Photo Credit: Daniele Dalledonne || Ever been to a place where everything was a little past its prime, but showed that it was a beautiful place in its time?
One of the great draws in?reading investment writing is the lure of “hot tips.” ?Everyone wants an investment idea that they can put a lot of money into that will reward buyers (or shorts) with a quick and large score. ?Thus most publications try to lure you in with articles like these, whether they will work or not.
We live in an era where market players scour as much fresh data as possible to make money, because there is validity to the idea that only fresh, previously unknown information can produce excess returns. ?The grand majority of us will never receive that information for free, and can’t afford to pay up for services that promise to give such carefully researched ideas (whether true or not, and whether they work or not).
So what’s a humble value investor to do, professional or amateur? ?I can suggest five?things:
Take a look at old ideas that seemed promising but when the news hit the market, there was a price jump, then a fall, then nothing. ?Typically, I have lists of companies that I have looked at — maybe it is time for a second look?
Source your own ideas — particularly look at smaller companies that have low or no analyst coverage. ?As regulations have come over Wall Street, you might be surprised at the number of companies in seemingly boring industries that have little to no real coverage. ?Some of them are sizable. ?(By “real coverage” I mean a human being, not an algorithm. ?Don’t get me wrong, algorithms are often better than people, but the value of a human being ?here is that he/she is more representative of how human investors think — and we love exciting stories.)
Scan 13Fs for new positions and additions — my favorite ideas are when a number of clever investors are adding on net to their holdings (and the stock has done nothing), or two hedge funds buy a new name at the same time that none of the other bright investors hold at all. ?(not a spinoff)
Or, look at spinoffs. ?For a little while, there will be liquidity and small or no analyst coverage. ?Many large investors and indexers will toss out the smaller spinoff, often leaving a undervalued company behind.
Hold onto companies in your portfolio if they stumble, but you still think management is making the right decisions.
One of the main ideas behind this is that it takes a while for business ideas to work out. ?Most valid ideas will hit a couple of bumps along the way, and short-term earnings will disappoint occasionally with good companies. ?Companies that never have disappointing earnings may be manipulating their accounting.
Many if not most of the companies that I hold for years run into disappointments, become an unrealized capital loss in my portfolio for a while, and come back to greater success. ?The short-term disappointments sometimes allow me buy a little bit more, but the main thing to analyze is that the company’s management continues to behave rationally for the good of all shareholders.
Final Notes
This only applies to healthy companies. ?Do not try this with companies that have weak balance sheets that might be forced to try to raise funds (at unattractive levels) if their plans don’t go right. ?All good investing embeds a margin of safety.
Another way to phrase this is think differently. ?There is a lot of money out there chasing the most liquid companies. If you can take on a little illiquidity on a quality company that is not well-known, that could be a good idea. ?But remember, thinking differently is not enough if?your idea isn’t smart. ?It has to be smart and different.
With that, happy hunting. ?Sometime in the near term, I will do a post on underfollowed companies. ?Read it when it comes — it might have some good ideas.
[bctt tweet=”So what?s a humble value investor to do, professional or amateur? I can suggest five things” username=”alephblog”]
Should a credit?analyst care about financial?leverage? ?Of course, the amount and types of financial claims against a firm are material to the ability of a firm to avoid defaulting on its debts. ?What about operating leverage? ?Should the credit?analyst care? ?Of course, if a firm has high fixed costs and low variable costs (high operating leverage), its financial position is less stable than that of a company that has low fixed costs and high variable costs. ?Changes in demand don’t affect a firm as much if they have low operating leverage.
That might be fine for industrials and utilities, but what about financials? ?Aren’t financials different? ?Yes, financials are different as far as operating leverage goes because for financial companies, operating leverage is the degree of credit risk that financials take on in their assets. Different types of lending have different propensities for loss, both in terms of likelihood and severity, which are usually correlated.
A simple example would be two groups of corporate bonds — ?one can argue over new classes of bond?ratings, but on average, lower rated corporate bonds default more frequently than higher rated bonds, and when they default, the losses are typically greater on the lower rated bonds.
As such the amount of operating risk, that is, unlevered credit risk, is material to the riskiness of financial companies.
Credit analysis gets done on financial companies by many parties: the rating agencies, private credit analysts, and implicitly by financial regulators. ?They all do the same sorts of analyses using similar underlying theory, though the details vary.
