As part of a continuing quest to turn up stock ideas in the midst of a market hitting new highs, I wanted to trot out a less commonly used statistic called “range.” ?Range is the distance that a company’s stock price is between its 52-week low and 52-week high. ?0% means the current price is at the 52-week low, and 100% means?the current price is at the 52-week ?high. ?So far, simple, right? ?How might industries look if their weighted average range statistics were calculated, weighted by market cap?
The top zone, which is shaded light red, are industries that are above the median?range statistic in the market which is around 78.5% (average is around 72.2%). ?The industries shaded yellow represent industries where the stocks are closer to their 52-week high than their 52-week low, but are have average range statistics lower than the median of the market. ?Finally, the industries shaded green, what few there are, their current prices are closer to their 52-week low on average.
Personally, I would be inclined to look through the industries toward the bottom of the list, looking for misunderstood companies that have good potential of future outperformance. ?That said, someone thinking that this rally would have a long way to go would be incented to look for companies at the top of the list who have trends that are underdiscounted.
As it is, this is where the industries are priced in terms of the past 52 weeks. ?You could?look at the industries with the view of finding things that are out of place, and prices could shift in the future to reflect it.
If nothing else, this is food for thought. ?Technology, Utilities and Healthcare look strong. ?Basic materials, Capital Goods, and Consumer Durables look weaker.
You can never quite tell where blogging may take you. ?I know that if I lived near New York City, some opportunities would open up that presently aren’t likely. ?Living near Baltimore/DC has had its share of opportunities, though.
In general, if I get asked to appear somewhere, I’ll try to make time on my schedule for doing so, whether it is:
Internet TV
Internet Radio
Local Radio
Fox Business News (with Cody Willard)
Speaking at a local High School
Speaking to a local College
Speaking to meetings of the Society of Actuaries, local Actuarial Societies, local CFA Societies, etc.
Talking to the staff at SIGTARP, giving a lesson on how insurance companies work
And more… if someone had told me all of the things that I would do as a result of saying “yes” to Jim Cramer’s invitation to write for RealMoney.com eleven years ago, I would have been surprised. ?The thing I would have been most surprised at would have been the total amount of words that I have written. ?I viewed myself eleven years ago as a mathematical businessman, but not a writer.
About five days ago, I was invited to appear on RT America’s show Boom Bust. ?What I did not know at the time was that Ed Harrison of Credit Writedowns was behind getting me onto the show. ?I’ve known Ed for some time — he was one of the original attendees at the only Aleph Blog Lunch.
I also didn’t know what I would be talking about on the show, so when I got pulled into the makeup room (me?) ten minutes prior to airtime, I was saying to myself, “I guess I have to ‘wing it.'” ?Then Ed popped his head through the door and said “Hi,” and explained everything to me. ?What a relief! ?I went back to the Green Room, scribbled out a few notes — not that I could take it with me, but just to get my mind in order for what I *might* be asked about.
As it was, it went fast, like every other time that I have been on live TV or radio. ?What was eight?or so minutes felt like two. ?Are there things I would have said differently with more composure? ?Yes. ?But that’s part of the fun of it: thinking on your feet, because I knew little about what the actual questions would be.
If you want to, enjoy watching the video of RT America Boom Bust. ?My particular portion is on from 3:30 to 12:00 or so. ?Ed Harrison is on at the end. ?I stayed to watch that segment live, and talk with Ed and the charming host Erin Ade afterwards. ?It was a fun end to my workday.
In the near future, I will be writing a a review of Guy Spier’s The Education of a Value Investor, which will be released next week. ?Until then, to whet your appetite, here is an 11 question Q&A that I did with Guy, for which I give him thanks, because his time is valuable.
What company have you owned the past that was the most surprising to you? (In prospect or in retrospect)
I think that many have surprised me in one direction or another, but one of the more memorable was Duff and Phelps Credit rating ? which I purchased in the mid-1990?s at a 7 Price to Earnings ratio. The company proceeded to increase in value by seven times over 2-3 years before being purchased by Fimalac, the owner of Fitch. I had expected the stock to double, but I did not understand that I had purchased a super high quality business with a manager who was committed to devoting every cent of free cash, which?was in excess?of reported earnings, to repurchasing shares.
Which rule(s) of your checklist would surprise average investors the most, if any?
