Category: Value Investing

GE Does Not Bring Good Things For Your Life

GE Does Not Bring Good Things For Your Life

Posted on by David Merkel

When is a stock safe enough to buy when it becomes difficult for corporations to find financing?? We can answer the question two ways: 1) Why should we buy stocks when the financial markets are choking?? Better to sit on cash.? 2) We can’t tell when the turn is coming, so if we buy companies that are cheap with strong balance sheets and free cash flow, we should do okay over the intermediate-to-long run.

I’m going to illustrate this with a single stock tonight: General Electric.? Why GE?? Here’s something I haven’t mentioned recently about how I source stock ideas.? I read widely, and when some one tells me a stock is cheap, I write it down for later analysis.? My initial cursory analysis during this time of credit stress looks like this:

Let’s look at earnings estimates:

Yeah, is does look cheap.? How has it done recently relative to expectations?

Mmmm…. not so good.? Looks like they are still working off all of the bad accruals from the Jack Welch era.

Now, let’s look at the balance sheet:

Mmmm… there are a lot of intangibles on the balance sheet.? Taqngible book value is light.? Perhaps the intangibles have real economic value.? If so, I would expect to see additional earnings over operating cash flow, and the is not there. Let’s look at debt maturities, could there be a call on cash?

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That doesn’t look good.? What if we look at only the holding company?

Okay, not so bad.? Most of the debt is from the finance subsidiary that I have argued for years should spun off.? In a pinch, what are the odds that they would send GE Capital into insolvency?? Very low, so I worry about the refinance risk.? Will GE Capital get attractive financing terms over the next several years?

On to cash flows.? Here are the cash flow screens:

Okay, free cash flow is positive, and congruent with earnings over the last five years.? That’s a good sign.? What else is there to look at?

holding-company-only.gif

Okay, Price-to-sales indicates that GE could be cheap versus their long history, but it could get cheaper.

Let’s look at summary statistics:

From all of the above, as I look at GE, there is a refinancing problem.? Many debts come due over the next 5-10 years, probably matched by debt repaqyments over the same horizon.? The effect of default from these repayments could be significant.? I doubt that GE would be willing to send its finance subsidiary into insolvency.

In conclusion, even at the low levels that GE stock price has reached, I’m not comfortable with it.? GE will have to refinance a lot of its debt over the next five years, unless they sell or default on GE Capital.? The debt load outweighs the seeming cheapness.

Full disclosure: no position

The Humility of Realism, Redux

The Humility of Realism, Redux

Posted on by David Merkel

I want to return to this topic to deal with some comments that I received.? Before I start, I want to repeat a comment that I made at Barry’s blog:

Barry, I?m going to toss out a third possible cause for the end of the Great Depression. The first two are FDR?s programs and WWII, both of which I don?t find compelling.

I grew up in this business as a risk manager, and a bit of a innovator there. I had experience with nonlinear dynamic modeling which most actuaries and financial analysts, even most quants, don?t get or use. The economy, and most industries are nonlinear dynamic systems, which means there will be cyclical behavior, and that behavior will be more volatile the greater the level of fixed commitments in the system that must be satisfied.

Economies that primarily use equity finance are more stable than those that primarily use debt finance. It becomes easier to have a cascade of failure the greater the overall debt burden is on the system. So, the total debt level has a major impact on the behavior of the economy. In 1929, total debt to GDP was 280%. By 1941, that level was 160% or so, where it stayed (more or less) until 1985.

After that, debt to GDP moved up parabolically to 360% by 2007, and now we find ourselves in the soup in two ways: 1) total level of debt, 2) complexity of debt because of securitization and to a lesser extent, derivatives.

Why did the depression end around 1941? Reason 3 (my reason): enough debt had been paid down or written off, and loans could be made to good borrowers, but only enough that financial sector would grow slowly (not faster than GDP).

The answer today, in my opinion, is that we need expedited procedures for bankruptcy to reset the system, getting lenders to compromise with borrowers, and bring down the debt to GDP ratio. I don?t think the present programs will work, and they may actually prolong the crisis, a la Japan. In my opinion, we won?t see significant economic growth until the debt to GDP ratio falls into the 150-200% range.

That is my opinion in a nutshell.? Or, as I commented regarding Hank Paulson here:

He could have tried a more modest solution of expediting bankruptcy processes, because the most pressing need for the economy is to turn bad debts into lesser equity stakes, so that the debt overhang can clear.

This probably includes streamlining personal bankruptcy such that lenders receive back loans with smaller principal balances, plus property appreciation rights.