Regulators typically codify their analyses through what they call risk-based capital. ?Given all of the risks a financial institution takes — credit, asset-liability mismatch, and other liability risks, how much capital does a financial institution need in order to stay solvent? ?Along with this usually also comes cash flow testing to make sure that?the financial companies can withstand runs on their capital structure.
When done in a rigorous way, this lowers the probability and severity of financial failures, including the remote possibility that taxpayers could be tagged in a crisis to cover losses. ?In the life insurance industry, actuaries have worked together with regulators to put together a fair system that is hard to game, and as such, few life and P&C insurance companies went under during the financial crisis. ?(Note: AIG went under due to its derivative subsidiary and that they messed with securities lending agreements. ?The only failures in life and P&C insurance were small.)
Banks have risk-based capital standards, but they are less well-designed than those of the US insurance industry, and for the big banks they are more flexible than those for insurers. ?If I were regulating banks, I would get a small army of actuaries to study bank solvency, and craft regulations together with a single banking regulator that covers all depositary financials (or, state regulators like in insurance which would be better) using methods similar to those for the insurance industry. ?Then every five years or so, adjust the regulations because as they get used, problems appear. ?After a while, the methods would work well. ?Oh, I left one thing out — all banks would have a valuation actuary reporting to the board and the regulators who would do the cash flow testing and the risk-based capital calculations. ?Their positions would be funded with a very small portion of money that currently goes to the FDIC.
This would be a very good system for avoiding excessive financial risk. ?Dreaming aside, I write this this evening because there are other dreamers proposing a radically simple system for regulating banks which would allow them to write business with no constraint at all with respect to credit risk. ?All banks would face a simple 10% leverage ratio regardless of how risky their loan books are. ?This would in the short run constrain the big banks because they would need to raise capital levels, though after that happened, they would probably write riskier loans to get their return on equity back to where it was.
My main point here is that you don’t want to incent banks to write a lot of risky loans. ?It would be better for banks to put aside the right amount of capital versus varying classes of risk, and size the amount of capital such that it is not prohibitive to the banking system.
As such, a simple leverage ratio will not cut it. ?Thinking people and their politicians should reject the current proposal being put out by the Republicans and instead embrace a more successful regulatory system manned by intelligent and reasonably risk-averse actuaries.
Now I’ve written at least one other article on this:?Numerator vs Denominator. ?(If you have time, it is a good summary article.) ?The basic idea is this: in the long-run stocks benefit from growth in the economy. ?In the short-run, growth in the economy can push up the demand for capital because new and existing businesses need investment, and the cost of capital rises as a result. ?Second, as the economy grows, sometimes resources other than capital are proven to be in short supply, e.g., labor and resources. ?GDP may grow, but in certain contexts, profits as a share of GDP can shrink, and the share going to wages, resources, and interest may grow.
I write this for a few?reasons:
It is by no means certain that the economy will grow more rapidly under President-elect Trump.
It is also not certain that profits will grow more rapidly.
Even if profits grow more rapidly, that does not guarantee that stock prices will rise.
There are often surprising second order effects when policies change.
After the election of Trump, the old economy stocks in portfolios that I manage for clients and me?did well, and the emerging market stocks did badly, aside from a Russian small cap ETF (which flew). ?At first I wondered about the emerging market stocks, but with rising interest rates in the US, the Volatility Machine kicked in, amplifying the effects of anticipated growth in demand capital in the US, and raised capital costs in the emerging markets, sending their stock prices down.
The same thing can happen to stocks in the US if there is enough demand for capital from the US Government to rebuild infrastructure. ?Let the US Government try to borrow more than $1 Trillion per year.? Watch interest rates rise, and watch stocks fall, as Government borrowing crowds out private investment.? On a related basis, higher interest rates make dividend-paying common and preferred stocks less attractive.
That doesn’t mean that the stocks supplying the needs of the government will do badly, but remember that the growth in demand for those goods and services might not persist. ?The prices of those stocks have already embedded higher growth rates into them — will the reality outcompete the expectations?
That’s the key question for all investors now and ever: reality versus expectations. ?Good investors make cold calculations of the expectations embedded in their investments versus likely reality, and as the situation changes, they keep adjusting.