I actually think that none of them would. They are common sense items that anyone would look over and say, ?yes ? that makes obvious sense?. What is key is not that they are surprising, but that in the wrong state of mind, I might easily skip over a particular factor in evaluating an investment.
Would you advise young people to get a CFA charter or an MBA or is there a better way to become an investor?
I don?t think that either is necessary in order to become a good investor. Attending the Berkshire Hathaway meetings, studying Warren Buffett and reading the Berkshire Annual Reports, along with Poor Charlie?s Almanack are an absolute necessity, in my view.
Would you ever consider setting up your own holding company like Buffett did? (Permanent capital has its attractions?)
Yes. It?s a no brainer to do it if you have the skills.?I hope that?I have the skills, but I don?t think that the time has been ripe for me. Mohnish Pabrai has recently launched Dhandho Holdings which?I think will be an?extraordinarily successful enterprise over?the years. It?s one to watch.
What would you say is the most common mistake that value investors make? Does this matter if the value investor is amateur or professional?
I think that all-too-often, we feel like we are forced to take a decision. Warren Buffett has often said that, unlike baseball, there are no ?called strikes? in investing. That is a truism, but the point is that too many of use act like it is not true. Amateur investors, investing their own money, have a huge advantage in this over the professionals. When you are a professional, there is a whole system of oversight that is constantly saying, ?What have you done for me lately!? or in baseball terminology, ?Swing you fool!?
?Amateur investors who are investing?unlevered?funds that they don?t need any?time soon have no such pressures.
Financial companies are usually a big part of the portfolio of value investors, because they seem cheap to industrials and utilities. But every now and then financials wipe out in a credit crisis. Why don’t many value investors pay attention to credit conditions?
Yes, that?s absolutely true. Many value investors love the financial industry: Probably because, in a certain way, we are in it ourselves. And yes, value investors probably pay far too little attention to the credit cycle. In my case, I think that I was utterly convinced that my?stocks were sufficiently cheap, such that I could invest without regard to financial cycles. But I learned my lesson big time in 2008 when I was down a lot.?I now subscribe to Grant?s Interest Rate Observer so as?to help me track the credit cycle.
Are your wife and children happier as a result of the changes to your life since becoming a value investor in the style of Warren Buffett?
Absolutely. I spend more time with them. I am simply around more,?although that can come with its own irritations. You might have to ask them.
I appreciate your “investing tools,” and I do things mostly like that, but isn’t the main goal of them to be reasoned, dispassionate, independent-minded, etc.? The actual form of the rules is less important than the effect it has on our personalities in making decisions rationally, yes?
Yes ? I 100% agree and thus a different personality might have a very different set of rules to guide them. That?s why the book is about my education as a value investor. It?s personal and idiosyncratic.?I would fully expect someone?else to come up with different rules of behavior. ?I do hope though that it will allow people to see that getting to a reasoned, dispassionate, independent minded state is a struggle for this investor, at least and that thinking about our meta environment and making good decisions about that is just as, if not more important than the actual investment decisions.
How do you balance keeping an independent view versus interacting with respected professional friends who have their views?
I try to switch off, or distance myself from people who I think communicate in a way that is not productive for me. The key is to have the kind of discourse that allows other people to come to their own conclusion. Asking open ended questions and not telling someone what to do are important aspects of that. When I come across people who do that, I try to build closer relationships with them. If they don?t I might still keep them in my circle, but I would not allow myself to interact with them too often ? because I don?t want to be swayed.
How do you feel about those who use 13F filings to generate ideas?
Mohnish Pabrai taught me to be a cloner. In the academic world, plagiarism is a sin. In business, copying other people?s best ideas is a virtue, and it is no different in investing. I would go further. In the same way that if I wanted to improve my chess, I would study the moves of the grandmasters, if I want to improve my investing, I need to study the moves of the great investors. 13F?s are a great way to do that.
How do you feel about quantitative value investors?
I am not sure that I understand the way that you are using the term. If you mean to use statistical methods to uncover value, Ben Graham style, then I?m all for it. That is what I did when I created my Japan basket. That said, I found it hard and monotonous work. Monotonous because, in the case of Japan it did not lead to greater knowledge or wisdom about the world, because there was a limit on the degree to which I could drill down. But that said, I do run screens for value on S&P CapitalIQ from time to time, and then drill down on some of what comes up.
