Category: Value Investing

“Welcome to our Country Club!”

Posted on by David Merkel

Image Credit: born1945 || When I was a boy, I spent many days caddying at the local country club.

(This is one of my occasional experiments. Bear with me if you will…)

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Wagner: I don’t get the thrill.

Hawker: What’s not to like?

W: This is nothing like the investment memorandum said it would be.

H: It’s a work in progress. Don’t look at what it is now, think of what it will be like when everyone clamors to join us.

W: This is just a field.

H: So?

W: When I bought a small share in the ownership of this club, the memorandum had pictures of the golf course, lodge, tennis courts, bar, swimming pool, pro shop, and more. All that is here is this field.

H: You needed to read the memorandum more closely. One day we will have all that and more. As for now, we promote the potential of this place to the masses who will want to join us at a much higher price than we got in at.

W: So when will it be built?

H: That is a matter of secondary importance.

W: Huh? What’s of primary importance?

H: Encouraging others to buy shares in this, and never selling our interests.

W: Wait. You did not buy this so you could golf?

H: No merely to own, and never to sell.

W: So this is a speculation on this land?

H: Don’t say speculation! Bad word! This is an investment in the concept of getting something valuable in the future. Besides, the country club doesn’t technically own this field yet… there is a memorandum of understanding to acquire it once the price of ownership interests get high enough… at that point we will swap newly issued shares for the land. We transact everything in shares; it is our currency.

W: It doesn’t own this field? What does it own?

H: The future. Everyone is going to want to buy a share in this wondrous venture, and at progressively higher prices. Congratulate yourself, you got in on the ground floor.

W: There is no floor here! Where has the money gone that I have paid?

H: An earlier investor sold you some of his interests. Don’t worry, he still owns over 25% of the shares. Purely a portfolio management decision for him. The Founder strongly believes in the vision for this concept.

W: The concept of building a country club?

H: The concept of selling interests in the club at ever higher prices to the masses who will want an appreciating asset. And we have the track record. Prices of ownership interests have continually gone up. On a mark-to-market basis, the returns exceed 20%/year. How is that for a successful investment?!

W: I can understand the concept of buying rare and beautiful art to hang on the wall of my house as an investment. It might appreciate over time or not. I enjoy looking at it, and my friends as well, while I pay insurance premiums to protect it for my heirs. Is the only value of this investment possible monetary gain? At least will there be dividends paid?

H: You are missing the point. With this, your heirs will have something far more valuable than a stream of dividends. They will own a share in something that everyone wants to buy. Everyone wants to own an investment that only goes up.

W: So the only driver of value here is others envying what we have, and wanting to buy it from us at prices higher than what we paid?

H: Envy is an ugly word, but yes, and that is why we continually promote how wonderful this investment will be.

W: I am disappointed. I really wanted to golf. Hmm… what if I sold my interests and used the money to go golfing, whether I buy another country club membership, or just hit the links at the local public course?

H: And I am astounded. Why would you give up the glorious future of this enterprise?

W: I want to golf. Say, if you are so convinced, would you buy my interests from me at 5% more than I paid for them?

H: Well, I would be a “better buyer” at that price, but I don’t have enough cash to do that.

W: Would the Founder be interested?

H: The Founder continues to acquire ownership interests as a result of his labors as management. That is how he gets paid. As far as I have heard, he graciously sells them to those who want a piece of the action.

W: Uh-huh. At this point I would rather golf. I will sell my interests to the best bidder.

H: I thought better of you than that. Giving up on an astounding future just to play a game?

W: No, giving up on a game to enjoy life.

Decentralized Ponzi

Posted on by David Merkel

Photo Credits: Jared Enos, Stephan Mosel & Pine Tools || Ponzi would have appreciated the cleverness of wallstreetbets

The operation of the “bull pool” at wallstreetbets resembles a Ponzi scheme. There are five things that make it different:

  • It is decentralized.
  • Because it is decentralized, there is no single party that controls it and rakes off some of the money for himself, at least not directly.
  • The assets can be freely sold in a somewhat liquid, but chaotic market. Most Ponzi schemes have time barriers for redemption.
  • They caught a situation where shorting was so rampant, that triggering a squeeze was easy. Situations where the shorts are so crowded are rare.
  • Gamestop [GME] and other companies whose stock prices get manipulated above their intrinsic value can take the opportunity to sell more shares, as can less than 10% holders of the holders of the stock, and even the greater than 10% holders once six months have passed since their last purchase.