That’s why I don’t think of the post-election period as a re-animation of “animal spirits.”? I do see it as?a rational response to likely changes. ?Does that mean that the likely changes are certain to happen? No. ?But it is likely for the economy and profits to grow faster in an environment where regulation is lower (for an example, consider the first term?of the Reagan Administration. ?It is also possible that interest rates could rise enough to erase the effect of higher profits on stock prices. ?Also, with a political neophyte in the White House, there could be significant volatility in all of the markets as the new President absorbs on-the-job training at our expense. ?Remember, volatility is risk in the short-run, but less so in the long-run. ?That can have a temporary effect on the prices of risky assets like stocks.
Permanent linear changes rarely happen in complex societies, so consider:
All sorts of things will get proposed, but what will get enacted?
Of what is enacted, will it have the expected effect?
Will there be other effects not presently expected, including a quick reversal or slowdown of policy changes because of public opinion changes and future electoral losses?
How will monetary policy react?
The election and its aftermath has not changed my investing plans in any major way. Tastes, demographics, and technology have not been radically altered. ?I am reacting to what the market is doing, but what is likely to get approved, and how regulatory efforts shift is likely to be moderate rather than revolutionary. ? Even if GDP grows faster, it is no guarantee of a rising stock market in the short run.
As such, my responses are?small, and I continue to watch and adjust.
Most days, I don’t trade. ?I study.? I model. ?I muse. ?I plan.
There are some clever traders out there. ?I am not one of them. ?What little trading I do is done efficiently and effectively to get the best prices for assets that I want to buy and sell, but that’s not where most of the money is made in investing.
I can be like a chef who goes out to the market in the morning and buys the best ingredients available that day at great prices, except that my period of analysis is years, not a day. ?The point is that I consider the deals that the market is offering, and choose attractive ones that will benefit my clients and me for years to come. ?(I am still the largest investor that I manage money for — I eat the exact same meal that I serve to clients.)
What trading I do divides into two categories, which are designed for two different time horizons. ?The first time horizon is long — 3-10 years in length. ?Can I find companies with good or better business prospects trading at prices more attractive than the businesses that I currently own?
This is mostly a patient thing, unless I conclude that I got something materially wrong, in which case I try to be quick to sell. ?Patience is needed, because investing is like farming. ?It doesn’t grow overnight. ?It will take time for value to be built, and time for people to recognize that the company is better than they thought it was. ?It won’t be a linear process, either, unless something unusually good happens. ?There are setbacks with almost every?winning investment. ?Keep your eyes on the main drivers of growth in value, and whether management is using excess cash to the best?ends, which will vary by company.
At least half of my winners spent time as an unrealized capital loss at some point. ?My timing is sometimes nonideal, but ideal timing is not required for great results if the time horizon is years. ?So I watch?and monitor, and occasionally trade away the position when I find something with materially better prospects.
As an aside, not all RIA clients would like this, because it looks like I’m not doing that much. ?I sometimes wonder how much better money management would be if clients were happy with portfolios that don’t change much and don’t have many of the current hottest and most recognizable companies in them. ?Portfolios filled with?unknown companies in boring but profitable industries… difficult to talk about at parties, but often more profitable.
What I have mentioned above is 85% of what I do. ?The shorter-run movements of the market provide the other 15% as ideas and companies go in and out of favor in the short run. ?I mentioned that my timing is often not the best. ?This gives me an opportunity to do a little better.
20% is a significant move — it’s enough to justify the trading costs. ?If the company is still a good one, the fall in price gives me the opportunity to lower my average cost modestly. ?Note that this is a modest change — I’m not trying to be a hero or a home-run hitter. ?I learned better when I was younger that making timing decisions on that level is too undisciplined. ?It is far better to edge in and edge out around a core position — with a good company, a lower price means lower risk, and a higher price means higher risk, so this method is always taking and shedding risk at appropriate levels.
Edge in, edge out — trades like this happen a few times a month — more frequently when the market is lively, less often when it is sleepy. ?Hey, don’t force things. ?This is gradual reallocation of money from less to more attractive homes for capital. ?The time horizon here is 3-12 months, and offers the ability to make a little more off of core positions.
Over 5 years, companies that I own might have a grand total of 5-10 trades from edging in and out. ?It will always be a mix of both buys and sells — few companies don’t have moves of 20%+ down amid growth. ?(As some will note, if markets are efficient, why is there such a large gap between 52-week highs and lows for individual stocks? ?Really, markets aren’t efficient — they are just very hard to beat.)
Now, others will come up with different ways of managing multiple time horizons in investing, but this method offers a decent balance between the short- and long-terms, and does so in a businesslike, disciplined way. ?And so I edge in and edge out.
