Category: Value Investing

Estimating Future Stock Returns

Estimating Future Stock Returns

Posted on by David Merkel
Idea Credit: Philosophical Economics Blog
Idea Credit: Philosophical Economics, but I?estimated and designed the?graphs

There are many alternative models for attempting to estimate how undervalued or overvalued the stock market is. ?Among them are:

  • Price/Book
  • P/Retained Earnings
  • Q-ratio (Market Capitalization of the entire market /?replacement cost)
  • Market Capitalization of the entire market / GDP
  • Shiller?s CAPE10 (and all modified versions)

Typically these explain 60-70% of?the variation in stock returns. ?Today I can tell you there is a better model, which is not mine, I found it at the blog?Philosophical Economics.? The basic idea of the model is this: look at the proportion of US wealth held by private investors in stocks using the?Fed?s Z.1 report. The higher the proportion, the lower future returns will be.

There are two aspects of the intuition here, as I see it: the simple one is that when ordinary people are scared and have run from stocks, future returns tend to be higher (buy panic). ?When ordinary people are buying stocks with both hands, it is time to sell stocks to them, or even do IPOs to feed them catchy new overpriced stocks (sell greed).

The second intuitive way to view it is that it is analogous to Modiglani and Miller’s capital structure theory, where assets return the same regardless of how they are financed with equity and debt. ?When equity is a small component as?a percentage of market value, equities will return better than when it is a big component.

What it Means Now

Now, if you look at the graph at the top of my blog, which was estimated back in mid-March off of year-end data, you can notice a few?things:

  • The formula explains more than 90% of the variation in return over a ten-year period.
  • Back in March of 2009, it estimated returns of 16%/year over the next ten years.
  • Back in March of 1999, it estimated returns of -2%/year over the next ten years.
  • At present, it forecasts returns of 6%/year, bouncing back from an estimate of around 4.7% one year ago.

I have two more graphs to show on this. ?The first one below is showing the curve as I tried to fit it to the level of the S&P 500. ?You will note that it fits better at the end. ?The reason for that it is?not a total return index and so the difference going backward in time are the accumulated dividends. ?That said, I can make the statement that the S&P 500 should be near 3000 at the end of 2025, give or take several hundred points. ?You might say, “Wait, the graph looks higher than that.” ?You’re right, but I had to take out the anticipated dividends.

The next graph shows the fit using a homemade total return index. ?Note the close fit.

Implications

If total returns from stocks are only likely to be 6.1%/year (w/ dividends @ 2.2%) for the next 10 years, what does that do to:

  • Pension funding / Retirement
  • Variable annuities
  • Convertible bonds
  • Employee Stock Options
  • Anything that relies on the returns from stocks?

Defined benefit pension funds are expecting a lot higher returns out of stocks than 6%. ?Expect funding gaps to widen further unless contributions increase. ?Defined contributions face the same problem, at the time that the tail end of the Baby Boom needs returns. ?(Sorry, they *don’t* come when you need them.)

Variable annuities and high-load mutual funds take a big bite out of scant future returns — people will be disappointed with the returns. ?With convertible bonds, many will not go “into the money.” ?They will remain bonds, and not stock substitutes. ?Many employee stock options and stock ownership plan will deliver meager value unless the company is hot stuff.

The entire capital structure is consistent with low-ish?corporate bond yields, and low-ish volatility. ?It’s a low-yielding environment for capital almost everywhere. ?This is partially due to the machinations of the world’s central banks, which have tried to stimulate the economy by lowering rates, rather than letting recessions clear away low-yielding projects that are unworthy of the capital that they employ.

Reset Your Expectations and Save More

If you want more at retirement, you will have to set more aside. ?You could take a chance, and wait to see if the market will sell off, but valuations today are near the 70th percentile. ?That’s high, but not nosebleed high. ?If this measure got to levels 3%/year returns, I would hedge my positions, but that would imply the S&P 500 at around?2500. ?As for now, I continue my ordinary investing posture. ?If you want, you can do the same.