Total debt levels must be reduced below 180% of GDP, and then the Fed must add a new constraint to their policy. Tighten when Debt/GDP rises above 180%, and raise bank capital thresholds in response to the overall indebtedness of the economy.

Better to go back to a gold standard, I say, but if you’re going to have fiat money, at least do it intelligently, so that debt does not get out of control, as it did in the 20s, and 1985-2007.

In essence this would give a third mandate to the Fed.? When total debt to GDP levels get above 180%, tighten, and make bank exams tougher.? Below 120%, flip it (sending a nickel to my pal Cody).

Now, I received a number of responses to my original article.? I’d like to mention a few of them here, and respond.

From Ray Taylor — ?.hmmm ? ?I say Big Bang???so you?re a financial analyst with a wife and eight children and you don?t mind being unemployed for a few years?or, alternatively, bagging groceries at Kroger (if it?s still in business)?you might want to ask the rest of your family for their opinion.

Good point.? I have a decent amount of safe assets laid away, but I am an equity manager, so I am not in a great spot.? I am more than willing to bag groceries, though, or work at other more mundane tasks if things get really bad.? My father taught me the value of hard work.? I am not worried for my family if our nation survives.? I am concerned over whether our nation survives.? Present policies are lowering the odds of survival.

Also, I have many friends in my church that will help me if things get bad.? I helped in the good times; they will help in the bad.

From Michael M. — First, I have a deep suspicion that people who advocate we take our medicine sharply, are generally in positions where the pain will not happen to fall sharply on them, but on other people. I suspect the author is one of these. I am pretty appalled at the indifference such people show to the enormous suffering real depression would bring to huge numbers of people.
Second, I do not know of strong agreement that the Great Depression cured itself; most seem to think the fortuitous enormous spending of World War II finished it off, not an automatic self-regulating process.

Michael, I am 65% exposed to equities relative to my net worth.? Part of that is a promise that I made to my long only investors that I would always have a minimum amount of my net worth exposed to what they are investing in.? I speak what I think is the truth because that is what I am supposed to do ethically, whether it hurts me or not.

Also, I believe my proposals would cause the most people the least pain.? The present proposals of our government point in the direction of FDR and Japan, prolonging the pain.

You are right that there is no consensus saying the Great Depression healed itself.? As I said to Barry above, what I am saying is that the consensus is wrong, and that the Austrian School and those that understand nonlinear systems theory are right.? We can’t establish prosperity by government actions (leaving aside infrastructure); prosperity comes through private actions.

From Mike in NOLa — With respect to protectionism, Michael Pettis has pointed out that China today is much like the US was in the late 1920?s, with huge foreign currency reserves and manufacturing overcapacity. As such, China may be the one to go protectionist, either explicitly, or by monetary manipulation. See his last two posts:

http://mpettis.com/

I read everything Michael Pettis writes.? I agree totally.

From JVDeLong:— David – a question for you. I cannot claim a good grasp of macro, but my intuitive sense is that the key is your comment about the ratio of debt to GDP. Some of these claims must be wiped out by default – but the chief political characteristic of the system is an utter inability to inflict losses. Everyone must be bailed out.

So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy ? which takes the form of meeting all the claims in nominal terms and then hyper-inflating?

I have stayed with stock market investments on the theory that either the crisis will be brought under control and the stocks will recover, or that the efforts will fail and national bankruptcy will ensue, which means that money-equivalents are not a conservative investment. I do not think the Fed/Treasury will repeat the deflation scenario of the 1930s.

BTW – I heard James Grant speak last week, and he is bearish on money and bullish on high yielding corporate bonds, but I dunno ? that looks like threading a needle.

Your thoughts (and I would be happy to be told that I am crazy)?

With respect to Mr. Grant and high yield, I would agree with him.? I am also bearish on the dollar, and would consider oil, gold, or yen as alternatives at present.

National bankruptcy, or significant inflation, is a possibility that everyone should consider.? I agree with you, the Fed and the Government do not want to repeat the 30s, which is why I think inflation is more likely, unless pressure from international interests makes the US government soak its own populace to pay foreigners.

Kevin Murphy says — David: Would a reverse ETF such as the Proshares Ultrashort treasury funds be a good hedge against inflation or a failure of the Government to finance it?s obligations at current interest rates?

Though I don’t like levered ETFs because they usually underperform their targets, yes, that would be a good strategy.

Ben Says: — Has anyone tried to estimate what the economic situation would have been in the US had we not won the war? I know it sounds stupid, but I?m very dubious about this ?WWII ended the depression theory?. Winning WWII was such a profound positive shock to the US economy that attempts to draw economic analogies and quantify an equivalent amount of peacetime stimulus seem stretched at best.