Again, thanks to Guy Spier for taking time to answer some questions for us… his book is being released on September 9th. ?Look for it.
Full disclosure: The Author and some PR flack?asked me if I would like a copy and I said ?yes.?
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 is a book that starts with a simple premise: buy stocks at a fraction of the per share intrinsic value of the company, conservatively calculated. ?Neat idea, huh, and it is called value investing.
The author starts by giving a preview of where he will end — with Carl Icahn when he was much younger, where he was buying closed-end funds at large discounts, and pressuring managers to liquidate the fund. ?Eventually he started doing the same with overcapitalized companies trading a discount to the net worth of the company.
Then the author takes us on a trip through history, starting with Ben Graham buying the shares of companies at?prices lower than the net liquid assets of the company, net of the debt. ?It was easy money while it lasted, but eventually many of those companies were bought up and liquidated, and many of the rest had the stock price bid up until the value was no longer compelling.
Then we get to travel along with Warren Buffett and Charlie Munger, who note that the easy pickings are gone, and begin investing in companies that are inexpensive relative to their growth prospects. ?This is more complicated, because these companies must have an advantage that will sustain their effort versus their competition.
Then we visit Joel Greenblatt, where he analyzes buying good companies at cheap prices, analyzing them the way an acquirer might do, but also looking for high returns on invested capital. ?Lo, but it works, and furthers the efforts of those trying to obtain excess returns.
Then the book gets gritty, and looks at mean reversion of companies that have done poorly over the last four years. ?Surprise! The worst tend to do quite well on average. ?Also, raw application of simple valuation ratios tend to work on average in stock selection. ?People undervalue the boring crud of the market, and overvalue the glamorous stocks, leaving an investment opportunity.
Then it tells a story that is personal to me, that of Litton Industries. ?Litton Industries was one of two stocks I owned as a boy — gifts from relatives. ?Litton Industries was a company that in the ’50s and ’60s used its highly valued stock to buy up companies that were not highly valued, and made Litton look like its earnings were growing rapidly, which propelled the value of Litton stock still higher. ?So long as Litton could keep acquiring cheap-ish companies, the idea kept working, but eventually that ended, and the stock price crashed. ?When did my relatives buy me shares of Litton? ?Near the end, natch, when everyone know how wonderful it was.
Quite a lesson for an eight year old to see the stock price down by 80% in a year. ?The other stock, Magnavox, did that also, so it is a testimony to my mother’s own clever investing that I ended up in this business… my story aside, the point of the Litton chapter was to point out that not all earnings growth is real, and that it is far better to focus on boring companies than what seems glamorous and successful. ?Untempered optimism tends not to be rewarded.
The book then moves onto investors large enough to effect change outright, buying enough of a company to force change in a management team that is lazy, incompetent, or overly conservative. ?The book goes through the experiences of Ronald Brierly, T. Boone Pickens, and Carl Icahn. ?The art of spotting an undervalued company, and gaining enough influence to buy the company and fix it, or see the company sold to another company that will?fix it, can lead to great gains.
Here the trail ends. ?It started with Ben Graham buying companies that would be good investments regardless, moves to companies that will be good investments if you analyze them more closely, and ends with companies that good be good investments if you could influence a change in corporate behavior. ?The same principles are being applied, but with much more analysis and potentially threat of a takeover.
In closing, the book talks about what can be a way of measuring moats, which is gross profits as percentage of assets. ?It also reviews what factors activist investors look for when they invest, which may give the clever a guide into what stocks to pursue.
Quibbles
I liked the book, and I?recommend it, but in one sense the book is a ?statement of how tough the value investing game has become. ?Ben Graham could sit back and do simple analyses, pursuing artistic endeavors and the good life in his spare time. ?We have to analyze far more closely, and be aware of whether what companies larger activist players may consider. ?Value investing still has punch for amateurs, but there is a lot more work and analysis to do.
Full disclosure: The PR flack?asked me if I would like a copy and I said ?yes.?
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.
One of the challenges of fundamental investing is trying to find decent ideas that are off the radar. There are a number of ways to try to do that by looking at:
smaller foreign companies
companies that have made some significant losses.
companies where the relative performance is so awful that no?manager benchmarked to an index would dare touch the company.
small companies with modest?insider buying.
companies in boring industries that you know can’t have any significant growth. ?(This excludes “buggy whip” industries.)
companies where insiders own so much of the company, that it can’t easily be taken over.
complex companies that are difficult to understand.