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PS — for those that like to hear about little things going on around the Aleph Blog, I would point you to this fine website that has started to publish some of my articles in Chinese. ?This article?is particularly amusing to me with my cartoon character illustrating points. ?This is the English article that was translated. ?Fun!

Think Half of a Cycle Ahead

Think Half of a Cycle Ahead

Posted on by David Merkel
Photo Credit: Robert Tuck || Of course, in half a cycle here, the moon will look the same
Photo Credit: Robert Tuck || Of course, in half a cycle here, the moon will look the same

 

Financial markets are trendy and?noisy in the short-run, sensible in the long-run, and perverse in the intermediate-term.

What do I mean?

Something like this:?short-run movements are news-driven, and driven by people trying to catch up with the latest data. ?Many people imitate the behavior of others, and over the intermediate-term, some stock prices get out of whack. ?Some subset of industries, factors, and/or companies gets out of alignment, and are mispriced. ?In the long run, those pricing errors get corrected, but it takes years to get there.

Here’s an example. to make this tangible and understandable. ?As a factor, value has been bad for eight years or so, and as evidence I quote?Rob Arnott, from his article entitled, ?How Can ?Smart Beta? Go Horribly Wrong??

The value effect was first identified in the late 1970s, notably by Basu (1977), in the aftermath of the Nifty Fifty bubble, a period when value stocks were becoming increasingly expensive, priced at an ever-skinnier discount relative to growth stocks. More recently, for the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama?French value factor in large-cap stocks returning ?4.8% annually over the same period. But, the value effect is far from dead! In fact, it?s in its cheapest decile in history.

And then later he says:

How many practitioners who rely on the value factor take the time to gauge whether the factor is expensive or cheap relative to historical norms? If they took the time to do so today, they would find value is currently cheaper than at any time other than the height of the Nifty Fifty (1972?73), the tech bubble (1998?2003), and the global financial crisis (2008?09).

The underlining is mine, to give emphasis. Now I would like to quote from a very old article of mine, The Fundamentals of Market Tops that was originally published at RealMoney.com back in 2004:

You?ll know a market top is probably coming when:

a) The shorts already have been killed. You don?t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

Point (b) is what I want to highlight? not that we have had many value managers forced into retirement recently, but value funds of all kinds have been losing clients. It?s like being fired fractionally, a sliver at a time, but it adds up to a lot.

Combine that with Arnott?s insight that the valuations of value stocks are at exceptionally low levels ? this gives me some hope that we are in the seventh inning or later in this market cycle regarding value investing.

Going Back a Step

Value isn’t the only cheap area presently — European stocks and emerging market stocks look cheap as well. ?When areas of the market with bad relative performance have a lot of people giving up on them to pursue recently successful strategies, that?helps to put in the bottom on the underperformers, and the top on the outperformers.

You can’t tell exactly when the process will end, but those jumping from one strategy to another, chasing performance, will just add a new set of losses to the old ones. ?The trick is to try to anticipate when the cycle will turn for a given market strategy, factor or industry. ?No one can do it perfectly, but it makes sense to act when relative valuations are in your favor.

Minimally, those that stick with a valid strategy through thick and thin can benefit from the strategy over the long-term… and that takes some courage, because there are times when your strategy will be out of favor. ?That’s what I do with value investing.

Maximally, you would sell a?strategy that you were invested in that was topping out in relative terms to buy a strategy?that has been trashed for a while, and might be ready to outperform. ?That’s even more difficult than sticking with one strategy through thick and thin. ?Everyone wants to buy a past winner, and nobody wants to buy a past loser. but that is what would offer large returns if the timing could be right. ?Another way of phrasing it, is to always look half a cycle ahead, to where a strategy will be when the excesses correct, or as is more likely, overcorrect, and take the appropriate action now.

Doing that is beyond me. ?I’m just grateful that the period of relative underperformance of value may be nearing its end.

If All Investments Were Private

If All Investments Were Private

Posted on by David Merkel
Photo Credit: Falcon? Photography
Photo Credit: Falcon? Photography? || In this story, TSB stands for “The Storage Bank”

This piece is another one of my experiments, please bear with me.

