which is the ratio of the Price-Earnings ratio divided by the growth rate expressed as a percentage (e.g. 8% => 8 for this calculation.).
I’ve written about the PEG ratio a long time ago, and it is a classic article of mine. ?The PEG ratio is a valid concept for “growth at a reasonable” price investors. ?It does not work well for value investors or aggressive growth investors. ?My rule for implementation comes to this: if the current P/E ratio is 12 or higher?and the PEG ratio is lower than 1.5, that stock might be worth a look. ?Better to find the PEG ratio below one, though.
I went through the article and concluded that maybe Becton Dickinson and Hanesbrands might be worth a look. ?But then I thought, “What if I applied the formula to propose overvalued stocks?”
I set my screener for a 2016 PE higher than 12 and a PEG higher than 2.0x, with failing momentum, where the stock was down more than 20% in the nine months prior to the current month. ?Here were the 50 stocks that resulted:
What I find fascinating here is the mix of hot companies, basic materials and energy names, and limited partnerships.
This is only a start for analysis, so don’t run out and short these. ?Not that I am big on shorting, but high earnings valuations, and failing price momentum could be a good place to start. ?I have no positions in any of these companies, and I rarely if ever short. ?I just thought this would be an interesting exercise.
These are just notes on the proposal so far. ?Here goes:
1) It’s a solution in search of a problem.
After the financial crisis, regulators got one message strongly — focus on liquidity. ?Good point with respect to banks and other depositary financials, useless with respect to everything else. ?Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty. ?Even money market funds weren’t that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.
The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough. ?In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.
The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use ?swing pricing.??
Swing pricing is the process of reflecting in a fund?s NAV the costs associated with shareholders? trading activity in order to pass those costs on to the purchasing and redeeming shareholders.? It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.? Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.
A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund?s NAV known as the swing threshold.? The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold.? The fund?s board, including the independent directors, would be required to approve the fund?s swing pricing policies and procedures.
But there are simpler ways to do this. ?In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly. ?This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on.
Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies. ?Those are frequently used for funds where the underlying assets are less liquid. ?Those would more than compensate for any losses.
2) This disproportionately affects fixed income funds. ?One size does not fit all here. ?Fixed income funds already use matrix pricing extensively — the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask.
In order to get a decent yield, you have to accept some amount of lesser liquidity. ?Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss? ?Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds.
Liquidity risk in bonds is important, but it is not the only risk that managers face. ?it should not be made a high priority relative to credit or interest rate risks.
3) One could argue that every order affects market pricing — nothing is truly liquid. ?The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk.
4)?Liquidity is not as constant as you might imagine. ?Raising your bid to buy, or lowering your ask to sell are normal activities. ?Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do. ?It is very easy to underestimate the amount of potential liquidity in a given asset. ?As with any asset, it comes at a cost.
I spent a lot of time trading illiquid bonds. ?If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of. ?What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry. ?Just be diffident, say you want to pick up or pose one or two?million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation. ?I actually found it to be a lot of fun, and it made good money for my insurance client.
5) It affects good things about mutual funds. ?Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm. ?Illiquid assets, properly chosen, can add significant value. ?As Jason Zweig of the Wall Street Journal said:
The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are ? and a rare few into bigger risk-takers than ever.
You want to kill off active managers, or make them even more index-like? ?This proposal will help do that.
6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc?
Summary
You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic. ?It would be better if the SEC just withdrew these proposed rules. ?My guess is that the costs outweigh the benefits, and by a wide margin.
Enter into large or exit from?commitments to risk assets cheaply (cost)
Borrow at tight credit spreads compared to the safest borrowers
Make large adjustments to their asset allocations rapidly (speed)
Most of these phenomena can be observed without complex models. ?Ask yourself:
Is credit growing rapidly?
Are the exchanges moving turning over stocks more rapidly?
Are credit spreads tight?
Have credit terms and conditions deteriorated?
Do lenders care more about volume of lending than quality of lending?
My bias is that I think most of the academic mathematical models of liquidity risk are overly technical, and tend to obscure liquidity conditions rather than reveal what is going on. ?You may disagree with that view.
But unless you disagree with that view and you like math, this book will not be worth a lot to you. ?Yes, there are qualitative sections, and they are good. ?For example, the beginning of chapter 2 is very good at illustrating the paradoxical nature of liquidity. ?Chapters 1-3 would have made a very good qualitative monograph on liquidity — but it would be so small that you couldn’t charge $80+ for it.
Chapters 4-6 will only be useful to the mathematically inclined. ?I’m dubious that they even be useful then, because much of it is calculus, which does not do well with discontinuous events such as market panics. ?(You would have thought that the quants on Wall Street would have learned by now, but no…) ?Even if the models did work, there are simpler ways to see the same things, as I pointed out above.