In terms of the question of how much stimulus we need, there must be many more examples of countries applying economic stimulus to study than the few people are bantering about at the moment. OK, so modern day Japan, Britain in the 70?s and the total experience of the New Deal are not encouraging for Keynesians. Where are the happy endings?

Good points, the Keynesian remedies have not generally worked. Policymakers follow those remedies not because they work, but because they maximize their own power.

VennData Says:– The claim that ?this will give a chance to see who was truly correct about what to do then versus now?? is an exaggeration of the benefit of ex post outcomes of economic cause and effect.

The idea that a ?Bling Standard? is somehow realistic, desirable, is wrong, Even the Swiss have dumped theirs. It makes you vulnerable to whomever buys up ?all the? gold: SWFs, foreign central banks, Private equity, Hedge funds etc? The Fed may have had a hand in too much leverage, but the system self-corrects. The biggest problem after Reagan?s appointment of Greenspan was Bush?s administrative fiat: the 2004 leverage ruling and Congress?s post-Clinton budget busting.

One change we need is addressed correctly above: government policies need to be counter cyclical during boom times – no nation wants to be hamstrung by the pro-cyclical ?Bling Standard? – government systems should be counter-cyclical.

At a minimum, the Fed needs to be allowed into VIP lounge where the punch bowl resides.

VennData, I agree with you that policy needs to be countercyclical under a fiat money or gold standard.? In general, governments are averse to doing so, because it reduces their power.? For that reason, I believe that the government should not be in the money business; it gives them power that they have not managed well, and don’t deserve.

But, you misunderstand my comment that you quoted.? I expect the government to interfere massively, and that the malaise will be prolonged as a result.? Bernanke’s methods, and those of the Treasury, will be ineffective, showing that we really did not learn the right lesson from the Great Depression.? The right lesson would be that in fiat money environment, the central bank must limit the creation of leverage.

Russ Wood Says: JVDeLong wrote — So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy ? which takes the form of meeting all the claims in nominal terms and then hyper-inflating?

The alternative lies in the denominator of the Debt/GDP ratio. We have to grow GDP as fast as possible. Unfortunately, no one wants to talk about creating incentives for growth. The only discussion is how to cushion everyone from slower growth.

Russ, I sympathize with your views, but growing GDP rapidly is impossible in a credit-based economy when the banks are compromised.? Debt reduction is the main way out, intially.

=–=-==-=-=-=-=-=–==-=-=-

So, my views remain unchanged, and perhaps affirmed.? Depressions, like popped bubbles, are primarily phenomena of finance.? They happen when cash flows from assets are insuffiicient to cover liability cash flows.

Would that our government would wake up and realize that the right policy is the one that feels wrong in the short run.? Aside from that, does anyone care about the implications regarding individual freedom?? Or, that group freedoms are affected as well?

What is a Depression?

What is a Depression?

Posted on by David Merkel

Before I try to explain what a Depression is, let me explain what a bubble is.? A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,? with the term of liabilities usually shorter than the lifespan of the asset class.

But, before I go any further, consider what I wrote in this vintage CC post:


 David Merkel
Bubbling Over
1/21/05 4:38 PM?ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:

1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?

This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.

To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.

Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.

It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.

none

Bubbles are primarily financing phenomena.? The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.? What’s the life span of an asset?? Usually quite long:

  • Stocks: forever
  • Preferred stocks: maturity date, if there is one.
  • Bonds: maturity date, unless there is an extension provision.
  • Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
  • Real Estate: practically forever, with maintenance.
  • Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.

Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.? The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.

But was this always so?? Let’s go back through history:

2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.? There was a tendency for more homeowners to finance short.? Investment banks rely on short dated “repo” finance.? Hedge funds typically finance short through their brokers.

1998-2000: Tech/Internet bubble.? Where’s the financing?? Vendor terms were typically short.? Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.? Also, equity capital was very easy to obtain for speculative ventures.

1998: Emerging Asia/Russia/LTCM.? LTCM financed through brokers, which is short-dated.? Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.? Debts in US Dollars, or other hard currencies are as bad as floating rate debt,? because in a crisis, it is costly to source hard currencies.

1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).? Mortgages?? As the Fed funds rates screamed higher, leveraged players were forced to bolt.? Self-reinforcing negative cycle ensues.

I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.? Consider this piece from the CC:


 David Merkel
Gradualism
1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

    • So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

    Position: None

    Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.? Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.? Yield spreads widen dramatically, and often financing cannot be obtained at all.? If a bubble is a type of “boom phase,” then its demise is a type of bust phase.

    Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.? As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.? Those parts with high yield spreads because of the bust do not get any benefit.

    But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?? That is a depression.? At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.? It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.

    Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.

    How does this end?

    It ends when we get total debt as a fraction of GDP down to 150% or so.? World War II did not end the Great Depression, and most of the things that Hoover and FDR did made the Depression longer and worse.? It ended because enough debts were paid off or forgiven.? At that point, normal lending could resume.

    We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.? It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)

    We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.? If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)

    We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.? In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.

    But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.? The proper investment actions here depend on what Government policy will be.? Will they inflate away? the problem?? Raise taxes dramatically?? Default internally?? Externally?? Both?

    I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.? One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.? But maybe gold and long nominal T-bonds is better.? Hard for me to say.? We are in uncharted waters, and most strategies do badly there.

    Last note: if you invest in stocks, emphasize the ability to self-finance.? Don’t buy companies that will need to raise capital for the next three years.

    Ten Notes For the Current Crises

    Ten Notes For the Current Crises

    Posted on by David Merkel

    1) General Growth Properties — another case of too much leverage, illiquid assets, and liquid liabilities.? I live near Columbia and Baltimore, so I know of a lot of property owned by General Growth that was bought when they acquired the Rouse Corp.? I can hear the Rouses in the distance congratulating themselves on a good sale.

    For those that haven’t read me much, the deadly trio of too much leverage, illiquid assets, and liquid liabilities is what causes most corporate defaults of financial companies, not lesser issues like mark-to-market accounting.

    2) The government thinks it is doing something good, and then it realizes that it is in over its head.? Consider AIG and Fannie Mae.? Where does the bailout end?? The government does not have a team of financial analysts competent to dig into murky balance sheets, and they have the mistaken notion that they must act fast.? Having worked on several takeovers of large financial firms, I can tell you that work done quickly destroys value.? Either there is an underestimate that leads to losing the bid, or an overestimate that leads to overpaying, and an eventual writeoff of part of the investment.

    With Fannie Mae and AIG, (and probably Freddie also) the government clearly did not know what it was doing.? What were the main drivers of the loss, and how much worse could they get?? Is this scenario self-reinforcing?? The cursory work led to a bad result that is getting worse.

    3) Amazing that we are almost to the end of the first $350 billion of bailout capital.? The government is behaving like a person that just won the lottery, and is profligate with spending, because they’ve never had that much money to throw around with complete discretion until now. As it says in Proverbs 13:11, “Wealth gained by dishonesty will be diminished, but he who gathers by labor will increase. [NKJV]”? Easy come, easy go.? I am not surprised in the slightest that the US Government has mis-estimated the loss exposures.? They don’t have anyone with a concentrated interest (a profit motive) in the result.

    4) Here’s another angle in the Fed refusing to disclose what assets they are financing.? If we knew who they were buying from, and what they were buying, the markets would ask the question, “How much more firepower are they willing to expend?”? If the judgment is “little”, market players would sell what the Treasury/Fed was buying, and if the judgment is “a lot”, market players would buy what the Treasury/Fed was buying.

    That leads me to believe that the Treasury/Fed doesn’t want to commit a lot more resources to this fight.? If they felt they had a lot more firepower, they would happily disclose their actions, because the private markets would aid their actions.

    5) I’ve been talking about it for over a decade, so pardon me if I point at the great pensions disaster.? We have had a lost decade where DB pension money needed to earn 8-9%/yr, and earned around 1%/year.? That gap of 7-8%/yr over 10 years is enough to destroy most well-funded plans at the beginning of the period.? The problem exists for DC plans as well, because as people age, they lose time to compound their money.? Hey, think of this — the dumb guys that put all their money in the stable value fund did much better than those that put their money at risk.? So much for the equity premium in hindsight, but now it’s time to begin committing funds to riskier assets.? (Don’t do it all at once.)

    6) At least Mr. Obama can make one market go up — muni bonds.? Wait, that’s not good?!? At least healthy municipalitiestheir borrowing rates improve as higher taxes lead the wealthy to shelter income from taxation.

    7) Maybe Obama’s tax poicy could have more bite.? Close down tax havens.? This is something I can get behind.? I like low tax rates, but I don’t like the ability for some to lower their tax rates, and not others.? Let there be a level playing field in the tax code, such that there is no advantage to moving profits offshore.

    Now, could Obama enact real tax reform that would be fair, and cause Buffett (and others) to pay taxes on his unrealized capital gains?? He could, but he won’t, because he is a slave of Democratic special interests.

