Since 1996, I’ve been aware of research that indicates that momentum works in the stock market.? My quandry as a value investor has been to figure out how to incorporate it, if at all.? My approach was to play for the weaker mean-reversion effect, and have a lower turnover rate than would be needed in a value plus momentum strategy.? I am now questioning that decision, even though I have done well in the past. I just finished the initial stages of an analysis that will be available to my clients highlighting the value of momentum strategies.? Using the industries in the S&P 1500 Supercomposite, from October 1995 to December 2008, investing in the Supercomposite yielded an annualized price return of 4.0% (with dividends 5.5%).? The annualized price return for each momentum quintile, where momentum was defined as return over the previous 200 business days, was as follows:
Top — 11.3%
Second — 4.4%
Middle — 6.5%
Fourth — 1.7%
Bottom — 0.2%
Now, there are several weaknesses with this analysis:
No trading costs.? (I think those could be minimized.)
Some industry groups are small, and could not accommodate a lot of money.? (Probably a large problem)
That said, even with those difficulties, there should still be some excess return from following a momentum strategy.? What industries would that imply at present?
Education Services
Brewers
Biotechnology
Water Utilities
Insurance Brokers
Environmental and Facilities Services
Hypermarkets & Supercenters
Health Care Services
Packaged Foods
Pharmaceuticals
Gold
Multi-Utilities
Restaurants
Tobacco
Household Products
Home Improvement Retail
Food Distributors
Distillers & Vintners
Reinsurance
Food Retail
Integrated Oil & Gas
Health Care Technology
Airlines
Health Care Supplies
Electric Utilities
Distributors
For a quick summary, think staples, utilities, health care (excluding insurance), and other industries with stable cash flow.? This is about as bearish as it gets, so be careful for now, and don’t speculate on when the turn in the economy will come.? Focus on what consumers always need. Or, as James Grant once said (something like), “Could this be a bull market in cash?” 😉
This leson goes way back with me, to my graduate student days, where I was assisting the teaching of Corporate Financial Management.? At UC-Davis, this was the class that attracted the bright and motivated students.? I happened to get it as my first assistant role at UCD, not realizing it was a plum role.
One of the things we taught was that most firms suffer financial distress from a failure to manage cash flow properly.? That is a salient lesson in the current environment.? I learned it again as a young life actuary, because life insurance companies can die from credit risk, run-on-the-company risk, or both.? Consider Mutual Benefit, which wrote fixed-rate GICs [Guaranteed Investment Contracts] putable on a ratings downgrade, or General American and ARM Financial, which wrote floating-rate GICs putable on a ratings downgrade.? The downgrades hit.? They were toast.
Illiquid assets must be funded by equity or long-term noncallable debt, where the term is as long as the asset’s horizon.? (Near asset price tops, longer, near bottoms, long enough for comfort.)? This is the first step in orthodox risk management: assuring that you can hold onto your assets under all conditions.
But in this current crisis, this rule has been violated many times:
Investment banks and mortgage REITs that relied on short-term repo funding.? Bye-bye, Bear and Lehman.? Mear miss to Merrill, protected by Bank of America.? Many mortgage REITs dead, or nearly so.
Derivative counterparties like AIG do not factor in the need for more collateral during times of credit stress.
ABCP and SIVs presume that easy lending terms will always be available.
This is the advantage of the actuarial model of risk over the financial model of risk.? I have previously called it table stability versus bicycle stability.? A table always stands, whereas a bicycle has to keep moving to stay upright.? What happens if markets stop trading in any reasonable fashion?? WIll you be broke?? I submit that that is not an acceptable risk to take, because markets do fail for moderate amounts of time.
Better to manage such that you can buy-and-hold for moderate lengths of time, with enough financial slack to tide over rough patches in the market.? Analyze your cash flows over pessimistic scenarios, and ask whether you can carry your positions with sufficient certainty.? Sell down your positions to levels where you are comfortable.
When I was the risk manager for two life insurance companies, one of the first things that I did was analyze the illiquidity of my assets and liabilities, making sure I had liquidity adequate to fund illiquid assets.? The second was analyzing cash flow needs and making sure there was always more cash available than cash needed, under all reasonable scenarios.
This is risk management at its most basic level.? Many on Wall Street looked at short-term asset/liability correlations, and missed whether they could adequately finance their businesses under stressed conditions.