As such, I really can’t recommend the book, and at $80+ the price is a lot more expensive than the free Monograph from the CFA Institute “The New Economics of Liquidity and Financial Frictions.” [PDF] ?Read that, not this, and save liquidity.
Quibbles
The book could have used a better editor. ?Too many typos in the introductory chapters.
Summary / Who Would Benefit from this Book
If you are a math nerd, and want to pay a lot of money to buy a book that I think will at least partially mislead you on liquidity risk, then this is the book for you. ?If you want to buy it, you can buy it here: Market Liquidity Risk.
Full disclosure:?I?received a?copy from a friendly?PR flack.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.
This article is another experiment. Please bear with me.
Q: What is an asset worth?
A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.
Q: Come on, the value of an asset must be more enduring than that. ?You look at the balance sheets of corporations, and they don’t list their assets at sales prices.
A: That’s for a different purpose. ?We can’t get the prices of all assets to trade frequently. ?The economic world isn’t only about trading, it is about building objects, offering services… and really, it is about making people happier through service. ?Because the assets don’t trade regularly, they are entered onto the balance sheet at:
Cost, which is sometimes adjusted for cost and other things that are time-related, and subject to writedowns.
The value of the asset at its most recent sale date before the date of the statement
An estimated value calculated from sales of assets like it, meant to reflect the likely markets at the time of the statement — what might the price be in a deal between and un-coerced buyer and seller?
Anyway, values in financial statements are only indicative of aspects of value. ?Few investors use them in detail. ?Even value investors who use the detailed balance sheet values in their investment decisions make extensive adjustments to them to try to make them more realistic. ?Other value investors look at where the prices of similar companies that went private to try to estimate the value of public equities.
Certainly the same thing goes on with real estate. ?Realtors and appraisers come up with values of comparable properties, and make adjustments to try to estimate the value of the property in question. ?Much as realtors don’t like Zillow, it does the same thing just with a huge econometric model that factors in as much information as they have regarding the likely prices of residential real estate given the prices of the sparse number of sales that they have to work from.
Q: What if it’s a bad day when I offer my asset for sale? ?Is my asset worth less simply because of transitory conditions?
A: Do you have to sell your asset that day or not?
Q: Why does that matter?
A: If you don’t need the money immediately, you could wait. ?You also don’t have to auction the asset if you think that hiring an expert come in and talk with a variety of motivated buyers could result in a better price after commissions. ?There are no guarantees of a better result there though.
The same problem exists on the stock market. ?If you want the the money now, issue a market order to sell the security, and you will get something close to the best price at that moment. ?That said, I never use market orders.
Q: Why don’t you use market orders?
A: I don’t want to be left at the mercy of those trading rapidly in the markets. ?I would rather set out a price that I think someone will transact at, and adjust it if need be. ?Nothing is guaranteed — a trade might not get done. ?But I won’t get caught in a “flash crash” type of scenario, or most other types of minor market manipulation.
Patience is a virtue in buying and selling, as is the option of walking away. ?If you seem to be a forced seller, buyers will lower their bids if you seem to be desperate. ?You may not notice this in liquid stocks, but in illiquid stocks and other illiquid assets, this is definitely a factor.
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That’s all for now. ?If anyone has any ideas on if, where, or how I should continue this piece, let me know in the comments, or send me an e-mail. ?Thanks for reading.
Imagine that you are in the position of a high cost crude oil producer that has a lot of debt to service. ?The price that you can sell your oil for is high enough?that you make some?cash over your variable cost. ?The price is low enough that you are not recouping the cost of what you paid to buy the right to develop the oil, the development cost, and cost of equity capital employed.
In this awkward situation you continue to produce oil, because it may keep you from defaulting on your debts, even though you are not earning what is needed to justify the GAAP book value of your firm. ?You’re destroying value by producing, but because of the debt, you don’t have the option of waiting because not surviving loses more money than pumping oil and seeing if you can survive.
Where there is life, there is hope. ?Who knows, one of three?things could “go right:”
Enough competitors could fail such that global industry capacity reduces and prices rise.
Demand for oil could rise because it is cheap, leading prices to rise.
You could get bought out by a more solvent competitor with a longer time horizon, who sees the assets as eventually valuable.
Trouble is with #1, you could fail first. ?With #2, the process is slow, and who knows how much the Saudis will pump. ?With #3, the price that an acquirer could pay might not be enough for shareholders, or worse, they could buy out your competitors and not you, leaving you in a worse competitive position.
One more thought: think of the Saudis, the Venezuelans, etc… all of the national oil companies. ?They’re not in all that different a spot than you are. ?They need cash to fund government programs or they may face unrest. ?For some like the Saudis, who assets in reserve, the odds are lower. ?For the Venezuelans, who have had their economy destroyed by the politics of Chavez, the odds are a lot higher.
There will be failures among energy producers, and that could include nations. ?Failures with?each will be temporary as debts get worked through/compromised and new management takes over, and high cost supply gets shut down. ?The question is: who will fail and who won’t. ?The job of the hypothetical firm that I posited at the beginning of this article is to survive until prices rise. ?What will a survivor look like?