Okay, tall order. ?That said, I’ll do a few articles over the next two months that try to unearth companies that might be suitable candidates for analysis. ?Tonight’s article follows up on what I wrote in my last article, where I said:
Sometimes I like to run a screen for?stocks have done badly over the last four years, but have begun to outperform over the last year. ?This can point out areas that are still ignored by most of the market, but where trend may have shifted. ?I?ll post that screen after my software has its weekly update on Saturday.
I’m going to show you the list, with some additional data to give some context, but remember this: the only reason these stocks are here is that they underperformed the market massively for the last four years, and have had a turn in performance in the last year. ?Anyway, here is the list:
I’ve been analyzing stocks for over 20 years… out of the 49 companies listed here, I recognize 24 of them. ?I own none of them at present, though I have owned four?of them in the past [AKS, DYN, TNP & YRCW]. ?That said, four years of lousy relative performance likely means that few are actively looking at these companies.
As with any analysis on the internet, purchasing or selling shares of companies like this is?at your own risk. ?I’m planning on looking through this list for ideas, and if I find one good enough to buy for my clients and me, I will do a write-up after we have established our position.
In order to get there, I would have to be satisfied about a number of things regarding any one of these companies:
What went wrong over the last four years?
Has management fixed what was wrong? ?(Or, is there a new management with better ideas?)
Is the business adequately capitalized?
Is the accounting likely honest/conservative?
Do they have a?large?area where they can earn money sustainably, or are they up against stronger competition almost everywhere?
If they are in a tough industry, are they one of the few that could survive if conditions got markedly worse?
Does management seem intelligent in using excess cash?
The question is to look for a margin of safety, and then see whether the company will earn a return on its business that is attractive at your entry price. ?This is a challenge, but maybe one or two companies out of 49 could make it.
I’m going to show you two portfolios — I’m not initially going to tell you much about either one, but then you can consider which one you might like better. ?Here’s portfolio A:
And here is portfolio B:
There is one obvious difference in the two portfolios: portfolio B has gone up more than portfolio A in the past year. ?But the hidden story is that portfolio A’s stocks have had price returns of -85% or worse over the past four years, whereas portfolio B’s stocks have has price returns of 1000% or better. ?They are the only stocks with current market caps of over $100 million that meet those criteria.
Now, which one would you choose, if you had to hold one portfolio for the next year? The next four years?
Oddly, the right answer might be portfolio A. ?Currently, I am reading through a book called Deep Value, which I will review in a week or two, and they cite in Chapter 5 some research by Thaler and De Bondt which indicates that portfolios that have gone through extreme failure tend to outperform portfolios?that have gone through extreme?success.
Though the momentum anomaly (weak as it has been recently) usually favors portfolios with stronger price momentum, the relationship breaks down over longer periods of time, and more severe moves, where mean-reversion tends to take over. ?One thing that I can tell looking at the two portfolios — the expectations are a lot, lot higher for portfolio B than portfolio A. ?Things only have to stop getting worse for there to some positive price action there.
Sometimes I like to run a screen for?stocks have done badly over the last four years, but have begun to outperform over the last year. ?This can point out areas that are still ignored by most of the market, but where trend may have shifted. ?I’ll post that screen after my software has its weekly update on Saturday. ?Until then.
PS — as an aside, it will be fun to review the relative performance of these portfolios.
Somewhat less than three years ago, I wrote two articles on Behemoth stocks [one, two], which I define as stocks with over $100 Billion of market cap. ?Today I want to revisit those stocks, and those that have joined them. ?The last time I wrote, there were 39 of them actively trading on US Exchanges. ?Now there are 61, for a difference of 22. ?24 stocks are new, and two?have dropped out. ?Let start with those two:
Vodapone plc [VOD] sold off its interest in Verizon Wireless to Verizon, creating a lot of value, and returned a lot of capital to shareholders. ?For those of us who were shareholders, I can only say, great job. ?You made Verizon pay up, and you didn’t blow all of the new free capital on suboptimal projects.
The stock price of Vale, SA [VALE] has gone down considerably (~40%). ?China is no longer a giant vacuum cleaner for minerals The pace of China’s expansion has slowed, and that has had an impact on base metals producers like Vale.