You have to give wallstreetbets credit for one thing, and only one thing: wiping out the shorts. It was an incredibly crowded short, and they identified an easy squeeze. But now it is harder to short, margin requirements have been tightened for both longs and shorts, given the market volatility, and even more so for options. That not only applies to individuals but to brokerages, because with the volatility, there is a greater probability of settlement failure, and broker failure. Robinhood faced possible failure and raised capital. What shorts remain are better financed than previously. When volatility goes up, so must the capital of intermediaries, including brokerages.

Ponzi schemes typically need ever-increasing flows of money to satisfy the cash need from the money being raked off. But there is no sponsor here, so what plays the role of the rake? I can think of three rakes for the money:

  • Most fundamentally driven longs have sold. Notable among them is MUST Asset Management of South Korea.
  • Some companies like AMC Entertainment and American Airlines are issuing new shares to take advantage of the artificially high price. Maybe GME will do it next week.
  • And, those who are more intelligent at wallstreetbets know that GME is overvalued, and have booked their gains. This is definitely a place where the old Wall Street maxim applies: “Can’t go broke taking a profit.” or “Bulls can make money, Bears can make money, but Hogs get slaughtered.” (The Hogs in this situation are the ones who buy and hold GME. Buy-and-hold only works for undervalued assets.)

Now, the grand change that has happened in the last two months is that the investor base of GME has shifted from being fundamental investors to momentum investors. There may be more institutional money pushing GME than is commonly understood. That said, institutional momentum longs tend to react quickly and sell when momentum fails, which makes matters even more volatile. They have more of a risk control discipline than naïve retail investors do.

This is similar to what happens with promoted penny stocks. Fundamentals seem not to matter, just the amount of money thrown at the stock. There is the pump; there is the dump. The amounts of money are bigger here. We have only seen the pump. The dump is coming. And penny stocks almost always lose.

There is no magic in markets — stock prices eventually revert to intrinsic value — it is only a question of how and when. Buyers can force a stock price above intrinsic value for a little while, but eventually the price will sag back, and the only winners will be those who sold stock to them.

When I was younger, I made a mistake with a microcap stock, and placed a market order to initiate a position. (Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was. The price promptly fell back to where it was prior to my purchase.  This is what will likely happen with GME, and other situations like it. Mere trading can’t permanently raise the price of an asset.

One last note: those at wallstreetbets and places life it should be careful. If you are communicating with other investors about a stock and you make money as a result of the communication, you may face legal troubles if that is deemed market manipulation. And, given that you have communicated it over the internet, that could be deemed “wire fraud.” This is the nature of a government with vague laws that likes to say “gotcha” when they deem something unsavory as illegal.

Do I think it should be illegal? No. Is it unethical? Certainly. No one should promote anything like a Ponzi scheme. But in US culture now, unethical and illegal get confused, and the ideas of “mail fraud,” “wire fraud,” etc., can be applied to unethical actions that may not strictly be illegal. Such logic has been applied to promoted penny stocks, with significant wins against the promoters.

So, to those at wallstreetbets, I would say that you are living on borrowed time. This isn’t going to work, and you and those that follow you will lose money, whether the government comes after you or not. Just as the Hunts tried to corner the silver market, and failed miserably as people sold their silver sets, and miners mined like crazy, in the same way pushing stock prices too high will only lead to dilution from the corporations, and losses to the buyers who came in late., if not the early ones as well.

Look out below.

GameStop: The Voting Machine Versus The Weighing Machine

Posted on by David Merkel

Photo Credits: Seattle Municipal Archives, Luis Anzo, piepjemiffy & Pine Tools || Truth is stranger than fiction, particularly with the behavior of crowds in markets

Before I start writing this evening, I want to say that what I write here is correct in its major findings, but it is quite possible that I got some details wrong. This is complex, and there are a lot of issues involved.