[bctt tweet=”This balances the short- and long-terms, and does so in a businesslike, disciplined way.” username=”alephblog”]
If you knew me when I was young, you might not have liked me much. ?I was the know-it-all who talked a lot in the classroom, but was quieter outside of it. ?I loved learning. ?I mostly liked my teachers. ?I liked and I didn’t like my fellow students. ?If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.
I read a lot. A LOT. ?Even when young I spent my time on the adult side of the library. ?The librarians typically liked me, and helped me find stuff.
I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it. ?She would watch Wall Street Week, and often, I would watch it with her. ?2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.
Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest. ?The two were the conglomerate Litton Industries, and the home electronics company?Magnavox. ?Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares. ?We did worse on Litton. ?Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss. ?Don’t blame my mother for any of this, though. ?She rarely bought highfliers, and told me that she would have picked different stocks. ?Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.
At the library, sometimes I would look through some of the research volumes that were there for stocks. ?There are a few things that stuck with me from that era.
1) All bonds traded at discounts. ?It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.
In those days, some people owned individual bonds for income. ?I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s. ?Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals ?in the mid-to-late ’70s. ?My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.
When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons. ?Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost. ?Any recoveries will be off the par value of the bond, which is usually $100.
2) Many stocks paid dividends that were higher than their earnings. ?I first noticed that while reading through Value Line, and wondered how that could be maintained. ?The phrase “borrowing the dividend” was bandied about.
Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability. ?Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.
3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go. ?I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.
The “Death of Equities” came and went, but that reminds me of one more thing:
4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency. ?Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things). ?Low stock and bond prices made pension plans look shaky. ?A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.
Takeaways
The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in. ?We are so absorbed in the zeitgeist (Spirit of the Times)?that we usually miss that other eras are different. ?We miss the possibility of turning points. ?We miss the possibility of things that we would have not thought possible, like negative interest rates.
In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy. ?Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.
The Soviet Union will bury us.
Japan will bury us. ?(I’m listening to some Japanese rock as I write this.) 😉
China will bury us.
Few people can see past the zeitgeist. ?Many can’t remember the past.
Should we?be concerned about companies not being able pay their dividends and fulfill their buybacks? ?Yes, it’s worth analyzing.
Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow. ?Stocks will likely fall with bonds if real interest rates rise. ?And, interest rates may not rise much soon. ?Are you ready for both possibilities?
Average people don’t seem that excited about any asset class today. ?The stock market is at new highs, and there isn’t really a mania feel now. ?That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates. ?Those that held onto the Nifty Fifty may not have lost money, but few had the courage. ?Will there be a correction for the highfliers of this era, or, is it different this time?
It’s never different.
It’s always different.
Separating the transitory from the permanent is tough. ?I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it. ?As Buffett has said, (something like)?”We’re paid to think about things that can’t happen.”
Ending Thoughts
Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:
The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order. ?Sovereign default used to be a large problem. ?It is a problem that is returning. ?As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement. ?Hopefully we don’t get a lot of wars as they did in that decade.
I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things. ?I’m flat there now. ?I think you almost have to be a trend follower there.
The yield curve will probably flatten quickly if the Fed tightens more than once more.
The internet and global demographics are both forces for deflationary pressure. ?That said, virtually the whole world has overpromised to their older populations. ?How that gets solved without inflation or defaults is a tough problem.
Stocks are somewhat overvalued, but the attitude isn’t frothy.
DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
Eventually emerging markets and their stocks will dominate over developed markets.
Value investing will do relatively better than growth investing for a while.
That’s all for now. ?You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way. ?The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. 🙂
I’ve thought about this problem before, but always thought it was more of a curiosity until I read this on page 66 of Jeff Gramm’s very good book, Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism. ?(Note: anyone entering through this link and buying something at Amazon, I get a small commission.)
I saw Eddie Lampert, a hedge fund manager who is chairman of Sears Holdings, make some interesting points at a New York Public Library event in 2006. When he was discussing the challenges of managing a public company, he raised a question few people in the room had considered. How do you run a company well when the stock is overvalued? What happens when management can’t meet investors’ unrealistic expectations without taking more risk? And what happens to employee morale if everyone does a good job but the stock declines? Lampert, of course, knew what he was talking about. Sears closed that day at $175 per share versus today’s price of around $35. In an efficient market, it’s easy to develop tidy theories about optimal corporate governance. Once you realize stock prices can be totally crazy, the dogma needs to go out the window.