This highlights three things:
In a bull market, once you are big, you tend to stay there.
If you want to create value for shareholders as a behemoth, you need to take radical actions that sell off parts of the company, and return capital to shareholders. ?Managements should think, “How can we reorganize the company such that each component part will be better managed, and lines that we aren’t so good at are sold off.”
In general, these companies are too large to be taken over; change must come from within. ?Activists will only succeed if the managements let them.
Now let’s look at the new companies, which fall into six main groups: Consumer Oriented, Banks,?Pharmaceuticals,?Information Technology,??Industrials, and??Internet.
Consumer Oriented
Anheuser Busch Inbev SA (ADR) [BUD]
British American Tobacco PLC [BTI]
Comcast Corporation [CMCSA]
Home Depot, Inc. [HD]
Visa Inc [V]
Walt Disney Company [DIS]
Banks
Banco Santander, S.A. (ADR) [SAN]
Bank of America Corp [BAC]
Citigroup Inc [C]
Royal Bank of Canada [RY]
Westpac Banking Corp (ADR) [WBK]
Pharmaceuticals
Amgen, Inc. [AMGN]
Bayer AG (ADR) [BAYRY]
Gilead Sciences, Inc. [GILD]
Sanofi SA (ADR) [SNY]
Information Technology
Cisco Systems, Inc. [CSCO]
QUALCOMM, Inc. [QCOM]
Taiwan Semiconductor Mfg. Co. [TSM]
Industrials
Siemens AG (ADR) [SIEGY]
United Technologies Corp [UTX]
Volkswagen AG (ADR) [VLKAY]
?Internet
Amazon.com, Inc. [AMZN]
Facebook Inc [FB]
?Energy
China Petroleum & Chemical Corp [SNP]
Most of these stocks have become Behemoths as a result of rising earnings and expanding P/E multiples amid the bull market. ?A few, like Facebook and Amazon don’t require much in the way of earnings to support their stock price versus something like an Apple or a Google. ?But let me show you my summary graph regarding now and three years ago for Behemoth stocks:
Three years ago, 2011-13 earnings were estimated, versus 2014-16 earnings today. ?If you look at 2008-10, you can see the impact of the new stocks on the median P/E of the group as a whole. ?In general, the P/Es of the new Behemoth stocks were higher than those that were already Behemoths three years ago, pulling the median at least one multiple turn higher.
And looking at 2011-13 estimated versus the actual, you can see how much valuations have increased over that period. ?It didn’t happen all at once, but the S&P 500 is ~60% higher now than when I wrote the first two pieces (not counting dividends).
In December 2011 you could consider getting 9-10% earnings yields out of the Behemoths. ?Today, you’re looking at 7%. ?Quite a difference. ?Some of it could be attributed to tighter yield spreads, but not to changes in Treasury yields, which are actually higher now than they were in December 2011.
You aren’t as well-compensated today relative?to BBB corporate yields to play in the Behemoth stocks today. ?Now, the Behemoths may be safer than many other stocks in the market, and are priced at a discount to the market averages, but your absolute margin of safety is lower.
What Can Behemoth Stocks do for You?
They can pay you dividends. ?They have relatively protected market niches, and they pay above average dividends — 2.9% on average, and that is with seven that have dividends of less than 1%.
They can go down less than other stocks whenever the next bear market?hits.
What Can’t Behemoth Stocks do for You?
They can’t grow as rapidly as smaller companies.
They can’t be taken over, so improvements from entrenched management teams must come from sweet reason convincing them, rather than barbarians at the gates.
What Could Behemoth Stocks do for You, if Management Teams were Willing to Take Some Chances?
These ideas aren’t likely, because those that manage Behemoth companies like managing these monstrosities, but if they did consider shareholders first:
Energy companies would split into upstream, midstream, refining?and retail companies.
Conglomerates would divide into more focused companies.
Large financial companies would split into companies focused on serving specific markets, realizing that there are few advantages from diversification, and much loss from lack of focus.
Companies would segment into slow-growing legacy businesses which can be reliable income vehicles, and the rapidly-growing portions that could be amazing with some focus.
Frito-Lay would spin off Pepsi.
Procter and Gamble and GE would be even more aggressive about spinning off entities.