I’ve had four friends ask me about GameStop [GME] over the last few days. Thus I am writing an explanation as to why things are so nuts here.

As a prelude, I want to tell everyone that I have no positions at present in GME, and have no intentions of taking a position in it ever. Mid-decade, I owned GME and lost a little bit on it. I came to the correct conclusion that their business model no longer worked before most of the market gave up on it. If anything, the business model is worse now than when I sold. I think the true value of GME is about $5/share, unless management does something clever with its overvalued stock. Fortunately, I have written a really neat article called How do you Manage a Company when the Stock is Considerably Overvalued? I’ll talk about this more toward the end of this piece.

One more note: I never short because it is very hard to control risk when shorting. When you are short, or levered long, you no longer control your trade in full, and an adverse price move could force you to buy or sell when you don’t want to.

I can imagine working at the hedge fund, and my boss says to me, “What should I do about GME?” My initial answer would be “Nothing, it’s too volatile.” If pressed, I would say, “Gun to the head, it is a short, if you can source the shares, and live with the possibility of being forced by the margin desk to put more capital.”

Now you know my opinion. Let me explain the technicals and the fundamentals here.

The Voting Machine

Ben Graham used to say that the stock market was a voting machine in the short-run, and a weighing machine in the long-run. In a mania, you can get a lot of people chasing the shares of a speculative company like GME, and in the short run, the aggressiveness of the buyers lifting the ask and buying call options can drive the stock higher.

With GME, there is another complicating factor — there are more shares shorted than there are shares issued. This means that some brokerages have been allowing “naked shorting,” i.e., allowing traders to sell short without borrowing shares. This is illegal, and I wouldn’t be surprised to see the SEC pursue a case against some brokers as a result.

When there are a lot of short sellers in a given stock, if buyers can get the price to rise, it can create a temporarily self-reinforcing cycle as shorts are forced by their brokers to put up more capital, or buy in their short position. This is called a “short squeeze.” I’m pretty certain that has been happening with GME.

Now, beyond that there are several other factors:

  • Longs that are locked because of large positions
  • Use of call options to magnify gains (and maybe losses)
  • Co-ordinated buying by small traders.
  • Possible use of total return swaps
  • Moving shares to the cash account

I’ll handle these in the above order. There are three entities that own more than 10% of GME. Blackrock, Fidelity, and RC Ventures (the investment vehicle of Ryan Cohen, CEO of Chewy.com). Once you own more than 10% of a company, you can’t sell shares until six months have passed since your last purchase. If you purchase more, you must notify the market within two days. If you finally get to the point where you can sell, you can’t buy again for six months, and if you sell you must notify the market within two days.

RC Ventures, which now has three board seats on the GME board, can’t sell GME shares until mid-June, as they bought their last shares in December. I have no idea when Blackrock and Fidelity last bought GME shares but it six months have passed, I would be bombing the market with shares. Since I haven’t seen a filing by either one, I assume they can’t do it for now.

With call options, when a call is sold, the writer of the option must either:

  • Bear the risk in full
  • Buy other call options to hedge, and/or
  • Buy GME stock to hedge, with the risk that you will have to buy more if the stock goes higher, or sell if the stock goes lower.

Buying call options is a leveraged strategy — you can win or lose a lot — usually it is lose. On net, the market is not affected much — for every buyer there is a seller, and derivative positions like calls net to zero. The only time when that is not true is when prices move so fast that margin desks can’t keep up. At that point, brokers take rare losses.

Co-ordinated trading by small traders, perhaps influenced by wallstreetbets at Reddit is something new-ish, though it is reminiscent of the bull pools that existed in the early 20th century. The main difference is that it is a lot of little guys versus a few big guys. Regulations today call a few big guys trying to manipulate the price of a stock “market manipulation,” which is illegal. That does not apply to little guys talking to each other, most likely.

But there is a greater problem here. Even if you are participating with wallstreetbets, how do you know when others will sell to lock in profits.? It’s not as if anyone is looking at the likely flow of future dividends. The dividend has been suspended. Eventually the willingness of the “bull pools” to extend more liquidity will run out. Then there will be a run for the exits — this is a confidence game. Don’t be a bagholder.