The price of Sears Holding is around $13 now, though there have been a lot of spinoffs. ?Could Eddie have done better for shareholders? ?Before answering that, let’s take a simpler example: what should a the managers/board of a closed end fund do if it persistently trades at a large premium to its net asset value [NAV]? ?I can think of three ideas:
1) Conclude that the best course of action is to?minimize the eventual price crash that will happen. ?Therefore issue stock as near the current price level as possible, and use it to buy non-inflated assets, bringing down the discount. ?What’s that, you say? ?The act of announcing a stock offering will crater the price? ?Okay, good point, which brings us to:
2) Merge with another closed end fund, trading at a discount, but offering them a premium to their NAV, hopefully a closed end fund?related to the type of closed end fund that you are. ?What’s that, you say? ?Those that manage other closed end funds are financial experts, and would never agree to that? ?Uhh, maybe. ?Let me say that not all financial experts are equal, and who knows what you might be able to do. ?Also, they do have a duty to their investors to maximize value, and for those that?sell above net asset value this is a big win. ?In the meantime, you have reduced your effective economic discount for those that continue to hold your fund.
3) Issue bonds or preferred stock convertible into common stock at a level that virtually guarantees conversion. ?Use the proceeds to invest in your ordinary investment strategy, bringing down the effective discount as dilution slowly takes place.
Of all the ideas, I think 3 might work best, because it would have the best chance of allowing you to issue equity near the overvalued level. ?If the overvaluation was 50%, maybe you could get it down to 25% by doubling the asset base, in which case you did your holders a big favor. ?If it works, maybe repeat it in two years if the premium persists.
A closed end fund is simple compared to a company — but that added complexity may allow strategies one or two to work better. ?Before we go there, let’s take one more detour — PENNY STOCKS!
Okay, I haven’t written about those in a while, but what do penny stock managements with no revenues do to keep their firm alive? ?They trade stock at discount levels in order to source goods and services. ?This creates dilution, but they don’t care, they are waiting for the day when they can exit, possibly after a promotion. ?Also, they could issue their stock to buy up a small firm,?adding some value behind the worthless shares. ?One guy wrote me after my penny stock articles, telling me of how he foolishly did that, with the stock being restricted, and he watched in horror as the ?price sank 60% before he was allowed to sell any shares. ?He lost most of what he worked for in life, took the company to court, and I suspect that he lost… it was his responsibility to do “due diligence.”
So with that, strategy one can be to issue as much stock as possible as quietly as possible. ?Offer your employees stock in order to reduce wages. ?Give them options. ?Where possible, pay for real assets and services with stock. ?Issue stock, saying that you have big plans for organic growth, then, try to grow the company. ?In this case, strategy three can make more sense, as the set of buyers taking the convertible stock and bonds don’t see the dilution. ?That said, the hard critical element is the organic growth strategy — what great thing can you do? ?Maybe this strategy would apply to a cash hungry firm like Tesla.
In strategy two, merge with other companies either to achieve diversification or vertical integration. ?Issue stock at a premium to the value received, but not not as great as the premium underlying your current stock price. ?Ordinarily, I would argue against dilutive acquisitions, but this is a special case where you are trying to reduce the premium valuation without reducing the share price.
This brings us to another set of examples: conglomerates and roll-ups. ?Think of the go-go years in the ’60s where conglomerates bought up low P/E stocks using?their high P/E stocks as currency. ?Initially, the process produces earnings growth. ?It works until the eventual bloat of the businesses is difficult to manage, and?the P/Es fall. ?Final acquisitions are sometimes ugly, leading to failure. ?The law of decreasing returns to scale eventually catches up.
With roll-ups an aggressive management team buys up peers. ?The acquirer is a faster growing company, and so its stock trades at a premium. ?If the acquirer is clever, it can shed costs in the target, and continue to show earnings growth for some time until it finally slows down and has to rationalize the mess of peer companies that have been bought.
This brings up one more area for overvalued companies: frauds. ?This past evening, my wife and I watched The Billion Dollar Bubble, which was the largest financial fraud up until Madoff. ?One thing Equity Funding?did was use the funds that they had generated to buy other insurers. (That’s not in the movie, which kept things simple, and compressed the time it took for the fraud to take place.)
Enron is another example of a fraudulent company that used its inflated share price to buy up other companies. ?Not everything Enron did was fraudulent, but having a highly valued stock allowed it to buy up companies with assets which reduced some of its valuation premium, though not enough for the stock to go out at a positive figure.