The main problem with Behemoths is that they are undermanaged. ?There is only so much a single senior management team can do; the incentives of management teams get rather dull with respect to each division. ?Even the radical decentralization of Berkshire Hathaway can only do so much; a day will come when they will centralize, reorganize and prune, but not while Warren Buffett still leads.
As for me and my clients, we own six of the cheaper Behemoth stocks, comprising ?14% of our holdings, biding our time until I?see better opportunities.
Full Disclosure: Long BRK/B, BP, CVX, SNP, TOT, and WFC
Starting again with another letter from a reader, but I will just post his questions in response to this article:
1)?How much emphasis do you put on the credit cycle? I guess given your background rather a great deal, although as a fundamentals guy, I imagine you don?t try and make macro calls.
2) ?What sources do you look at to make estimates of the credit cycle? Do you look at individual issues, personal models, or are there people like Grant?s you follow?
3) Do you expect the next credit meltdown to come from within the US (as your article suggests is possible) or externally?
4)?How do you position yourself to avoid loss / gain from a credit cycle turn? Do you put more?emphasis?on?avoiding loss or looking for profitable speculation (shorts or quality)
1) I put a lot of emphasis on the credit cycle. ?I think it is the governing cycle in the overall economic cycle. ?When some sector of the economy finds itself under credit stress, it has a large impact on stocks in that sector and related areas.
The problem is magnified when that sector is banks, S&Ls and other lending enterprises. ?When that happens, all of the lending-dependent areas of the economy tend to slump, especially those that have had the greatest percentage increase in debt.
There’s a saying among bond managers to avoid the area with the greatest increase in debt. ?That would have kept you out of autos in the early 2000s, Telecoms after that, and Banks/Finance heading into the Financial Crisis. ?Some suggest that it is telling us to avoid the junior energy names now — those taking on a lot of debt to do fracking… but that’s too small to be a significant crisis. ?Question to readers: where do you see debt rising? ?I would add the US Government, other governments, and student loans, but where else?
2) I just read. ?I look for elements of bad underwriting: loosening credit standards, poor collateral, financial entities focused on growth at all costs. ?I try to look at credit spread relationships relative to risks undertaken. ?I try to find risks that are under- and over-priced. ?If I can’t find any underpriced risks, that tells me that we are in trouble… but it doesn’t tell me when the trouble will hit.
I also try to think through what the Fed is doing, and think what might be harmed in the next tightening cycle. ?This is only a guess, but I suspect that emerging markets will get hit again, just not immediately once the FOMC starts tightening. ?It may take six months before the pain is felt. ?Think of nations that have to float short-term debt to keep things going, particularly if it is dollar-denominated.
I would read Grant’s… I love his writing, but it costs too much for me. ?I would rather sit down with my software and try to ferret out what industries are financing with too much debt (putting it on my project list…).
3) At present, I think that an emerging markets crisis is closer than a US-centered crisis. ?Maybe the EU,?Japan, or China will have a crisis first… the debt levels have certainly been increasing in each of those places. ?I think the US is the “least dirty shirt,” but I don’t hold that view strongly, and am willing to be challenged on that.
That last piece on the US was written about the point of the start of the last “bitty panic,” as I called it. ?For a full-fledged crisis in US corporates, we need the current high issuance of??corporates to mature for 2-3 years, such that the cash is gone, but the debts remain, which will be hard amid high profit margins. ?Unless profit margins fall, a crisis in US corporates will be remote.
4) My goal is not to make money off of the bear phase of the credit cycle, but to lose less. ?I do this because this is very hard to time, and I am not good with Tactical Asset Allocation or shorting. ?There are a lot of people that wait a long time for the cycle to turn, and lose quite a bit in the process.
Thus, I tend to shift to higher quality companies that can easily survive the credit cycle. ?I also avoid industries that have recently taken on a lot of debt. ?I also raise cash to a small degree — on stock portfolios, no more than 20%. ?On bond portfolios, stay short- to intermediate-term, and high to medium high quality.
In short, that’s how I view the situation, and what I would do. ?I am always open to suggestions, particularly in a confusing environment like this. ?If you’re not puzzled about the current environment, you’re not thinking hard enough. 😉
About 1 1/2 years ago, I wrote a seven-part series on investing in insurance stocks. ?It is still a good series, and worthy of your time, because there aren’t *that* many writers freely available on the topic.