With that, I ask you:
Do you have an adequate liquidity buffer against negative events?
Are you only risking money that you can afford to lose in entire?
Are the companies that you own subject to financing risks?
Asset allocation is paramount in investing.? Bonds and cash get sneered at, but they play an important role in risk reduction for both individuals and institutions.? As my boss at Provident Mutual taught me, “Never risk the franchise.”? That motto guided me, and I avoided crises that other companies suffered.
Will it be the same for you and your assets?? Analyze your survivability in personal finance, and that of your assets, and make adjustments where needed.
When I was an actuary interacting with the investment department inside a life insurance company, one of the things that I learned early was that there was an inpenetrable jargon on the part of the bond investors that neophytes had to learn.? My boss, the best actuarial businessman that I have ever known, insisted that we have a weekly meeting with the investment department, and in their offices.? Being on their own turf made them freer to talk their own lingo, and that helped us learn it.
When I went to work in an investment department years later, the shoe was on the other foot.? I was still learning investment lingo, but when the actuaries showed up, I was there to translate.? Not surprisingly, there is jargon on both sides, often with the same term having two different names, because it is used two different ways.
It was true until the day I left the firm, where I heard a bond term I had never heard before.? We have a lot of jargon in investing, whether it is fixed income or equities.? There is additional jargon in insurance.
Here’s my offer: I try to define what I write about, but if I fail to define something adequately, let me know in the comments, and I will add an entry to the new Jargon page.? Let me know; I live to serve.
At the beginning of each calendar year, I sit down and see how my expenses have tracked over the past year.? I make a table and a pie chart to show my wife.? She is always amazed at how much goes to taxes, though the new amazement is what it takes to put children through college.? We spend some time discussing plans for the next year.? Since my wife is not money-oriented (not a big spender, and focused on teaching the children) this gives her a quick way to get reoriented in our financial situation.
After that, I look at investment income.? 2008 was an unusual year for me in this way: it was the first year in my working life that my net worth fell.? Though painful, at age 48, I’m grateful that I have had a good past.
I then look at how individual stocks in the portfolio did.? Here’s a chart for 2008:
The chart is in order from the biggest gain to the biggest loss.? XIRR is the internal rate of return on funds during 2008, and days was the number of days I held a position during 2008.? Needless to say, this was my worst year ever, but I still did better than the S&P 500 by a middling single digit percentage.
That is important to me, because in 2009 I hope to gain my first external client. I have been banging my head against the wall, because I have a small bunch of investors that want to sign on, but they all don’t want to be my first client.? They want to see an institutional investor invest in my fund, then they will invest with me.? Frustrating.
Since strategy inception in 2000, I have beaten the S&P every year except 2007, where I missed by less than a percent.? And, given the performance of many well known value managers in 2008, beating the S&P ain’t bad.
Going back to the table above, I got whacked on names with bad balance sheets, life insurers, and names with too much cyclicality.? I did well on a number of names that I bought cheaply, and particularly on my October reshaping, where I focused on survivability.
I still think survivability is the watchword here.? I’ll be putting out my candidates list for the next reshaping soon, as well as my main industry model, but in an environment like this, raw cheapness doesn’t matter; a company must survive to realize the discount on its valuation.? Remember, the main rule of value investing is not “buy them cheap,” is not “lowest average cost wins,” but is “margin of safety.”
One more note: the present portfolio “long only” portfolio is 22% cash.? That is the highest level in eight years.? I have raised cash into the recent rally through my normal rebalancing discipline.? I will deploy cash as I get opportunity into strong names with strong balance sheets.
Asset Allocation
I also look at our asset allocation.? Excluding our house (no mortgage), it looks like this:
30% Cash and TIPS
20% International Stocks
18% Large Cap US Stocks
17% Small Cap US Stocks
15% Private Equity
I have no debts, but I have eight liabilities, two of which are going to college, and six of which might do so.? That is my main financial challenge for the next fifteen years (the little one is almost seven, and what a cutie.)
Even though I am bearish, I am comfortable with the amount of risk that I am taking, partly because I may derive a business from it through my ability to pick stocks that do relatively well.? The private equity is illiquid, but in this environment even it is doing well — having clever businessmen as friends is a help.