“Measure Twice, Cut Once” — A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered

“Only buy something that you?d be perfectly happy to hold if the market shut down for 10 years.” — Warren Buffett

Imagine for a moment:

  • The public secondary markets didn’t exist
  • Investment pooling vehicles were all private, and no one published NAV estimates
  • Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation. ?This includes short-term debts like commercial paper.
  • Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly. ?In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date.
  • Accounting rules are only partially standardized.
  • Deposit insurance still exists.
  • So does limited liability.

In this thankfully fictitious world, what would investing be like?

The main factor would be that liquidity would be dear. ?Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study. ?The 4 Cs of credit would be present with a vengeance –?character, capacity, capital and conditions — and character would be chief among them as J. P. Morgan famously said.

This would be true even if one were investing in the stock of a firm, rather than the debt. ?Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get.

You’d have to be very certain of what you were doing. ?Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms — we take for granted how information flows today, but with private firms, you are subject to the board and management. ?What do they choose to share with outside passive minority investors?

Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.” ?It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.”

Why would private firms choose to be open with outside private minority investors? ?They want a continuing flow of capital, and with no secondary markets, that can be difficult. ?Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, “There’s a sucker born every minute.” ?Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets.

The same would apply to the debt markets. ?The fourth C, Conditions, would also impact matters. ?If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights.

You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent. ?The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally?compelled, might not find it in their interests to be open. ?Control is a valuable option, one that is only surrendered when the situation is virtually hopeless.

That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.” ?And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams.

Back to the Present

“…[R]isk control is best done on the front end. ?On the back end, solutions are expensive, if they are available at all.” ?– Me, in this article, and a bunch of others.

The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept. ?All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification.

If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens. ?The same is true of corporations needing liquidity. ?Buffett said something to the effect of, “Get financing before you need it; it may not be available later.”

It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders. ?(True for me, too.) ?The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.”

Beyond that, realize that character does matter. ?A lot. ?The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact. ?It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless. ?But consider those that try to warn about financial disasters — they do not get listened to until it is too late. ?Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc. ?Very few listen to them, because seeming success talks far louder than an outsider.

My counsel is the same as always, just look at the risk control quote above. ?But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?” ?Then measure twice, thrice, ten times if needed, and cut once.

Is Value Coming Back?

Is Value Coming Back?

Posted on by David Merkel
Photo Credit: Paw Paw
Photo Credit: Paw Paw || The excitement of anticipating our friend’s arrival is overcoming our dignity

While perusing Barron’s on Saturday, I wondered if I had picked up a?publication entitled, “Hope for Broken-hearted Value Investors.” ?Note the articles, most of which should be behind a paywall:

Two things: First, this could just be a bounce off of the recent run-up in oil prices. ?Lots of value investors are hiding there, and I think they are early. ?Also, many people are hoping for a bounce in global growth, but there isn’t a lot to commend that in the short run.

Second, there are too many people hoping for this. ?Lots of money is flowing out of value strategies, and the stocks are cheap. ?I’ve lost several clients, and may lose some more.

Oddly, it is the losing of clients that gives me the most hope. ?You need people to leave a strategy when it is down and out for the strategy to bottom. ?These are the sorts of people that create the difference between time-weighted and dollar-weighted returns. ?They will move to strategies that have outperformed, so they can lose money again.

As for me, I’m not changing. ?I like my stocks more than ever, and I think I’ve got good ideas throughout?the portfolio. ?But I am not?depending on value investing as a strategy turning upward now. ?I think we still need and will get more pain before it turns.

Another Year in Buffett’s House

Another Year in Buffett’s House

Posted on by David Merkel
Photo Credit: TEDizen || Buffett's house is a humble abode -- mine is dumpy
Photo Credit: TEDizen || Buffett’s house is a humble abode — mine is kind of dumpy

Last year, when BRK [Berkshire Hathaway] reported their annual earnings with the letter, report, and 10K, I concluded:

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. ?A few new subsidiaries like NV Energy added earnings, but existing subsidiaries? earnings were flattish. ?Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway. ?The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

What I said one year ago would be a good summary for this year, though Buffett was more upbeat about outcomes this year, with BRK’s book value advancing while the S&P 500 fell on a total return basis.