This particular article deals expands on part 4 of that series, which deals with insurance reserving. ?I wanted to do this at the time, but I was short on time, and wrote out the general theory there, while not actually doing the time-consuming job of ranking the conservativeness of P&C insurers reserving practices.
Let me quote the two most important sections from part 4:
When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.
Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don?t know for sure.? Some lines of insurance do not have a strong method of calculating reserves.? This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.? The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.
Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.? That is why I try to underwrite insurance management teams to understand whether they are conservative or not.? I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.
and
What is the company?s attitude on reserving?? How often do they report significant additional claims incurred from business written more than a year ago?? Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.
So get out the 10K, and look for ?Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.?? That value should be consistently negative.? That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.
One final note: point 2 does not work with life insurers.? They don?t have to give that disclosure.? My concern with life insurers is different at present because I don?t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.
As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.? Simplicity of product design is a plus to investors.
Today’s post analyzes Property & Casualty Insurers, and looks at their history of whether they consistently reserve conservatively each year. ? Repeating from above, management teams that reserve conservatively?establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves. ?This should give greater confidence that the accounting is fair, if not conservative.
So, I went and got the figures for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years,” for?67 companies over the past 12 years from the EDGAR database. ?Today I share that with you.
When you look at the column “Reserving by Year,” that tells you how the reserving for business in prior years went over time. ?A company that was consistently conservative of the past twelve?years would have “12N’ written there for twelve negative adjustments to reserves. ?Using Allstate as an example, the text is “5N, 1P. 3N, 3P” which means for the last 5 years [2013-2009], Allstate had negative adjustments to prior year reserves. ?In 2008, it had to strengthen prior year reserves. ?2007-2005, negative adjustments. ?2004-3,?it had to strengthen prior year reserves.
Now, in reserving, current results are more important than results in the past. ?Thus, in order to come up with a score, I discounted each successive year by 25%. ?That is, 2013 was worth 100 points, 2012 was worth 75, 2011 was worth 56, 2010 was worth 42 points, etc. ?Since not all of the companies were around for the full 12 years, I normalized their scores by dividing by the score of a hypothetical company that was around as long as they were that had a perfect score.
Now, is this the only measure for evaluating an insurance company? ?Of course not. ?All this measures?in a rough way is the willingness of a management team to reduce income in the short-run in order to be more certain about the accounting. ?Consult my 7-part series for more ways to analyze insurance companies.
As an example, imagine an insurance company that consistently writes insurance business at an 80% combined ratio. ?[I.e. 20% of the premium emerges as profit.] ?I wouldn’t care much about minor reserve understatement. ?Trouble is, few companies are regularly that profitable, and companies that understate reserves tend to get into trouble more frequently.
Comments and Surprises
1) Now, it is possible for a company to game this measure in the short run, where the management aims to always release some reserves from prior year business whether it is warranted or not. ?That may have happened with Tower Group. ?Very aggressive in growth, after their initial periods, they consistently released reserves for eight years, before delivering huge reserve increases for two years.
Now, someone watching carefully might have noticed a reserve strengthening for their non-reciprocal business in 2011, and then strengthenings in mid-2012, before the whole world realized the trouble they were in.
2) Notice in the red zone (scores of 40% and lower) the number of companies that did subprime auto insurance — Infinity, Kingsway, and Affirmative. ?That business is very hard to underwrite. ?In the short run, it is hard to not want to be aggressive with reserves.
3) Also notice the red zone is loaded with companies with much recent strengthening of reserves. ?Many of these companies are smaller, with a few exceptions — the law of large numbers doesn’t apply so well with smaller companies, so they mis-estimate more frequently. ?I won’t put companies with less than $1 billion of market cap into the Hall of Shame. ?It’s hard to get reserving right as a smaller company.
4) As for larger companies, they can be admitted to the Hall of Shame, and here they are:
Hall of Shame
AIG
The Hartford
AmTrust Financial Services
Mercury General, and?
National General Holdings
AIG is no surprise. ?I am a little surprised at the Hartford and Mercury General. ?National General Holdings and Amtrust are controlled by the Karfunkels, who are aggressive in managing their companies. ?Maiden Holdings, another of their companies is in the yellow zone.
Final Notes
I would encourage insurance investors to stick to the green zone for their investing, and maybe the yellow zone if the company has compensating strengths. ?Stay out of the red zone.