Swap — Bought Japan Smaller Capitalization Fund, sold SPDR Russell Nomura Small Cap Japan? (The CEF was trading at an extreme discount)
Rebalancing Sales
Assurant (3)
RGA
Valero Energy
CRH
Magna Automotive
Safety Insurance
Charlotte Russe
Shoe Carnival
Devon Energy
Japan Smaller Capitalization Fund
Rebalancing Buys
Assurant (2)
Charlotte Russe (2)
Magna Automotive
Shoe Carnival
Nam Tai Electronics
I also participated in the RGA exchange, where I traded my A shares for B shares when the discount was wide, and received RGA shares one-for-one when the exchange was complete.
Blog News
I have several book reviews coming, including one on Technical Analysis, and one on how wealthy people got that way.? I also have a panoply of other article ideas:
How the lure of free money corrupts politicians
Setting up mutual banks
The risk of no significant change (not yes we can, but, why do we need to change?)
Hidden correlations
The mercantilists lost
Analyzing TIPS
Momentum strategies
Buybacks
Confidence means keeping assets inflated
How securitization could aid resolution of our current crisis
It is a lot of fun writing this weblog.? I enjoy it a lot.? As I close this note, I would like to thank:
Those that read the blog
Those that comment here, and send me email (all of which I read, but I can’t answer all of it)
Seeking Alpha
Others that republish me
Those that buy products at Amazon through my site
Those that buy blogads at my site
Other bloggers that give me good ideas
And the firm that employs me, Finacorp, but bears no liability for my mutterings here.
2009 may prove to be a better year than 2008.? If that is not true, we will be rivaling the Great Depression.? That said, there are opportunities even in bad economic environments, and lts see if we can’t make the best of what we do get.? Here is to making the most of our opportunities in 2009.? May the LORD bless us all in our endeavors.
Full disclosure: long COP SBS DIIB.PK MGA IBA XEC VLO TNP JSC NTE VSH SAFT CHIC SCVL HIG RGA HMC ESV KPPC DVN ALL PRE CRH PEP GPC LNT NUE AIZ (yes, that is the complete current portfolio)
If you have time, there are two long articles that are worth a read.? The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.? It was written in three parts — one, two, and three, corresponding to three phases:
Growth of a clever enterprise, AIGFP.
Expansion into default swaps.
Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.
What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”? There is no free money, but the lure of “free money” brings out the worst in mankind.? This is not just true of businessmen, but of politicians, as I will point out later.
My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.? Boy, were they arrogant!? It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.
As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.? The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.? Again, the AIGFP people were arrogant — but what was I to say?? They were more successful, seemingly.
The last era, as AIG got downgraded, was while I wrote for RealMoney.? After AIG was added to the Dow, I was consistently negative on the stock.? I had several worries:
Was AIGFP properly hedged?
Were reserves for the long-tail commercial lines conservative?
Why had leverage quadrupled over the last 15 years?? ROA had fallen as ROE stayed the same.? The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
Was AIG such a bespoke behemoth that even Greenberg could not manage it?
My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.? (I was privy to a number of significant reserving errors 1989-1992).
In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.? AIG fit that mold well.
Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.? This is only an opinion, but I think AIG stock is an eventual zero.? Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.? Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.
The second article is from Bethany McLean of Vanity Fair.? I remember reading her writings during the accounting scandals at Fannie Mae.? She was sharp then, and sharp now.? There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:? I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.
Again, there is a growing bubble, as with AIG.? The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.? It also leads them to buy the loans made by their competitors.? It leads them to lever up even more.? It leads them to dilute underwriting standards.? Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.
One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.? On a cash flow basis, that might not happen for a long time, but it would happen.? Defaults would be well above what was their worst case scenario, and too much for their thin capital base.
The last article is another three part series from the Washington Post that is about the failure of our financial markets.? (Here are the parts — one, two, three.)? What are the main points of the article?
Bailing out LTCM gave regulators a false sense of confidence.? They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
Because of turf and philosophy conflicts, derivatives were left unregulated.? (My view is that anything the goverment guarantees must be regulated.? Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.? The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.? Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.? Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
Standards fell everywhere as the party went on, and the bad debts built up.? It was a “Devil take the hindmost” situation.? But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.? Cash, cash, who’s got cash?!