Overall, BRK had a mediocre year. ?Insurance wasn’t that great. ?Here are my summary points:

  1. BRK is reducing reinsurance — i suspect they aren’t getting the rates that they want. ?There are too many reinsurance wannabes attempting to write business to generate float that they can invest against. ?Typically, writing insurance in order to invest usually doesn’t work out. ?People forget how much money was lost writing marginal insurance business in soft markets thinking they would more than make up the losses with investment income. ?BRK is showing some discipline here — good.
  2. Aside from new lines of business (specialty insurance), growth is slowing; BRK is trying to remain a conservative underwriter.
  3. Reserving conservatism has not changed.
  4. Asbestos position has not materially changed.
  5. GEICO had a bad year for claims — maybe they grew too much, and maybe picked up a lower class of auto driver.
  6. Profit margins falling
  7. Float growth slowing
  8. Continued problems with workers’ comp and long-term care at Gen Re. ?Also problems with payment annuities (blames FX, should blame longevity) and Life Reinsurance.

A few?quotes from the 10K on insurance issues:

“We define pre-tax catastrophe losses in excess of $100 million from a single event or series of related events as significant. In 2015, we recorded estimated losses of $136 million in connection with a property loss event in China.”

and on GEICO:

“Losses and loss adjustment expenses incurred in 2015 increased $2.7 billion (17.1%)?over 2014. Claims frequencies (claim counts per exposure unit) in 2015 increased in all major coverages over 2014, including property damage and collision coverages (three to five percent range), bodily injury coverage (four to six percent range) and personal injury protection (PIP) coverage (one to two percent range). Average claims severities were also higher in 2015 for property damage and collision coverages (four to five percent range), bodily injury coverage (six to seven percent range) and PIP coverage (two to four percent range). We believe that increases in miles driven, repair costs (parts and labor) and medical costs, as well as weather conditions contributed to the increases in frequencies and severities.”

Regarding Gen Re:

“The property/casualty business generated pre-tax underwriting gains in 2015 of $944 million compared to $1.4 billion in 2014. In 2015, we incurred losses of $86 million from an explosion in Tianjin, China. There were no significant catastrophe losses in 2014. Underwriting results in 2015 included comparatively lower gains from property catastrophe reinsurance and the run off of prior years? business.”

I found the mention of two large loss events in China interesting — maybe it was just one event of $136 million, but they could have been more clear.

Float Note

Before I leave the topic of insurance, I do want to set the record straight on how valuable float is. ?This is my best article on the topic. ?Buffett is a bit of a salesman in his annual letter, but generally an honest one.

Float is only as good as the insurance business generating it. ?If it is generating underwriting losses, the investments will have to earn at least as much per year as the losses divided by the average duration of how long the float will exist in years, in order to break even.

We’re coming off of years where there have been no underwriting losses, so float is?magical — but the P&C insurance industry is getting more competitive, and float will no longer be costless.

Widespread use of float for financing is like trying to finance off of other seemingly costless liabilities — in the hands of some?investors, that can lead to disaster — after all, consider all of the disasters that I have written about where people finance short to invest long.

Conservative insurers invest their premium reserves in cashlike instruments, and their loss reserves they invest in bonds of a similar duration. ?They typically don’t invest float in equities, and certainly not whole businesses.

Buffett has done just that and done well. ?That said, he runs his insurers at lower levels of leverage than most insurers, to allow room for taking more investment risk.

Note that BRK doesn’t guarantee the debts of BNSF, BHE, etc., but does guarantee the debts of the finance arms.

There is room for another article on float and cost of capital — not sure when I will get to it, but it will be a WACC-y article. 😉

Final Notes:

1) Note that Buffett keeps profits overseas also. Quoting the 10K: “We have not established deferred income taxes on accumulated undistributed earnings of certain foreign subsidiaries. Such?earnings were approximately $10.4 billion as of December 31, 2015 and are expected to remain reinvested indefinitely.” ?My guess is that he will use them to buy a foreign subsidiary.