With respect to total return swaps, it is the same issue as call or put options. Someone has to take the other side of the trade, and either bear the risk or hedge the risk. There usually should be no net effect.

Finally, there is moving GME shares to the cash account, which means those shares can’t be borrowed in order to short them. There are two points here:

  • There is already illegal naked shorting going on here, so moving shares to the cash account may not do much.
  • If you are a monomaniac, and are pursuing only GME, you might decide to lever your position via margin. At that point it is not possible to move shares to the cash account.

That takes care of the technicals, now on to the fundamentals.

The Weighing Machine

The fundamentals of GME are lousy. How many of you know their debt ratings? I see one guy in the back raising his hand at half mast. Well, let me tell you that GME has two bonds outstanding:

  • $216+ million of a secured first-lien note rated B2/B- maturing in 2023 with a 10% coupon trading in the mid-$103 area for a mid-6% yield-to-worst, which GME can’t likely call.
  • $73+ million of an 6.75% unsecured note rated Caa1/CCC+ maturing in less than two months with a mid-5% yield.

Both of these notes are trading above par, but they still trade as junk. If it were not from the interest of RC Ventures they would trade a lot lower. They did trade much lower before RC Ventures bought their stake — yields for the unsecured debt exceeded 40% annualized.

This is a troubled company that would be teetering on the brink of bankruptcy were it not for the efforts of RC Ventures. As such, I would say that the value of GME is at most the price that RC Ventures is willing to pay for it, and that amount is uncertain. (Did I mention that they are losing money regularly?)

And to the bulls I would add, don’t discount the possibility of a trading suspension where you can’t get out of your positions. I can tell you that if that happens the price of GME will be a LOT lower when trading resumes.

What is not “Advice”

Here is my non-advice for everyone.

For those that own GME, sell now. I said NOW, you waited ten seconds.

For those that are short GME, hold your short to the degree that you can.

To the management of GME, do a PIPE, sell a convertible bond or preferred stock. Buy another company in a stock swap. Do anything you can to monetize the idiocy of the bull pool at wallstreetbets. They are offering you a free lunch. Hey, and as an added incentive, RC Ventures can’t sell right now, but you can. Every bit of monetization that you do will benefit RC Ventures to a degree, and dilute them as well (a plus!).

Take the dopes at wallstreetbets to the cleaners, and show them the power of the primary market as you dilute them. Oh, and while you have the opportunity, pay off your bonds, or at least set the money aside in escrow to redeem them at the call date. That is the rescue strategy for GME: sell stock to the losers who have foolishly bid the price up, and use it to rebuild you business. Even RC Ventures may thank you.

Full disclosure: no positions in GME

The Challenge for Warren Buffett

Posted on by David Merkel

Photo Credit: Javier || THis is a much younger version of Buffett. Has the present Buffett learned to adapt?

Barron’s ran an article called Why Berkshire Hathaway Stock Has Rarely Been This Cheap. It was written by Andrew Bary, a man that I respect. I wrote a comment at the article, and it reads as follows:

So long as the government & its commercial paper financing arm (The Fed) is willing to create grants and credit out of thin air to rescue businesses, Buffett will not get opportunities to buy stock at the discounts that he has liked to see in the past. The cash pile will grow, & BRK stock will likely muddle.

Buffett’s justification for the cash pile changed at his last annual meeting, saying BRK needed it for catastrophes from their insurance underwriting. He has always faced that risk, and in the past has said that he might need $20B for that. (And he commented that his insurance companies were well-reserved, which is probably true.)

Choices for Buffett: 1) lower his hurdle rates for purchase down to levels where the government starts to act. 2) let the cash pile grow, and buy a huge business with significant moats that he could never dreamed of owning. 3) Start a slow buyback of stock and set a slightly higher multiple of book for where to cut it off. 4) Pay a special dividend, or, start a regular dividend. 5)Tell the managers of the operating businesses to look for decent-sized private businesses that they admire, particularly ones with succession issues. Send Buffett a proposal, and he will send a price. You can make the offer to the firm to join the BRK family. 6) Give Ted and Todd and the operating managers lower hurdle rates for investment. 7) Just muddle along, as it is now.