In the aftermath, regulation will rise.? Some will be smart, some will be irrelevant, some will be dumb.? But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.
A few final notes:
Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
This could never happened as badly without the misapplication of monetary policy.? Greenspan enver let the recessions do their work and clear away bad debts.
Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
The investment banks relied too heavily on risk models that assumed continuous markets.? Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.? But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.? We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.? Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”? And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.? I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.? For that, I apologize.? It is what I hate most about investment writing — people losing because they listened to me.
1) Greenspan — what a waste.? A bright, engaging man becomes a slave to the Washington political establishment.? Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.? Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.
On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.? I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.? Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.
2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.? When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.? In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.
3) You want accounting reform?? Start with accounting that disallows gains-on-sale in a financial context.? WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.? No profits at sale.? Profits are earned in a level way over the life of the business as risk decreases.? Let other financial firms use something akin to SFAS 97, and many business problems would be solved.
4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.? Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.
5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.? Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying? recently.
Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.? Once they reject their current pose, the equity market could rally.
6) Is the economy weak?? Well, look at the states.? If their tax receipts are going down, so is the economy.? We are in a recession, and maybe a depression, given the lack of strength in the banks.
7) Do we need a new system for managing the global economy?? The Chinese certainly think so.? They finance the US and don’t get much in return.? Perhaps China could host the new global reserve currency?? I don’t think so.? Their banking system isn’t real yet, and they still want to subsidize their exports.? The global reserve currency role will flow to the largest economy allowing free flow of capital.? Now, who is that?? Japan?? Too small, but the world now recognizes that their banks may be in better shape than many other countries.? Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.? The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.
Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.? The Euro is a creation of an alliance of nations untested by economic crisis.? Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.
For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.? (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)
8 ) On the bright side, some boats are rising.? After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.? The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”? That said, the developed market banks financing them will get whipped too.? This is truly a global crisis.
And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?? I’m skeptical, as usual.? Perhaps the Treasury can send them a raft of T-bills.? The IMF can ask the Fed for contact info.
We’re nearing the end of second quarter earnings season, and I have have had my share of hits and misses, compared to the estimates that the sell side publishes.? What is the sell side?? The sell side is the analysts working for broker-dealers who publish research on companies, often estimating what they think they should earn in a quarter or year.? There is a buy side as well, which are analysts working for mutual funds, asset managers, etc., who analyze companies for their employers.
As investors, we are pelted with terms for corporate performance:
Comprehensive income — increase in net worth (approximately)
EBITDA? (Earnings before interest, taxes, depreciation and amortization) — what monies are the assets of the company generating in cash terms
Operating income — Net income, excluding one-time charges.
Net income — An attempt to show the repeatable increase in the value of the business, excluding the adjustments that operating income makes.? It also excludes “temporary differences” that are expected to reverse, which go into Accumulated Other Comprehensive Income on the balance sheet, and not through income.? An example would be unrealized capital losses on unimpaired credit instruments.
Which of these measurements should an investor use?
In takeovers, EBITDA is the most relevant, because it shows the cash generating capacity of the assets.
Operating income is the most relevant each quarter for companies that are going concerns.? It excludes “one time” events.
Over the long haul, accumulated net or comprehensive income is the most relevant, because all of the “one time” adjustments are aggregated.
In the short run, the adjustments that come from one-time events (mostly negative) can be tolerated.? But managements are supposed to try to control the factors that generate one-time events in the long run.? That part of their job.? If you have enough track record on a management team, you can sit down and calculate accumulated operating income less accumulated net income.? For good managements, that number is negative to a small positive.? For bad managements, it is a big positive.? I’ve seen estimates over a long-ish period of time, and the average difference between the two is around +5% — +10%.? That much typically goes up in smoke from operating earnings, never to reappear.
Now, some have toyed with adjusted dividend yield formulas, where they add back buybacks, and they use that as a type of true earnings yield.? After all, that reflects cash out the door for the benefit of shareholders.? True as far as it goes, but other uses of retained earnings aside from buybacks are valuable as well.