This analysis could be improved by using prior year reserve releases as a fraction of beginning of year reserves, and then discounting by 25% each year. ?Next time I run the analysis, that is how I will update it. ?Until then!
In your Industry Ranks August 2014 post you mentioned that you use Value Line analytic tools.
If it is not a secret, what other third-party research and analysis do you use, especially for company analysis (MorningStar, Zacks…)?
Do you rely/subscribed on Interactive Brokers “IBIS Research Essentials?” If yes, do you find it valuable?
In addition, if you do not mind, you said that you make adjustments to your portfolio once in a quarter. Does it mean that you do not look at market quotes during the day at all and, hence, you are not subscribed to IB real-time data (NYSE, Nasdaq, US Bond quotes?)
I would greatly appreciate your answers.
Thank you very much!
I don’t like to spend money on aids for research. ?I can only think of two things that I pay for and actively use:
I do pay for quotes at Interactive Brokers, but because I don’t trade much, I don’t pay for the expensive packages. ?I have not subscribed to?Interactive Brokers “IBIS Research Essentials.”
But many of the best things in life are free. ?My local library offers free Morningstar and Value Line online… I don’t have to leave my home to use it, an it is open all the time. ?If I go two blocks to my library, there is a wealth of business data and books that I can draw upon.
That said, the Web offers a lot of free resources, and I make use of:
Yahoo Finance, which I think I have been using since 1996 — pretty close to its inception. ?There is no better place on the web to get business news tagged for each corporation. ?It has gotten better since removing some feeds that have questionable value. ?There’s a great range of information to be had in a wide number of areas.
FRED, which just keeps getting better… more data series, more ways to use them… and I have been using them since it was a “bulletin board” (remember those?) back in 1991 or so.
Bloomberg.com is excellent in the general and business news areas.
Beyond that, Reuters, Marketwatch, the New York Times, and the Financial Times (especially FT Alphaville) have excellent business news coverage. ?With the last two, NYT & FT, you have to decide if you want to pay for it, and I don’t pay for them.
When I do my stock research, I generally go to the SEC website and read the documents. ?Then I go to Yahoo Finance and the company’s own website for color.
Finally there is a lot of wisdom in many bloggers out there, and I strongly recommend you get to know them. ?Some of the best are expertly curated each day at Abnormal Returns?by Tadas Viskanta.
Now as to your question as to whether I look at prices of assets in my portfolio: in general, I check them 3-5 times a day, usually at a point where I will be switching tasks. ?I sort my stocks two ways at that time:
By absolute percentage change descending — all of the largest movers are at the top of the screen, and I can look for patterns and trends, which may make me check Yahoo Finance for news. ?But that doesn’t make me trade, unless it ends up revealing something that I think will get a lot better or worse, and the market hasn’t figured that out yet. ?(That doesn’t happen often.)
By size of positions — if a position has gotten too large, I trim some back. ?If it has gotten too small, I stop and research why the price has fallen. ?If I am convinced that the stock offers significant returns, and low downside risk, I add a little to the position. ?(See?Portfolio Rule Seven?for more details.) ?In a rare number of cases, about once every two years, I will “double weight” the position that has fallen. ?So far, all of those have worked over the last 14 years. ?But if I realize that the company is unlikely to return anything comparable to the other stocks in my portfolio, I sell it.
Portfolio Rule Seven?trades maybe amount to 3-12 small trades per quarter. ?More trades come when the market is trending, fewer when it is choppy. ?Portfolio Rule Eight?is where I do the big trades once per quarter, comparing each stock in my portfolio against a group of potential replacements. ?I usually sell 2-4 companies, and then buy a similar number of replacements. ?That has my portfolio turn over at a 30%/year rate. ?More details available in the article?Portfolio Rule Eight.
In general, it is wise for both amateur and pro investors to trade by rule. ?Take as much emotion out of the process as possible, and avoid greed and panic. ?It is genuinely rare that decisions have to be made quickly, so take your time, do your analysis, and try to find assets with good long-term prospects.
The top zone, which is shaded light red, are industries that are above the median?range statistic in the market which is around 78.5% (average is around 72.2%). ?The industries shaded yellow represent industries where the stocks are closer to their 52-week high than their 52-week low, but are have average range statistics lower than the median of the market. ?Finally, the industries shaded green, what few there are, their current prices are closer to their 52-week low on average.