Order of likelihood: 7, 2, 3, 5, 6,1, 4. I don’t think Buffett will change much.

Why Berkshire Hathaway Stock Has Rarely Been This Cheap

My main contention with Buffett, as I am a shareholder, is that you can’t rely on the past when considering how far the market may fall when there is a crisis.

The nature of the US economy is that the Fed, and maybe the Treasury, or Congress, may borrow money to bail out those in distress, partly because the US economy is so indebted, that they can’t let debts be liquidated, lest we have a depression. Thus, low interest rates, low marginal productivity of capital, and low GDP growth.

In such a situation, the market will not fall enough to offer the values of a lifetime. The Fed will dilute the capital stock to provide a rescue, while Buffett finds himself diluted. Buffett’s money can’t buy a good company at a cheap price.

I sold half of my holdings in BRK recently, after I learned that Buffett did nothing during the recent fall in the stock market. Market values are relative, and there were certainly decent values to be realized in late March. You wouldn’t blow the whole wad, but surely you should have bought something.

I may sell off the rest of my holdings in BRK. Under the right conditions, I would buy more. The question is whether Buffett has an outdated view of how much the market could fall, given the skittish attitudes of economic policymakers.

Full Disclosure: long BRK/B for myself and clients

The Rules, Part LXVI

Posted on by David Merkel

Photo Credit: Heather R || Round and round it goes, where it stops, nobody knows

Don’t bet the firm.

Attributed to the best boss I ever had, Mike Cioffi. I learned so much from him.

I was surprised to see how many times I mentioned at this blog how I considered and dropped the idea of writing floating rate Guaranteed Investment Contracts [GICs]. A lot of effort went into that decision, and unlike most decisions like that, the failures of competitors with a different view happened quite rapidly.

Also, this blog highlighted those that wrote terminable floating rate GICs later, and insurers that wrote contracts that had clauses allowing for termination upon ratings downgrades.

But that’s my own story. What of others?

The best recent example that I can give is oil producers both in 2015-6 and today. When oil prices plunged, many smaller marginal oil producers went broke. Why didn’t they take a more cautious view of their industry, and run with stronger balance sheets that could endure low crude oil prices for two years?

If you are managing for the price of your stock, maximizing the return on equity is a basic goal for many. That means shrinking your equity capital base, and living with the risk that your company could go broke with many others if the price of crude oil drops significantly. Of course, you could try to hedge your production, but at the risk of capping your returns.

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The main idea here is to have a strategy where you stay in the game. This means running with a thicker balance sheet, and hedging material risks. What stands in the way of doing that?

Having a thicker balance sheet might give a firm a lower valuation, and attract activists that will attempt to buy up the firm, partially using the excess capital that aided safety. The antidote to this is to actively sell shareholders on the idea that the firm is doing this to preserve the firm from the risk of failure, much as Berkshire Hathaway keeps excess assets around for reasons of avoiding risk and allowing for the possibility of gaining significant returns in a crisis.

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If you work for a single firm, most would say, “Of course! Don’t bet the firm! What, are you nuts!?”

But incentives matter. Where there are bonuses based on sales growth, sales will happen, regardless of the quality of them. Where there are bonuses based off of asset returns over a short period, you will have managers swinging for the fences. Where there are annual profit goals, there may be aggressive accounting and aggressive sales practices. But who cares about next year, much less the distant future? Who cares for the long-term interests of all who are affected by the firm?

Corporate culture matters. Excellent corporate cultures balance the short- and long-runs. They strive for excellent results while protecting against the worst scenarios. If the firm is able to survive, it can potentially do great things. Not so for the firm that dies.

To that end, incentives should be balanced. Those that play offense, like salesmen, should have a realized profitability component to their bonus. Investment departments should be judged on safety as well as returns. Conversely, defensive areas need to have some of their bonuses based on profits, and profit growth. It’s good to get all of a firm onto the same page nd be moderate, prudent risk-takers.

In closing, the main point here is that there is no reward so large that it is worth risking the future of the firm. Take moderate and prudent risks, but don’t take any risk where you and all of your colleagues may end up searching for new work. It’s not worth it.