2) BRK Pays taxes at about a 30% rate.

3) Regarding his comments on goodwill amortization — he thinks some of it is economically valid, and some not. ?Buffett has the option of putting more data on the income statement if he wants. ?Or put it in note 11 (goodwill). ?He already does that by breaking apart revenues and expenses by corporate divisions on the income statement. ?Do us all a favor, BRK, and split the goodwill into what you think is economically valid, and what is not.

4) Buffett gives an extended defense of Clayton Homes lending. ?In general, I thought his points were good — even before Buffett, Clayton was the “class act” in manufactured housing, and financing it.

5)?Even BRK has underfunded pension plans, and it has a relatively conservative 6.5% expected return on assets.

6) I note a modest change in 10K risk factors — BNSF and the automatic braking issue. ?BNSF will have to spend a lot of money to deal with the need to stop runaway trains remotely. ?True of all?US and Canadian railroads.

 

7)?BRK has less free cash flow to invest in new projects because more of their businesses are capital-intensive. ?BRK invested $16B in property, plant and equipment.

8 ) BNSF had a good year. ?BH Energy had a good year, mostly from a new Canadian Transmission utility, and their home brokerage arm.

9) BRK bought Precision Castparts, Van Tuyl (auto dealerships), and AltaLink (the Canadian Transmission utility). ?Also bolt-ons to existing subsidiaries.

10) Kraft merged with Heinz.?Heinz preferred will be redeemed.

11) The big four publicly traded firms owned by BRK didn’t have a good year. AXP, KO, IBM, WFC — he bought more of IBM and WFC. ?Buffett argues that the retained earnings of the firms benefit BRK. ?I’m dubious. ?IBM has particularly been a dog — look at free cash flow. ?Much of the earnings at IBM?aren’t real. ?You can’t use what they don’t dividend.

12) Quoting Buffett from his section?on optimism about the US, he tempered it by saying: “Though the pie to be shared by the next generation will be far larger than today?s, how it will be divided?will remain fiercely contentious.”

Well, you can say that again, but fairness is a squishy concept. ?Is fairness:

  • Even division (from each according to his ability, to each according to his needs)
  • Proportionate to productivity
  • Equal to what you negotiate
  • Derived from the formula of a bureaucrat
  • What you can negotiate through the political process
  • Impossible
  • Or something else?

Buffett worked with the easy stuff, and waved his hands at the hard stuff. ?I’ll phrase it this way: in general, the US has done well because we have not wrangled as much as the rest of the world over distribution issues, and have left a lot of room for people to?gain a lot from their own productivity. ?That has led to a lot of wealth, and in general, a growing pie for everyone to benefit from.

Productivity goes in waves, and labor plays catchup with capital after technological progress. ?We have seen people redeployed from agriculture and servanthood/slavery in the past 150 years. ?We will see them redeployed from manufacturing in the next 100 years. ?They will provide services to their fellow men, should there continue to be peace and tranquility, allowing labor income to catch up with that of capital.

Full disclosure: long BRK/B

 

Thoughts on MetLife and AIG

Thoughts on MetLife and AIG

Posted on by David Merkel
Photo Credit: ibusiness lines
Photo Credit: ibusiness lines

In some ways, this is a boring time in insurance investing. ?A lot of companies seem cheap on a book and/or earnings basis, but they have a lot of capital to deploy as a group, so there aren’t a lot of opportunities to underwrite or invest wisely, at least in the US.

Look for a moment at two victims of the?Financial Stability Oversight Council?[FSOC]… AIG and Metlife. ?I’ve argued before that the FSOC doesn’t know what it is doing with respect to insurers or asset managers. ?Financial crises come from short liabilities that can run financing illiquid assets. ?That’s not true with insurers or asset managers.

Nonetheless AIG has Carl Icahn breathing down its neck, and AIG doesn’t want to break up the company. ?They will spin off their mortgage insurer, United Guaranty. but they won’t get a lot of help from that — valuations of mortgage insurers are deservedly poor, and the mortgage insurer is small relative to AIG.