Summary
It is an unusual situation, but the best strategy for a company with an overvalued stock is to try to grow their way out of it, usually through mergers and acquisitions. ? The twist I offer you at the end of my piece is this: thus, watch highly acquisitive firms. Not all of them are overvalued or fraudulent, but some will be. Avoid the shares of those firms.
[bctt tweet=”watch highly acquisitive firms. Not all of them are overvalued or fraudulent, but some will be. Avoid the shares of those firms.” username=”alephblog”]
Three months ago, I bumped against my upper cash limit. ?After that, I put an additional 6% of funds into the market. ?Now cash is up to 18%, near my cash limit of 20%. ?As I look at my portfolio now, most of the portfolio is above the central band. ?I may buy another stock to bring cash levels down, but I am going to use?a different tool because everything?has moved up. ?I’m moving the band itself up. ?(Last time, if I had moved the band up, there were a lot of stocks near the lower edge of the band, and I don’t like moving the band when results are dispersed. ?I don’t want to buy or sell as a result of moving the band.)
I don’t adjust the trading bands often — maybe once a year or so. ?I leave them fixed in nominal dollar terms, adjusting for when clients add or remove?assets. ?When the market has moved so much that almost every?stock is above or below the central line of the band, rather than add or sell?a stock, I adjust the height of the band. ?I moved my band up 6%, which puts half of my stocks above and below the central line of band, from which if a stock is 20% over the central line, I sell down to the central line, and if a stock is 20% under the central line, I buy up?to the central line if I still believe that the stock is a good one to own. ?This is the way that Portfolio Rule Seven works.
This makes the sell points further away and makes the buy points nearer, which in turn makes it incrementally more likely that cash will be dispersed, not accumulated. ?Now, if the market keeps running up, particularly for value stocks, cash will still accumulate, but it will take more to make that happen.
Why do I do it this way? ?In this environment, I look at the height of the market, which is considerable, but I also look at the momentum, and conclude that I ought to let things run more, if they will. ?In my opinion, the stocks that I own for clients are undervalued, even if the market is not undervalued. ?Old economy stocks have lagged for years behind new economy stocks, and valuation differences are pronounced. ?I experienced much the same thing in 2000-2001 when growth got whacked, and value kept performing until everything went through the wringer in 2002.
Now, I’m hoping, but not saying that value is coming back, but it is certainly overdue. If this period is anything like the beginning of the 2000s, it will be very good for value investors. ?The challenge will be managing high absolute market valuations versus favorable relative valuations. ?It makes for a bumpy ride, but I like the stocks that I own, and will keep adjusting through all of the bumps.
[bctt tweet=”Now, I’m hoping, but not saying that value is coming back, but it is certainly overdue.” username=”alephblog”]
For those that missed the rally, do you feel bad about it? ?Regretful? ?Really, it’s too bad that the bear bug got you to the degree that you acted on it. ?Those who have read me for a long time know that I often sound bearish, because I am natively bearish. ?But, I don’t let it force me to take aggressive actions. ?There is a point where I will hedge everything, but that is around 2600 on the S&P 500 at present. ?I sit and worry a little, let?Portfolio Rule Seven?trim a little as my stocks hit new highs, but I won’t let cash go over 20% — we’re at about 16% now. ?After I?Bumped Against My Upper Cash Limit, I bought more stock — good thing too, at least in the short run.
If you think this is all a mirage, and there aren’t any structural reasons why the market should go any higher, and you are not going to do anything here — well, good for you. ?Maybe you are right, and you can buy lower someday. ?Just don’t get jumpy if the market continues to rise, and you don’t have much in the game. ?(To those so inclined, don’t be macho fools and try to short into new highs — wait until there is some blood on the sword before shorting, something that I almost never do because of the bad risk/reward tradeoff.)
But if you are feeling jumpy and think you should get in on the action, let me give you two words:??Do Half.?? If at normal valuations you would have 60% of your assets in stocks, and you have nothing in stocks now, don’t take position above 30%. ?Go up to half of a normal position. ?If things continue to go up, you will be happy you have something in the market.??If things go down you can bring it up to a full position on weakness, and be grateful you didn’t go up to 60% all at once.
Now, I’m not telling you to buy anything, invest with me, or anything like that. ?I just know that regret is one of the most powerful forces in the market, and lots of people make stupid decisions under its influence. ?Rules that I use, like “Do Half” and the portfolio management rules are designed to keep me from making rash decisions influenced by my emotions.