Buy/create a new technology, plant or equipment
Buy/create a new product line
Buy a competitor, or, a new firm that offers synergies
Buy/create a new marketing channel
In the hands of a good management team, these actions have value.? In the hands of bad management teams, little value to negative value.? So, I prefer earnings to these new measures based off dividends and buybacks for good management teams.? With a bad management team you want them to not have much spare capital for bad decisions, but would you trust the safety of the dividend and commitment to the buyback to a bad management team?? So, in general I prefer earnings, or, if calculable, free cash flow, to dividend/buyback metrics.
What is free cash flow?? The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.
Ideally, free cash flow generation is what we shoot for, but it is difficult to estimate in practice.? When I took the CFA exams, the accounting text suggested that the goal of earnings was to reflect free cash flow to the greatest extent possible.? I’m not holding my breath here; I don’t think that goal is achieved or achievable.? To do that, we would have to have managers expense maintenance capex, and we would have to reflect the capital requirements of financial regulators as a cost of doing business for financial companies, and there are many more adjustments like those.
So, I like accumulated net income in the long run and operating earnings in the short run for measuring financial performance.? I’ll give you one more measure to consider which might be better.? From a not-so-recent CC post (point 2, rest snipped for relevance sake):
Notes Before I Leave for ANother Series of Conferences
11/9/04 5:44 PM?ET
1. Be sure and read Howard’s piece “Hurricanes and the Limits of Rebuilding .” He comments more extensively on something I touched on when Frances was threatening Florida. Recovery from disasters often makes GDP look better afterward, because the destruction is not captured in the GDP statistics as a loss, save for the reduction in insurance profits, whereas the work of rebuilding does get fully captured.
2. The same idea can be applied to equity investing. This is why I pay attention to growth in book value per share, ex accumulated other comprehensive income, plus dividends, rather than earnings. Nonrecurring writedowns, charges for changes in accounting principles, and other adjustments, if they happen often enough, it makes a statement about the way a company handles accounting. Companies that are liberal in their accounting may have good looking earnings, but growth in book value per share can be quite poor. I trust the latter measure.
Growth in fully diluted tangible book value (ex-AOCI) is a good measure of firm performance, if you add back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price. Why the current market price?? Some managements buy back stock indiscriminately, not caring about the price at purchase.? That’s rarely a good idea.? Good management teams wait until their shares are near or below their estimate of fair value before they buy back.
Good management teams are also sparing/judicious with share and option grants.? Measuring the cost of the issuance/grants/dilution at the current market price penalizes the financial performance appropriately for what they have given away from shareholders equity per share all too cheaply.
So, that’s my preferred measure for how much has the underlying value of the firm increased: growth in fully diluted tangible book value (ex-AOCI), adding back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price.
There are things that this measure does not capture, though.? Look for places where assets are misstated on the balance sheet. E.g., property may be worth more or less than the carrying value.? Plant and equipment may be worth more or less than the carrying value.? Having a feel for the appreciation/depreciation in value, however slow, can be an aid to estimating the true change in value for a firm.
Estimating the true value of a firm’s earnings is challenging.? There is no one good measure; it depends on the question that you are trying to answer.? But knowing the outlines of of the problem helps in analyzing the earnings releases as they pelt us each quarter.
PS — I know I have excluded EVA, NOPAT, and other measures here.? Perhaps another day…
Be wary when managements sell their best/safest assets to stay alive.It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.
Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times.Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.
So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.
The same applies to Merrill regarding their stakes in Blackrock and Bloomberg.? Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market.? I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort.? Merrill Lynch has more running room, but even they could face the same fate.
Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits.? It failed when loan underwriting ceased to be done in any prudent way.? Alt-A lending will return, but it is less likely that Indymac will see the light of day again.? Whether in insurance or lending, underwriting is the key to long-term profits.? Foolish lenders/insurers economize on expenses at the cost of losses.
Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer.? My question is whether $15 billion is enough.? It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?
Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.
As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety.? I write this not to sneer at those who have messed this up, because I have done it as well.? Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion.? (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)
I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability.? Many value managers have been hurt from an overallocation to credit-sensitive financials.? They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?
Well, I have made that bet.? Maybe I should not have owned as many insurers, but they should be fine in the long run.? There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here.? Look at companies that can survive moderate-to-severe downturns.? If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.
What did I do last week while the market was being whacked? I bought some Reinsurance Group of America, Shoe Carnival, YRC Worldwide, SABESP, and Universal American. I reduced cash in the portfolio from 11% to 8%. It may have hurt me in the short run, but should be good in the long run.