As I have also pointed out before AIG’s reserving was liberal, and recently AIG took a $3.6 billion charge to strengthen reserves. ?Thus I am not surprised at the rating actions of Moody’s, S&P, ?and AM Best. ?Add in the aggressive plans to use $25 billion to buy back stock and pay more dividends?over the next two years, and you could see the ratings sink further, and possibly, the stock also. ?The $25 billion requires earning considerably more than what was earned over the last four years, and more than is forecast by sell-side analysts, unless AIG can find ways to release capital and excess reserves (if any) trapped in their complex holding company structure.

AIG plans to do it through?(see pp 4-5):

  • Reducing expenses
  • Improving?the Commercial P&C accident year loss ratio by 6 points
  • Targeted divestitures (United Guaranty, and what else gets you to $6 billion?)
  • Reinsurance (mostly life)
  • Borrowing $3-5B (maybe more after the $3.6B writedown)
  • Selling off some hedge fund assets to reduce capital use. (smart, hedge funds earn less than advertised, and the capital charges are high.)

Okay, this could work, but when you are done, you will have reduced the earnings capacity of the remaining company. ?Reinsurance that provides additional surplus strips future earnings out the the company, and leaves the subsidiaries inflexible. ?Trust me, I’ve worked at too many companies that did it. ?It’s a lousy way to manage a life company.

Expense reduction can always be done, but business quality can suffer. ?Improving the Commercial lines loss ratio will mean writing less business in an already overcompetitive market — can’t see how that will help much.

I don’t think the numbers add up to $25 billion, particularly not in a competitive market like we have right now. ?This is part of what I meant when I said:

…it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise. ?Insurance is a set of complex businesses, and few understand most of them, much less all of them. ?It would be easy to naively overestimate the ability to improve profitability at AIG if you don?t know the business,? the accounting, and how free cash flow emerges, if it ever does.

They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings. ?Icahn and his friends might be surprised at how little value could initially be released, if any.

Thus I don’t see a lot of value at AIG right now. ?I see better opportunities in MetLife.

MetLife is spinning off their domestic individual life lines, which is the core business. ?I would estimate that it is worth around 15% of the whole company. ?In the process, they will be spinning off most of their ugliest liabilities as far as life insurance goes — the various living benefits and secondary guarantees that are impossible to value in a scientific way.

The main company remaining will retain some of the most stable life liabilities, the P&C operation, and the Group Insurance, Corporate Benefit Funding, and the International operations.

I look at it this way: the company they are spinning off will retain the most capital intensive businesses, with the greatest degree of reserving uncertainty. ?The main company will be relatively clean, with free cash flow being a high percentage of earnings.

I will be interested in the main company post-spin. ?At some point, I will buy some MetLife so that I can own some of that company. ?The only tough question in my mind is what the spinoff company will trade at.? Most people don’t get insurance accounting, so they will look at the earnings and think it looks cheap, but a lot of capital and cash flow will be trapped in the insurance subsidiaries.

There is no stated date for the spinoff, but if the plan is to spin of the company, a registration statement might be filed with the SEC in six months, so, you have plenty of time to think about this.

Get MET, it pays.

One Final Note

I sometimes get asked what insurance companies I own shares in. ?Here’s the current list:

Long RGA, AIZ, NWLI (note: illiquid), ENH, BRK/B, GTS, and KCLI (note: very illiquid)

Our Growing World

Our Growing World

Posted on by David Merkel
Photo Credit: Ejaz Asi
Photo Credit: Ejaz Asi

In general, I tend not to go in for macro themes. ?Why? ?I tend to get them wrong, and I think most investors?also get them wrong, or at least, don’t get them right consistently.

I do have one macro theme, and it has served me well for a long time, though not over the past two years. ?I was using the theme as early as 2000, but finally articulated it in 2006.