Relatively high contribution margins (Price – variable cost per barrel)
Relatively little debt
Debt has long maturities and/or low coupons.
Now, I’m going to give you 40% of the answer here… I’m still working on the contribution margin question, but I can give you a useful measure regarding debt. ?My summary measure is total debt as a ratio of market capitalization. ?It’s crude, but I think it is a good first pass on debt stress, because the market capitalization figures carry an implicit estimate of the probability of bankruptcy.
Anyway here’s a list of all of the oil companies in the database that have debt greater than their market cap:
Company
Country
ticker
Mkt cap
Debt / Market Cap
Energy XXI Ltd
Bermuda
EXXI
171
26.93
SandRidge Energy Inc.
United States
SD
264
16.63
Comstock Resources Inc
United States
CRK
146
9.45
Linn Energy LLC
United States
LINE
1,172
8.81
EXCO Resources Inc
United States
XCO
213
7.2
Cosan Limited(USA)
Brazil
CZZ
1,015
6.34
W&T Offshore, Inc.
United States
WTI
245
6
Halcon Resources Corp
United States
HK
620
5.89
BreitBurn Energy Partners L.P.
United States
BBEP
614
5.05
Magnum Hunter Resources Corp
United States
MHR
188
5.05
California Resources Corp
United States
CRC
1,325
4.92
Sanchez Energy Corp
United States
SN
368
4.74
Crestwood Equity Partners LP
United States
CEQP
543
4.64
Rex Energy Corporation
United States
REXX
171
4.51
Penn West Petroleum Ltd (USA)
Canada
PWE
403
4.19
Atlas Resource Partners, L.P.
United States
ARP
365
4.09
Gastar Exploration Inc
United States
GST
108
3.8
Petroleo Brasileiro Petrobras
Brazil
PBR
35,748
3.71
Stone Energy Corporation
United States
SGY
292
3.59
Bill Barrett Corporation
United States
BBG
252
3.19
EP Energy Corp
United States
EPE
1,552
3.15
Memorial Production Partners L
United States
MEMP
599
3.05
Premier Oil PLC (ADR)
United Kingdom
PMOIY
828
2.95
Triangle Petroleum Corporation
United States
TPLM
286
2.88
Ultra Petroleum Corp.
United States
UPL
1,281
2.68
Bonanza Creek Energy Inc
United States
BCEI
333
2.55
Northern Oil & Gas, Inc.
United States
NOG
359
2.47
Denbury Resources Inc.
United States
DNR
1,479
2.37
Jones Energy Inc
United States
JONE
354
2.36
Chesapeake Energy Corporation
United States
CHK
4,917
2.35
Vanguard Natural Resources, LL
United States
VNR
833
2.27
LRR Energy LP
United States
LRE
128
2.23
Pengrowth Energy Corp (USA)
Canada
PGH
705
2.21
Legacy Reserves LP
United States
LGCY
461
2.1
Aegean Marine Petroleum Networ
Greece
ANW
391
1.85
GeoPark Ltd
Chile
GPRK
202
1.8
Mitsui & Co Ltd (ADR)
Japan
MITSY
23,727
1.74
Oasis Petroleum Inc.
United States
OAS
1,390
1.69
Santos Ltd (ADR)
Australia
SSLTY
3,813
1.59
Whiting Petroleum Corp
United States
WLL
3,593
1.46
Midcoast Energy Partners LP
United States
MEP
558
1.45
Paramount Resources Ltd (USA)
Canada
PRMRF
1,006
1.35
Encana Corporation (USA)
Canada
ECA
5,944
1.33
Clayton Williams Energy, Inc.
United States
CWEI
597
1.25
Clean Energy Fuels Corp
United States
CLNE
468
1.23
EV Energy Partners, L.P.
United States
EVEP
405
1.23
WPX Energy Inc
United States
WPX
1,660
1.2
Baytex Energy Corp (USA)
Canada
BTE
1,068
1.19
ONEOK, Inc.
United States
OKE
7,453
1.18
SunCoke Energy Partners LP
United States
SXCP
505
1.18
TransAtlantic Petroleum Ltd
United States
TAT
126
1.13
Global Partners LP
United States
GLP
1,071
1.12
NGL Energy Partners LP
United States
NGL
2,659
1.12
Sprague Resources LP
United States
SRLP
495
1.11
Amyris Inc
United States
AMRS
266
1.07
Sunoco LP
United States
SUN
1,605
1.06
SM Energy Co
United States
SM
2,360
1.05
Solazyme Inc
United States
SZYM
202
1
This isn’t a complete analysis by any means. Personally, I would be skeptical of holding any company twice as much debt as market cap without a significant analysis. ?Have at it your own way, but be careful, there will be a lot of stress on oil companies with high debt.