    8 ) I understand why the Treasury did it.? They wanted an opaque way of encouraging the purchase of weak banks by stronger banks.? So, they let them absorb tax losses of the acquired bank.? Too bad it is not legal, but legality doesn’t affect our government much these days.

    9) Give Spain a hand — they managed to increase capital requirements on their banks during the good times.? Things aren’t perfect now, but Spanish? banks are in decent shape given all of the credit stress.

    10) Why is the Fed funds rate so low?? The 75 basis fee point forces the effective Fed funds rate from 1.00% to 0.25%.? Though some see the Fed hemmed in here, I think that as they reduce the Fed funds rate, they will also reduce the 75 bp fee.

    How Stocks Work, Sort of

    How Stocks Work, Sort of

    Posted on by David Merkel

    I enjoyed the pieces by Felix Salmon and James Surowiecki, and Eddy Elfenbein on how stocks work.? I have reproduced their arguments here, together with my thoughts.

    Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?

    Jim Surowiecki: Your first question, unfortunately, can’t really be answered in the abstract. It’s perfectly possible for a business with high returns on capital to still be overvalued – that is, for its stock price to overestimate the cash flows it will generate over time. In that case, the fact that a company is generating high returns on capital won’t translate into an increase in its stock price. Microsoft’s average return on invested capital, for instance, is consistently good – above 25% — but its stock is just about where it was a decade ago.

    This speaks to your second question, which is really about expectations. If the market is accurately forecasting the returns on capital of the low-ROIC company and the high-ROIC company, you wouldn’t expect the latter’s stock price to dramatically outperform the former. But assuming both are fairly valued, the high-ROIC company will have a much higher valuation, meaning it will generate more income for shareholders going forward (in the form of dividends, buybacks, etc.)

    That’s why, all things being equal, you want to own shares of companies that generate high returns on capital rather than those of companies that don’t. This is, in a way, self-evident. If you put money into a company, you want it to use that money to generate high returns, higher than you could get elsewhere. That’s what companies that have high returns on capital do: Microsoft earns an additional twenty-five cents for every dollar it invests. By contrast, companies with low returns on capital create less value, and companies that earn returns that are lower than their cost of capital (as was true of Japanese companies between 1990 and the early part of this century) actually destroy value for their shareholders.

    Eddy Elfenbein: A company?s share price is the net present value of all future cash flows. A company?s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks? net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.

    This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:

    Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.

    Earnings……….Sales…………..Assets
    —————X—————-X————–
    Sales…………….Assets………..Equity

    Note that the sales and assets cancel each other out to give you Earnings divided by Equity.

    David Merkel: The question can be answered in the abstract, with some noise.? With a few assumptions/limitations as disclosed in this article, Quantitative Analysis is not Trivial ? The Case of PB-ROE.? In most mature industries where capital constrains growth, there is a linear relationship between price-to-book and and ROE.??? This is a result of the dividend discount model, given the assumptions of the article that I cited.

    There is the inherent assumption that net worth is the limiting factor in doing new business.? If that is not the case, then the model does not work.? If sales is the limiting factors the equation becomes price-to-sales as a function of profit margins.

    FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?

    JS: You would expect returns on invested capital to be lower in countries with lower risk-free rates (like Japan). Two reasons suggest themselves for this: first, the low risk-free rate may be indicative of lower growth prospects for the economy as a whole. But also, when the risk-free rate is low, the hurdle rate for corporate investments is also lower (because investors’ expectations of what counts as a reasonable return are also lower.) That may make companies more likely to invest in low-return projects. Both factors have something to do with why Japanese firms have underperformed over the last twenty years (and in particular in that 1990-2002 stretch). But I think the most important factors explaining the low ROIC of Japanese firms were their indifference to shareholder value and their willingness to invest in value-destroying projects.

    EE: Again, a company?s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That?s why a lower risk-free rate tends to boost equity prices.

    According to the Gordon Model, it should look something like this:

    Price = Earnings/(Risk Free Rate + Equity Risk Premium – ROE)

    DM: The risk free rate often has little to do with where corporations can source funds.? Eddy talks about the equity risk premium, but that varies over time.? At present that risk premium is high.? If the country in question is in a liquidity trap, like Japan, equity risk premiums are high.? In general, equity risk premiums are a free market, and disconnected from the “risk free rate” represented by short government bonds

    FS: How can a company with a positive ROE destroy economic value for shareholders?