Beyond that, to those that structure bonus pay, be balanced in the incentives that you give. Let them benefit from their individual efforts, but also benefit from the long-run safety and profitability of the firm as a whole. That will result in the greatest benefit for all.

Estimating Future Stock Returns, December 2019 Update

Posted on by David Merkel

Graphic Credit: Aleph Blog, natch… same for the rest of the graphs here. Data is from the Federal Reserve and Jeremy Siegel

Here’s my once a quarter update. If you owned the S&P 500 at the end of 2019, it was priced to give you a return of 2.26%/year over the next 10 years. That said, the market has changed a lot in the last 2.6 months –as of the close of business on March 18th the market was priced to give you a return of 7.28%/year over the next 10 years. Finally, you have a chance to double your money over the next ten years, while a 10-year Treasury would give you 1.5%/year over the same horizon. To match the expected returns on stocks at this point in bonds, you would have to invest in junk debt, but junk typically doesn’t go longer than 10 years, and who knows what the defaults will be over the next two years?

Now, actual returns from similar levels have varied quite a bit in the past, so don’t take the 7.28%/year as a guarantee. WIth a 2%/year dividend yield, price returns have ranged from -0.95%/year to 6.89%/year, with most scenarios being near the high end.

At the end of 2019, valuations were higher than any other time in the past 75 years, excluding late 1964, and the dot-com bubble. It is not surprising there was a bear market coming. Because “there was no alternative” to stocks, though, it took an odd external event or two (COVID-19, oil price war) to kick bullish investors into bear mode. This was not a supply and demand issue in the primary markets. This was a shift in estimates of investors regarding the short-term effects of the two problems extended to a much longer time horizon.

Two more graphs, and then some commentary on portfolio management. First, the graph on the channel the market travels in, subject to normal conditions:

This graph shows how the model estimates the price level of the S&P 500. It is most accurate at the present, because the model works off of total returns, not just the price level. The gap between the red and blue lines is mostly the effect of the present value of future dividends, which are reflected in the red line and not the blue.

The maximum and minimum lines have hindsight bias baked into them, but it gives you a visual idea of how high the market was at any given point in time — note the logarithmic scale though. If you are in the middle using linear distance, you are a little closer to the bottom than the top.

And finally, that’s how well the model fits on a total return basis. Aside from the early years, it’s pretty tight. The regression explains more than 88% of the total variation in returns.

Implications for Asset Allocation

If you haven’t read it, take a look at my article from yesterday. I am usually pretty disciplined about rebalancing, but this bear market I waited a while, and created two schedules for my stock and balanced fund products to adjust my cash and bond versus stock levels. I decided that I would bring my cash levels to normal if the market is priced to give its historical return, i.e. 9.5%/year over the next ten years. That would be around 2100 on the S&P 500. Then I would go to maximum stock when the market is offering a 16%/year return, which is around 1300 on the S&P 500.

The trouble is this is psychologically tough to do when the market is falling rapidly. I am doing it, but when I rebalance at the end of the day I sometimes wonder if I am throwing my money into the void. Remember, I am the largest investor in my strategies, and if my ideas don’t work, I will lose clients, so this is not an idle matter for me. I’m doing my best, though my call on the market was better during the first decade of the 2000s, not the second decade.

In the process, I bought back RGA at prices at which I love to have it, and have been reinvesting in many of the companies I own at some really nice levels… but for now, things keep going down. That’s the challenge.

In summary, we have better levels to invest at today. Stocks offer better returns, but aren’t screaming cheap. Some stocks look dirt cheap. Most people are scared at the speed of the recent fall. I view my job as always doing my best for clients, and that means buying as the market falls. I will keep doing that, but I have already lost a few clients as a result of doing that, even though I tell them in advance that I will do that. So, I will soldier on and do my best.

Full disclosure: long RGA for clients and me

The S-Curve, Once More, with Feeling

Posted on by David Merkel

Photo Credit: Lars Plougmann || Indeed, this seems like a race, and the S-Curve is a major challenge to drive through

This will be brief, because I am still working on it, but it is my weak conviction that as far as the markets are concerned, the COVID crisis will largely be over by next Friday. How certain am I? Not very — I give it a probability value of around 30%.