At that time, I was running my equity strategy for my employer, as well as in my personal account. ?They used it for their profit sharing plan and endowment. ?They liked it because it was different from what the firm did to make money, which was mostly off of financial companies, both public and private. ?They didn’t want employees to worry that their accrued profit sharing bonuses would be in jeopardy if the firm’s ordinary businesses got into trouble. ?In general, a good idea.

At the end of the year, I needed to give a presentation to all of the employees on how I had been managing their money. ?Because my strategies had been working well, it would be an easy presentation to make… but as I looked at the prior year presentation, I felt that I needed to say more. ?It was at that moment that the macro theme that i had been working with became clear to me, and I called it: Our Growing World.

The idea is this: in a post-Cold War world where most economies have accepted the basic idea of Capitalism to varying degrees, there should be growth, and that growth should create a growing middle class globally. ?This middle class would be less well-off than what we presently see in America and Western Europe, at least not initially, but would manifest itself in a lot of demand for food, energy, and a variety of commodities and machinery as the middle class grew.

Now, I never committed everything to this theme, ever. ?Maybe one-third of the portfolio was influenced by it, on averaged. ?Most of what I do was and still is more influenced by my industry models, and by bottom-up stock-picking.

That said, the theme has a cyclical bias, and cyclicals have been kicked lately. ?I still think the theme is valid, but will have to?wait for overinvestment and overproduction in certain industries to get rationalized globally. ?Were this only a US problem, it might be easier to deal with because we’re far more willing to let things fail, and let the bankruptcy process sort these matters out. ?Governments in the rest of the world tend to interfere more, particularly if it is to protect a company that is a “national champion.”

But the rationalization will take place, and so until then in cyclical industries I try to own financially strong companies that are cheap. ?They will survive until the cycle turns, and make good money after that. ?That said, the billion dollar question remains — when will the cycle turn?

More next time, when I write about my industry model.

Cheapness versus Economic Cyclicality

Cheapness versus Economic Cyclicality

Posted on by David Merkel
Photo Credit: Paul Saad
Photo Credit: Paul Saad || What’s more cyclical than a mine in South Africa?

This is the first of a series of related posts. ?I took a one month break from blogging because of business challenges. ?As this series progresses, I will divulge a little more about that.

When I look at stocks at present, I don’t find a lot that is cheap outside of the stocks of companies that will do well if the global economy starts growing more quickly?in nominal terms. ?As it is, those companies have been taken through the shredder, and trade near their 52-week lows, if not their decade lows.

Unless an industry can be done away with in entire, some of the stocks an economically sensitive industry will survive and even soar on the other side of the economic cycle. ?At least, that was my experience in 2003, but you have to own the companies with balance sheets that are strong enough to survive the through of the cycle. ?(In some cases, you might need to own the debt, and not the common equity.)

The hard question is when the cycle will turn. ?My guess is that government policy will have little to do with the turn, because the various developed countries are doing nothing to clear away the abundance of debt, which lowers the marginal productivity of capital. ?Monetary policy seems to be pursuing a closed loop where little?incremental lending gets to lower quality borrowers, and a lot goes to governments.

But economies are greater than the governments that try to milk them. ?There is a growing middle class around the world, and along with that, a growing need for food, energy, and basic consumer goods. ?That is the long run, absent war, plague, resurgent socialism, etc.

To give an example of how markets can decouple from government policy, consider the corporate bond market, and lending options for consumers. ?The Fed can keep the Fed funds rate low, but aside from the strongest?borrowers, the yields that lesser borrowers?borrow at are high, and reflect the intrinsic risk of loss, not the temporary provision of cheap capital to banks and other strong borrowers.

It’s more difficult to sort through when accumulated organic demand will eventually well up and drive industries that are more economically sensitive. ?Over-indebted governments can not and will not be the driver here. ?(Maybe monetary policy like the 1970s could do it… what a thought.)

So, what to do when the economic outlook for a wide number of industries that look seemingly cheap are poor? ?My answer is buy one of the strongest names in each industry, and then focus the rest of the portfolio on industries with better current prospects that are relatively cheap.