I have modest concerns about the current profitability of Smithfield Foods, but no concern about their long-term profitability. They have an intelligent management team. I may buy some more soon.
Now, as to my comments yesterday regarding quantitative risk measures: yes, I am highly skeptical. Economics is not Physics. The relationships are not stable enough for the quantitative statistics to be valuable. I go back to what Buffett said, “I’d rather have a noisy 15% than a stable 12%.” If you have a long time horizon, why do you care about standard deviation or beta? If you have a short time horizon, why are you investing in risk assets?
Risk is not short-term variation, unless your time horizon is short. Consider my article on longevity risk.? All good risk management considers when the money will be needed. Risk is unique for each person, and can’t be summarized through a “one size fits all” statistic. What are the odds of not meeting the goals of the investor? How severe will the shortfall be? That is risk.
Personally, I am annoyed at the consultant community. They employ statistics that have little relation to future performance in an effort to earn fees. They get away with it because clients don’t get investing. They buy the concept of randomness, and ignore the managers with good processes that have been hit by bad short-run performance.
Eventually value investing wins. Do value investors calculate the Modern Portfolio Theory [MPT] statistics before investing? Of course not. They know that their job is to find undervalued businesses. They don’t care about market trends.
As you consider investments, ignore MPT. It is better (if you have a long horizon) to focus on overall investment processes, with a review of the names in the portfolio over time, to get a feel for the methods of the manager.
Before I start this evening, I just want to say to new readers who are reading me because my piece, Ten Notes on Crude Oil: The Fixation made an unexpected splash, that my blog is a hodgepodge. I write about a wide variety of topics, but mostly it boils down to macroeconomics, stocks, bonds, portfolio management, value investing, insurance, speculation, real estate and mortgages, and structured products and derivatives. When I wrote more actively for RealMoney, I realized that I was probably the columnist with the widest field, including Cramer. I like to think that I am a good generalist, but I try not to push my expertise beyond its limits. Writing about energy fits into many of my posts, but it is not what I write about most of the time.
On to AIG. I write about AIG this evening, because businessweek.com cites my blog post as the source of “buzz” for breaking up AIG. (I like what I do in blogging, but my voice isn’t that big.)
Well, the dissident shareholders won. Martin Sullivan is out, Robert Willumstad is in. Whether having been part of Citigroup when it grew into a behemoth is an advantage here is questionable. He is clearly a bright guy, but so is Martin Sullivan. One thing is certain, and I wrote about it when Greenberg was shown the door in 2005, no one can replace Greenberg. He built AIG, and he is a bright guy who had his fingers on the pulse of a very complex operation. No one else can match his institutional knowledge, or the culture of fear that he ran.
This brings me to my controversial point for the evening: what if AIG did so well for so long by shading/shaving their reserves? A new CEO coming in to clean up would find a continual stream of assets marked too high, and liabilities markets too low. Martin Sullivan found that out the hard way. What then for Robert Willumstad?
If there are large holes on the balance sheet, the old mantra about eating elephants applies. How do you eat an elephant? One bite at a time. Much as the credit rating has fallen, AIG would not want to see it fall further. If I were in Mr Willumstad’s shoes, I would do a thorough scrubbing of every asset and liability on the balance sheet, and then do the following exercise:
If the restatement is small, take it all at once, declare victory, and make a splash to the media.
If the restatement is moderate, such that it would wipe out a year of earnings or so, take some writeoffs quarter by quarter, until the hole is filled.
If the restatement is large, such that it would wipe out 3-5 years of earnings, or wipe out a large amount of book value, I would create a plan for a turnaround, and then sit down with the rating agencies and the regulators. That would minimize the ultimate damage. The stock price would get killed when the problems are revealed, though.
I have a few other thoughts if the loss is larger still, but I will leave those to the side, because they would be too sensational. Now as to breaking up AIG, this WSJ article suggests that some units could be sold. That’s a good idea; as companies get huge, diseconomies of scale set in. It becomes more and more difficult to manage behemoth firms.
Perhaps AIG can get back to areas where they had a true sustainable competitive advantage: serving foreign markets where there is little/less competition. Maybe ILFC [International Lease Finance Corp]. Beyond that, what is truly distinctive about AIG? In my opinion, not that much.