    JS: The key to understanding how a company with a positive ROE can nonetheless destroy economic value is simply recognizing that equity is not free. It has a cost, just like debt does, a cost that reflects the return that investors demand as compensation for the risks and opportunity costs that owning equities entail. We can debate how to calculate that cost of equity (risk-free rate + market risk premium is a simple solution). But the basic principle is, as I said above, that a company is only creating economic value for its shareholders if it’s earning more than its cost of capital. Again, this is intuitive: if you were the part owner of a company that, on a risk-adjusted basis, was earning less than the yield you could get on a 30-year T-bill, you probably wouldn’t keep your money in that company, because you would effectively be losing money with every day that passed. Shareholders feel the same way, so the share prices of companies that earn less than their cost of capital are unlikely to rise over time. According to a study by the Japanese government, Japanese companies’ return on capital was below their cost of capital for roughly the entire decade of the 1990s through 2002. If you want to know why Japanese stock prices fell precipitously during that period, that’s the biggest reason why: the companies weren’t creating any value for shareholders. And what made it worse was that, as a result of the bubble, expectations were already inordinately high.

    One thing I should say, though: Japanese companies have significantly improved their performance in the past five years, and there’s a strong case to be made that, as in the U.S., the recent sell-off of the Nikkei has been massively overdone. In fact, if you think that the transformation of Japanese firms in recent years will be long-lasting (I’m agnostic on the question), then the Nikkei looks very undervalued right now – or at least it did before it rose something like 15% in the last week and a half.

    EE: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can?t see it, you?re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

    DM: No disagreement here.? Companies must earn more than their cost of capital in order to add value.? This helps explain why low positive ROEs trade at a discount to book value.

    =-=-=–==-=-=-=-=-=-=-=-=-=-

    That’s all, and spite of all the discussion here, I own shares of? Honda Motors and the SPDR Russell/Nomura Small Cap Japan ETF,

    Full disclosure: long JSC HMC

    The Biggest, Baddest Bubble of Them All

    The Biggest, Baddest Bubble of Them All

    Posted on by David Merkel

    It’s election day, and I may as well try to fuse economics and politics for a moment.? Personally on an economic basis, I don’t think this election means that much.? Consider this post at RealMoney from earlier this year:


    		 David Merkel
    Cultures are Bigger than Economies, Which are Bigger than Governments
    1/7/2008 1:19 PM EST

    To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.

    I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.

    As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.

    There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.

    The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.

    Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.

    Position: none

    Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.? We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.? Our debts are getting deeper, not shallower.

    Consider this graph from this article at Clusterstock:

    We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.? My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.

    Now, I’m still dubious that the bailout policy will work.? Reasons:

    When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.? (That’s just an example, there are other reasons to enter into such a CDS.)

    Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.? From another comment at RealMoney:


    		 David Merkel
    Digging a Hole to China (So We Can Borrow Some More)
    10/28/03 08:26 AM?ET
    With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD):

  • Net Liability: $6.8 trillion
  • Soc Sec, Pen & Dis: $4.6 trillion
  • Medicare, part A: $5.1 trillion
  • Medicare, part B: $8.1 trillion
  • Total: $24.6 trillion

    • This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

    np

    That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.? New figures out in two months.)? By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.? You have been the most damaging president on economics since Nixon.? (Sorry, I lost my cool. 🙁 )

    That $50 trillion does not count in state and corporate underfunding of pensions and benefits.? Oh, and with the fall in the markets, they want a bailout also.

    Who doesn’t want a bailout?? The US Government can just borrow some more to aid us on our way to prosperity.? Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).? The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.

    Our problems in the US are larger than our politics.? It goes down to our very culture, borrowing from the future to take care of the present.? It is true for our Government, and many corporations and individuals.? The pain will come, the only question now is what form it will take.

    Time to Ditch the Style Box

    Time to Ditch the Style Box

    Posted on by David Merkel

    If you were trying to create a system for controlling investment risk in equity investing, how would you do it?? What I would do is look at the factors that are the least positively correlated in terms of return generation, and focus on them.

    But what do investment managements consultants do?? They divide the world up into managers that look at two factors: large/mid/small capitalization, and value/core/growth.? This has been popularized by the Morningstar “Style Box.”

    Looking over the last 15 years, the style box is very correlated with itself.? The lowest correlation is 75%, between largecap value and smallcap growth.? That is not a reason to categorize managers; the difference between the average largecap value and growth manger is teensy. It is even true between largecap value and smallcap growth.? And in more recent years, the correlations have been tightening to nearly 90% at worst.

    So, consider country allocations.? Over the last 15 years, the correlations in developed markets have been 45% at worst, with the average being near 70%.? Looking at the last few years, both figures are higher.? My opinion: the advent of naive quantitative investing has pushed all correlations higher.

    But now consider correlations across economic sectors.? Over the past 14 years, the correlations have been 32% at worst.? Across industries, which are more diverse than sectors, some of the correlations are negative, perhaps affording true diversification.