Anyway, this is the first of a few articles on this topic. ?My next one should be on industry valuation and price momentum. ?Fasten your seatbelts and don your peril-sensitive sunglasses. ?It will be an ugly trip.

The Limits of Risky Asset Diversification

The Limits of Risky Asset Diversification

Posted on by David Merkel
Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?
Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. ?First, I don’t like infographics or video. ?I want to learn things quickly. ?Give me well-written text to read. ?A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem. ?Do you want to reduce?the volatility of your asset portfolio? ?I have the solution for you. ?Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard. ?Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” ?In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. ?Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Not much. ?The diversification from investor behavior is largely gone (the liability side of correlation). ?Different sectors of the global economy don’t move in perfect lockstep,?so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets? ?Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what? ?Much the same thing happened here as happened with non-“blue chip” stocks. ?Initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Some, but less. ?Not everyone was willing to do all of these. ?The diversification from investor behavior was reduced?(the liability side of correlation). ?These don’t move in perfect lockstep,?so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are some?that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. ?Many of those blew up last time. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again? ?Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. ?Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder. ?Think of cash, which doesn’t earn much or lose much. ?Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time. ?Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). ?This isn’t a call to go nuts and sell all of your risky asset positions. ?That requires more knowledge than I will ever have. ?But it does mean having some dry powder. ?The amount is up to you as you evaluate your time horizon and your opportunities. ?Choose wisely. ?As for me, about 20-30% of my total assets are safe, but I?have been a risk-taker most of my life. ?Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. ?You will have to wait for those ideas to be forgotten. ?Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

Ten Investing Books to Consider

Ten Investing Books to Consider

Posted on by David Merkel

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Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.

This post was also prompted by a post by another blogger of sorts publishing at LinkedIn. ?I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement. ?The successful traders seem to have systems that go beyond the simple systems that they write about. ?If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed. ?That’s why the books I am mentioning are longer-term investment books.

General Books on Value Investing

Don’t get me wrong. ?I like many books on value investing, but the first?three are classic. ?Graham is the simplest to understand, and Klarman is relatively easy as well. ?Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so. ?But even Ben Graham recognized that value investing needed to change at the end of his life.

Whitman takes more of a private equity approach, and aims for safe and cheap. ?Can you find mispriced assets inside a corporation or elsewhere where the value would be higher?if placed in a different context? ?Whitman is a natural professor on issues like these, though in practice, the?stocks he owned during the financial crisis were not safe enough. ?Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing. ?This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”

The last book is mostly unknown, but I think it is useful. ?Penman?takes apart GAAP accounting to make it more useful for decision-making. ?In the process, he ends up showing that very basic forms of quantitative value investing work well.

Books that will help you Understand Markets Better

The first link is two books on the life of George Soros. ?Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot. ?Why is there momentum? ?Why is the tendency for price to converge to value weak? ?What do markets look and feel like as they are peaking, troughing, etc? ?Expectations are a huge part of the game, and they affect the behavior of your fellow market participants. ?Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.

Consider what things are like now as people justify high equity valuations. ?At every turning point, you find people defending vociferously why the trend will go further. ?Who is willing to think differently at the opportune time?

Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time. ?They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds?by a little and cash by a lot.

For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.

Books on Managing Risk

After the financial crisis, we need to understand better what risk is. ?Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure. ?We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders. ?For the latter, think of the Chinese using too much margin to carry stocks. ?For the former, think of Fannie Mae and Freddie Mac. ?They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions. ?(You can drown in a river with an average depth of six inches. ?Averages reveal; they also conceal.)

Hot money has a short attention span. ?It needs to make money NOW, or it will leave. ?When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.” ?So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s. ?Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.

As for the last book, hedge funds as a group are a dominant form of hot money. ?They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group. ?With any individual hedge fund, your mileage may vary, there are some good ones.

These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way. ?Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it. ?A few simple changes have been made, along with a bunch of ineffectual complex changes. ?The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.

An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.

Summary

I chose some good books here, some of which are less well-known. ?They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of?The Most Important Thing, by Howard Marks. ?Oops, also great, and all for now.

PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet. ?You can figure that out for yourselves. ?Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.

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