The same “Do Half” rule could be applied to lightening up on bond positions and other matters, like raising cash or edging into commodities. ?(I am doing neither of those now — they are just examples from others that I know.)
The main idea is to be self-controlled, and not let emotion drive you. ?Investing is a business; determine your policies, and act on them, whether you do it yourself, or farm it out to others. ?But if you?feel that you have to do something now, then my advice to you is “Do Half.” ?[bctt tweet=”But if you feel that you have to do something now, then my advice to you is ‘Do Half.'” username=”alephblog”]
There is a statement commonly made that firms in the US aren’t doing as well as they can in the long-run because the calculation of quarterly earnings inhibits long-term investment. ?I’m not sure that such statements are true or false, but I will try to explain the problem or lack thereof in this post.
Common reasons for alleging the problem
The division between management and ownership means that managements often act in their own interests rather than those of shareholders.
Management incentives are calculated over too short of a period of time.
Quarterly earnings distract from long-term planning.
Accounting methods do not allow for capitalizing certain types of investments, and so they don’t get done to the degree necessary.
Investing for the long-run will create greater returns.
It is easier to simply buy back stock or pay dividends in the short run. ?Investing more?will create greater returns.
I’d like to get rid of a few of these arguments quickly. ?First, there is no evidence that investing more produces greater returns, and there is evidence that stocks that do buybacks and pay dividends tend to outperform. ?There is evidence in specific cases that buying back stock at high prices destroys value, but what?high prices are is often only know in hindsight. ?That said, I encourage corporate boards and managements to have their own conservative estimate of the private market value of their firm, and only to buy back stock when the price is below that estimate.
Second, there is no evidence that long-term investing produces greater returns on average. ?Here’s why: longer investments are less certain than shorter ones, and require longer-term capital to finance them, which is more expensive.
I remember the Japanese making their long-term investments in the 1980s — they were regarded as very farsighted. ?They invested a lot at what seemed like low ROEs, but their stock market kept going up, and they were hailed as geniuses that would bury the barbaric capitalism of the US. ?As it was, the ROEs were low, and in many cases negative.
I liken it to trying to hit a home run in baseball. ?It’s a high-risk, high-return strategy, but tends to lead to worse results than just trying to get on base. ?Many good returning projects for firms are small, and short-term in nature. ?Incremental improvement can go a long way.
Reasons 1-4 have a little more punch in my opinion, but they are all solvable by setting up an alternative accounting basis that facilitates long-term projects, using that as the definition for pro-forma earnings to present to Wall Street, and using it for management performance measurement and compensation.
There is a trick here, though. ?Management and the board have to be intelligent enough to have both:
A long-term investment that they know with high probability will be a success, and
A means of measuring the progress toward the goal over a long period of time.
Both of those are tough. ?Long-term projects can go wrong for a lot of reasons — cultural change, technological change, economic change, competitive change, change in the ability to keep the company as a whole financed, and more.
And, it’s not as if I don’t see project timelines in presentations that managements give to investors and analysts. ?Long-term investing does get done, even if the GAAP or tax accounting treatments don’t favor it in the short run.
As I have mentioned before, corporate valuation depends on free cash flow, and GAAP accounting does not affect that. ?As such, quarterly GAAP earnings should not affect the willingness of companies to take on long-term projects that they think will be winners.
That leaves management incentives, which are always a problem. ?Most good incentive plans are a mix of short and long-run items. ?The mix will depend on the maturity of the industry, and the relative opportunities faced by the firm.
Conclusion
If there is a problem here, boards and managements have adequate tools at their disposal to try to solve the problem, with the added risk that the cure could prove worse than the disease. ?As an example, consider trying to get sleepy pipelines and utilities to innovate on long-term projects that are hard to manage and measure. ?Well, that was Enron, Dynegy and a variety of companies that learned that there aren’t a lot of ways to dramatically improve performance in a mature business.
But there may be no problem here at all. ?The US has been one of the better performing markets in the developed world, and in general, industries that invest a lot do not outperform industries that do less investing. ?We may not need to adjust our methods at all.
Also, we might not need as many tax incentives from the government to promote investing either. ?In my opinion, the good investments will get done. ?Investments that require tax incentives just encourage management teams to do tax farming.