    My point here is that those that look at capitalization size and value/growth are missing the boat.? If you classify managers based on that, you are focusing on minor concerns that do not aid much in diversification.? Better to focus on the industries that a manager invests in, and/or the countries that those companies are located in — there is a real oportunity to limit risks through either of those two methods.

    Now, as for me, when I pick stocks, I start with the industry.? I ignore the factors in the style box.? I look for industries that are near the bottom of their pricing cycle, and buy the highest quality companies there.? For industries that are doing well, but are undervalued, I buy companies with undervalued growth prospects, with good quality balance sheets.

    I strongly believe that the investment consultant community has shortchanged its clients by focusing on the “style box.”? Very little of the risks of the market result from factors in the style box, while much resluts from industry selection, which is a richer model.

    So, as for me, if I have to be squeezed into the style box, call me midcap value with some style drift, buying companies larger and smaller, and outside the US, as conditions dictate.? I’m looking for the best value over the next three years, and I don’t like non-economic factors distracting me.? Why should that be such a crime, that the ignorant gatekeepers screen me out?

    The risk model for the investment consultants is broken.? Let them find one that better reflects the way that the market works.

    Recent Portfolio Moves

    Recent Portfolio Moves

    Posted on by David Merkel

    Since I wrote my last portfolio update two months ago, it is time for a new report.

    New Buys

    • PartnerRe
    • Allstate
    • Assurant
    • Nucor
    • Genuine Parts
    • Pepsico
    • CRH
    • Alliant Energy

    New Sells

    • Avnet
    • Lincoln National
    • YRC Worldwide
    • CRH
    • Jones Apparel
    • Assurant
    • Group 1 Automotive
    • Smithfield Foods
    • MetLife
    • International Rectifier
    • Cemex
    • Officemax
    • Universal American

    Rebalancing Buys

    • Shoe Carnival
    • Charlotte Russe
    • Devon Energy (2)
    • RGA
    • SABESP
    • Ensco International (2)
    • Industrias Bachoco
    • Magna International
    • Valero
    • Kapstone Paper
    • Hartford International (3)
    • Cimarex Energy
    • Lincoln National
    • Smithfield Foods
    • Allstate
    • ConocoPhillips (2)
    • Tsakos Energy Navigation

    Rebalancing Sells

    • PartnerRe
    • Safety Insurance
    • Devon Energy
    • Ensco International
    • Hartford Financial (3)
    • Kapstone Paper
    • Cimarex Energy
    • Nam Tai Electronics (2)
    • Honda Motors (2)
    • Lincoln National (2)
    • ConocoPhillips
    • Charlotte Russe
    • Shoe Carnival

    I’ve had a lot of trades over the past two months, which is normal for me when volatility rises.

    I have been asked by a number of parties why I don’t write about the insurance industry in this environment, given my past experience.? My main reason is that I have left it behind.? When I became a buyside insurance analyst, I had strong opinions about what made a good or bad insurance company.? For the most part, those opinions were correct, but there is a fundamental opaqueness to insurance.? One truly can’t analyze it from outside.? No boss would hear that, even if true.

    I benefitted from the cleaning up of insurance assets 2002-3, and thought that the cleanup had persisted.? Largely, it has, but many life companies rely too heavily on variable products for profitability, and as the market has fallen, profits from variable products have fallen harder.? Thus my mistakes with Hartford, MetLife and Lincoln National.

    That brings up two other possibilities where things can continue to go wrong in life insurance.? If fees are permanently reduced the companies might have to write down the deferred acquisition costs [DAC] that they capitalized when originally writing the business, if the expected cumulative fees are less than the DAC.? The second issue is hedging the guaranteed living benefits.? I will never forget the look that the CEO of Principal Financial gave me when I asked him how well the futures/options hedges during a month where the S&P 500 is down 20-30%.? It was not a pleasant look.? Not that that scenario could ever happen. 😉

    My picks in pure P&C insurance have fared better.? Safety Insurance is a solid company; so is PartnerRe.? Would that I had done more there, and less in life companies, especially the equity sensitive ones.

    So what do I hold today among insurers?

    • Allstate
    • Assurant (bought after the marginally bad earnings announcement)
    • Hartford (yes 🙁 )
    • PartnerRe
    • Reinsurance Group of America
    • Safety Insurance

    Yes, I am overweight insurance, and I have paid the price, particularly with Hartford.? There is an uncertainty connected with life insurance holding companies about the ability to upstream dividends to service debt.? That uncertainty only appears in bear markets, and all the hubbub over optimizing the capital structure is so much hooey.? Assurant is in better shape because it ceased buying back stock because of the (somewhat bogus) investigation of a few of their executives.