If my thesis is correct, reported new cases of COVID-19 in the US will peak by Friday of this week, and will be 90% complete by next Friday. I will be watching how many new cases are reported. New cases tend to peak when total cases increase at a mid-teens percentage rate over the prior day. Because reporting is noisy, you don’t see that so easily, but the inverse logistic curves I am estimating are consistent on that figure for all the countries I have modeled so far.

I’ve run models for South Korea and Italy as well, and I’ll run them for a few more countries tomorrow. They are all pretty consistent with each other. Italy’s new cases should peak tomorrow, if they haven’t already.

I know everything is dark and gloomy now. Even if my modeling is wrong, which is a significant likelihood (I am extrapolating), I find it difficult to believe that we will still be in crisis mode by tax day.

So, cheer up. The number of COVID-19 cases is unlikely to be overwhelming, and we are all likely to survive this. The markets will revive, though maybe not energy stocks for six months. Those are a separate issue.

And if new cases track my estimates, I will put more money into the market. That’s all for now.

SImilarities of the Coronavirus to 9-11

Posted on by David Merkel

Photo Credit: Gene Han || This picture was taken four years after the attack.

I am going to reprint here the beginning of the article The Education of a Corporate Bond Manager, Part VI. I am doing this because it describes how our investment department dealt with 9-11. Here it is:

After 9/11, and and before the merger was complete on 9/30/2001, our investment team got together and came to an unusual conclusion ? 9/11 would have little independent impact on the credit markets, so be willing to take credit risk where it is not well-understood by the market.? We bought bonds in hotels, airplane EETCs (A-tranches), anything having to do with confidence in the system at that time.? I consciously downgraded our portfolio two full notches from September to November.

I went to a Chief Investment Officers’ conference for insurance investors in October 2001.? What I remember most is that we were the only company being so aggressive.? In a closed-door meeting, the representative from Conseco told me I was irresponsible.? To hear that from a company near bankruptcy rang the bell.? I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!? The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.? We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous ?up in credit? trade as we began to make a lot of money.? By the time I was done in early June, I had upgraded the whole portfolio three full notches.? A great trade?? You bet, and more.? What?s worse, it was what the client wanted, but not what it should have wanted.

The Education of a Corporate Bond Manager, Part VI

9-11 was a shock to the system, but one where our investment team concluded that everything would return to normal, and relatively soon. We thought that the terrorists had gotten lucky, and that there was no persistent threat. Thus, prosperity would return, well, as long as the economy would hold up, which was in question at that time. The second-order effects of the deflation of the dot-com bubble were more severe than 9-11 would ever be.

From October 2001 through October 2002, our department bravely soldiered on, and during that time I played the speculation cycle relatively well, as noted in other episodes of “Education of a Corporate Bond Manager.”

The main challenge was trying to separate the transitory from the medium-term from the permanent. 9-11 was transitory. Deflation of the dot-com bubble was medium-term, and general prosperity was the long term — and definitely so at the valuations experienced in October 2002.

The same is true today. The coronavirus, no matter how ugly it will be, is transitory, as are the effects on the supply chain, travel, etc. But if you can believe it, valuations are still absolutely high (5.5%/year over the next 10 years), though not high relative compared to bonds and cash.

So, if you have courage, buy the damaged industries. People will still travel, and not a lot of people will die. Buy the strongest companies that you know will survive.

My main point to you is this: the coronavirus is transitory. Act as if it is so, and think about what the economy will be like 3-5 years from now. Do that, and you will likely prosper, unless the effects of too much debt finally comes to bear on the market. We can’t tell when the day of reckoning will come on that topic.

What Makes An Asset Safe?

Posted on by David Merkel

Photo Credit: acciarini ||Sometimes a good conversation elucidates a matter…

Q: What defines a safe asset?

A: My, but that is a broad question. Do you have something more specific that you are trying to answer?

Q: Well, I’ve heard that the wealthy often invest their excess assets in real estate. It seems perfect. As Twain said, “Buy land, they aren’t making any more of it.” It provides income, and protects against inflation.