Management teams are less short-term focused than most imagine. ?If they don’t invest a lot for the long-term, it may just be that there aren’t many attractive long-term investments capable of providing returns greater than the cost of longer term capital needed to finance the investments.
Well, I’m back in suburban Baltimore after the struggle of getting to the the center of DC and back. ?It takes a lot of energy to write 4000 or so words, tweet 26 times, meet new people, old friends, etc. ?Here are some thoughts after the sip from the firehose:
1) There was almost no media there this time. ?Maybe it’s all the action associated with a new president being elected. ?All the same, I see almost nothing on the web right now aside from the Twitter hashtag #CatoMC16?and my posts echoed at ValueWalk.
2) I came out of the conference thinking that I need to read three of the papers, the ones by:
Hanke & Sekerke — color me dull, but it finally dawned on me the potential degree to which structural regulatory change has been fighting ZIRP.
Jordan — his idea on how to sop up excess liquidity sounds interesting.
Goodspeed — I am a sucker for economic history — it broadens the categories that you think in. ?His presentation was very data-oriented, and I thought the methodology was clever for analyzing alternative deposit guarantee methods back in a time when the states regulated the banks. ?(Please bring back state regulation of banks; it works better. ?Many more failures, but they are all small.)
3) Jim Grant is always educational to listen to. ?I also appreciated O’Driscoll, Thornton, Orphanides, and Hoenig.
4) I would not invite back Spitznagel (irrelevant), Allison, Todd, and Gramm (three living in fantasyland).
5) That brings me to the fantasies of the conference as I see them. ?This is what I think is true:
The Community Reinvestment Act [CRA] was not a big factor in the crisis, aside from the GSEs. ?Intelligent banks make decent CRA loans; I’ve seen it done.
Subprime lending was the leading edge of of bad lending on residential real estate, but regulators did not do their jobs well in supervising lending.
Tangible bank leverage was way too high, and was a large part of the crisis. ?So was a lack of liquidity from losing the wholesale funding markets, which disproportionately hit the big banks.
The big banks were disproportionately insolvent, though a few of them did not need more capital, like US Bancorp BB&T, and Wells Fargo. ?Many more small banks were insolvent also, but they weren’t big enough to move the systemic risk needle.
Banks are?a little over-regulated, but given the poor ways that they managed liquidity prior to the crisis, you can’t blame Dodd-Frank for trying to avoid that problem again.
The big bank stress tests are not real in the US or Europe; they exist to mollify politicians and bamboozle the public. ?If they ARE real, then publish the data, methods and results in detail.
Banks?need a strong risk based capital formula. ?The one for insurers works very well. ?Perhaps banks should imitate the stronger and smarter solvency regulations that insurers use. ?They might even find them looser than what they currently do, but be more accurate as to real risks.
Inverting the yield curve is?necessary in a fiat money system. ?You need to deflate and liquidate bad lending so that new lending in the next part of the credit cycle can recycle the capital to better projects.
6) That brings me to the realities of the conference as I see them. ?This is what I think is true:
Fannie/Freddie were a large part of the crisis. ?Undercapitalized relative to the amount of default risk they were taking.
Housing prices were pushed too high as a result of too much debt getting applied to finance them. ?Loose monetary policy aided the creation of this debt. ?Falling housing prices were the main cause of the crisis, as many loans became inverted, and a slowing economy led to many losing their ability to pay their mortgages.
We needed a different bailout where bank stockholders lost all, and debtholders lose also, only after that should the FDIC have been tapped to protect depositors.
Bank solvency is important for the long run for the economy. ?A crisis like the last one erases a lot of the growth that would occur from looser bank regulatory policy. ?Things may be tight now, but once the system adjusts, growth should resume.
A?healthier economy has lower debt and less debt leverage/complexity. ?Debt and layered debts make an economy inherently fragile.
A gold standard does not increase instability, unless banks are mis-regulated for solvency.
The wealth effect is tiny, and the Fed should stop pretending that it does much.
7) While at Cato, I noticed the area named for?Rose Wilder Lane, the same Rose in the “Little House on the Prairie” books (daughter of Laura and Almonzo Wilder). ?She was a libertarian later in life, and knew Ayn Rand. ?Their pictures are near each other in Cato’s basement. ?Just a little trivia.
8 ) There was a lot of sympathy for the idea of not paying interest on excess reserves, and certainly not same rate as on required reserves.
. ?(Note: anyone entering through this link and buying something at Amazon, I get a small commission.)