    Two final notes to close.? I had a bad October, worse than the S&P 500 by a significant margin.? My exposures in life insurance and emerging markets drove that.? Second, I may have my first equity client, and so I may be curtailing some of my discussion of individual names in my portfolio, and deleting my portfolio at Stockpickr.com.? My clients come first.

    Full disclosure: long ALL AIZ HIG PRE RGA SAFT SCVL CHIC COP HMC NTE XEC KPPC ESV DVN TNP VLO MGA SBS CRH LNT PEP GPC NUE (what have I left out?!)

    What is the Value of Market Dividend Yields?

    What is the Value of Market Dividend Yields?

    Posted on by David Merkel

    Blogging is often a cooperative venture, so this piece begins with thanks to three people:

    When I read the piece at The Capital Spectator, my response was “Huh, neat article, wonder how it would look with a larger data set?”? Given Eddy’s help, I had that data set, and so I got to work.? Here is the main result:

    The results at The Capital Spectator went from 1995 to 2003. My results go from 1871 to 2003. His results give a tight relationship, while mine indicate a loose relationship.? His R-squared was far? higher than my 7%.? Why?

    In aggregate, many relationships in finance are tenuous.? Do interest rates mean-revert?? Yes, but the tendency is weak.? In this case, high dividend yields foreshadow high five-year total returns, but that tendency is weak.

    In the graph above I tried to highlight the eras for different alignments of dividend yields and future five-year returns.? Depending on the era, the relationship of dividend yield to future returns differed.? In the long run, there is a weak positive relationship between dividend yields and total returns, but in the short run, many other factors predominate.

    So what does this tell us?

    • Use larger data sets when possible.
    • Realize that many relationships in finance are not stable.? Indeed, that is a strength of Capitalism.? It adjusts to changing conditions, and is not stable.
    • When dividend yields are high the market is attractive.? Of course, factor in how high bond and cash yields are at the time.
    • Beware relying on intermediate-term relationships in quantitative finance.? They last for less than a decade.
    • Beware trusting correlation coefficients calculated over short intervals.
    • In finance, we know less than we think, so we should be cautious in our conclusions.
    • The best forecasts come when we are at extreme values of the system.? In the middle, everything is a muddle.

    I am a firm believer in dividends. My portfolio has an above average dividend yield.? In general, high dividend yields pay off in investing, subject to credit quality.? But, the payoff varies over time; a heavy reliance on the dividend yield of the market as a sole indicator is not advised.

    Neomercantilism and Sloppy Central Bankers

    Neomercantilism and Sloppy Central Bankers

    Posted on by David Merkel

    When I wrote for RealMoney, one of my continuing themes was that the Federal Reserve was less relevant because neomercantilistic nations like China (and perhaps OPEC nations) had reasons for promoting exports to the US that were less than economic.? As such they would buy US fixed income in order to facilitate their exports.? What could be sweeter?? You send goods; we send promises, denominated in our own currency.

    With that, I want to point to a short post from Marginal Revolution.? Like me, he takes the “modified Austrian” view that the bubble was caused not only by the Fed, but also by the neomercantilists, both of which I fingered in my “Blame Game” series.? Buying longer dollar-denominated debt stimulated mortgage rates more than the Fed could, because under normal conditions the Fed can only affect the short end of the yield curve.

    PS — What a long day, to NYC and back.? I appeared on Fox Business News show “Happy Hour.”? They said I did very well.? If I get video I will post it here.? As I have said before, time on live television goes fast.? The four minutes seemed like the blink of an eye.? At the end, Liz asked me for a third stock, and I blanked out, so I said Assurant, a company that I love, but don’t currently own.? I will own it in the future.? I meant to say Pepsico, but it just didn’t come to mind.

    I also had dinner with my friend Cody Willard after the show.? Though our rhetoric is different, we basically agree that the actions of the government in the bailout offer much possibility/potential for favoritism.? Also, that it is easy to start a bailout, and hard to end one.

    Let the government chew on this: Pepsico issued $3.3 billion of corporate debt yesterday.? For a company with recession-proof products and a Aa2/A+/AA- balance sheet, for them to pay 4%+ over Treasuries is astounding.? Liquidity?? What liquidity?? If financing needs are outside the A-1/P-1/F1 CP box, there is no help.? Not that there should be help, but the corporate bond market is a truer indicator of our stress than the money markets, which still aren’t in great shape.

    Full disclosure: long NUE PRE PEP

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