A: Do you own the land free and clear, or did you have to borrow to own it?

Q: I don’t own any land, aside from my house, and yes, I have a mortgage there. Why are you asking this?

A: Do you remember the financial crisis 2008-2011?

Q: Yes, but why does that matter?

A: Many people had paid a lot for their homes, and were stretched in making mortgage payments. Then one of the Ds hit.

Q: Ds?

A: As written by one wordy blogger:

3) As housing prices fall, which they should because housing is in oversupply, more homeowners find themselves in trouble.  Remember, defaults occur because a property is underwater, and one of the five Ds hits:

  • Divorce
  • Disability
  • Death
  • Disaster
  • Dismissed from employment

Q: My, but he is a piece of work. So, houses aren’t a safe asset?

A: Well, most of the time they are, particularly if don’t have any debt on them. But there are situations where housing prices have been bid up to where the prices don’t justify the cash flows if you are borrowing to own it and are renting it out.

Q: What do you mean?

A: No asset’s price can survive if the implicit net rent is negative. I.e., if you have to feed the property to hold it.

Q: Huh?

A: Imagine that instead of living in your home, you borrowed money to buy the house, and have rented it out. What I am saying is that when those that do this are losing money, the price of the house is too high. They are relying on price appreciation to bail them out, and no one can control that.

Q: Is there a simpler way to say this?

A: When you have to give up money to hold onto an asset, you are in a weak position, and it means you should sell, particularly if many people are having to do the same thing. Properly priced assets produce cash; they don’t consume cash. If on net it is cheaper to rent than borrow and own, then it is probably better to rent.

Q: Are you just saying that risk is a function of the price of the asset? An overpriced asset is risky, and an underpriced asset is not?

A: I am saying that, but there is more to say as well. An asset could be priced below its fair market value, and it could still be risky if it is misfinanced. Take for example the insurance company General American back in August 1999.

Q: Huh?

A: Old news, I know, and most people don’t follow insurers. But they had written a lot of floating rate GICs terminable at par in 7 days if they got a ratings downgrade. What was safe if it had only been 5% of their assets became toxic at 25% of their assets. The amount they were selling ballooned because money market funds could treat the assets as short-term paper.

Once the downgrade came, there was no way to raise that much money so fast. They ended up selling out to MetLife for 50% of their net worth. MetLife picked up control of one of their subsidiaries, RGA, in the process. They made exceptionally good money on that purchase.

It’s like crossing a stream that is 3 feet deep on average, but there is a spot in the middle that is 20 feet deep. If you can’t swim, don’t cross it.

Q: I heard you wrote to Cramer about General American at the time.

A: Yes, that was my first email to him, and I explained the situation in such detail that he republished the email for readers. That was my introduction to Cramer.

Q: So, you are saying there are two things to safety — price and financing?

A: That’s all I’ve said so far, but there are a few other things. The character of management matters. Remember my piece, Dead as a Severed Horse?s Head?

Q: Oh, the zinc miner that sided with the bondholders against the shareholders?

A: Exactly. With better management, they could have skated through the troubles, and perhaps sold the company to a larger base metals miner like BHP.

Q: Is any of this similar to the losses you took on Scottish Re or National Atlantic?

A: Yes. I thought you were my friend, though.

Q: Well, I read your confession pieces on both of them.

A: It still hurts, but faithful are the wounds of a friend.

Q: Proverbs 27:6, I like it.

A: I still remember the stress and the losses.

Q: Then is that all? Price, leverage, and management?

A: Pretty much. There are some secondary matters to those who do not want to do the hard work. Companies that pay dividends and buy back stock are shareholder friendly, and that is good so long as they don’t borrow too much to do that.

Also, there are the issues of operating leverage — companies with low fixed costs are safer. But that’s about it, unless you want to talk about investments other than stocks.

Q: Can we take this up later?

A: Sure, let’s take this up in part 2.

Limits

Posted on by David Merkel

Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are

I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”

Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”

Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.

These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.

I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.

In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).

It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.

Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.

Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.

Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.

One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.

Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.

Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.

As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.

One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.

Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.

Summary

Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.

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