This should be a brief article.? I remember back in 1999 to early 2000 how P&C insurance stocks, and other boring slower-growth industries were falling in price despite growing net worth, and reasonable earnings.? I was working for The St. Paul at the time (a Property & Casualty Insurer), and for an investment actuary like me, who grew up in the life insurance business it was interesting to see the different philosophy of the industry.? Shorter-duration products make competition more obvious, making downturns uglier.
The market in 1999-2000 got narrow.? Few groups and few stocks were leading the rise.? Performance-conscious investors, amateur and professional, servants of the “Church of What’s Working Now,” sold their holdings in the slower growing companies to buy the shares of faster growing companies, with little attention to valuation differences.
I remember flipping the chart of the S&P 1500 Supercomposite for P&C Insurers, and laying it on top of an index of the dot-com stocks.? They looked like twins separated at birth, except one was upside down.
When shares are sold, they don’t just disappear.? Someone buys them.? In this case, P&C firms bought back their own stock, as did industry insiders, and value investors — what few remained.? When managed well, P&C insurance is a nice, predictable business that throws of reliable profits, and is just complex enough to scare away a decent number of potential investors.? The scare is partially due to the effect that it is not always well-managed, and not everyone can figure out who the good managers are.
So shares migrate.? Those that fall in the midst of a rally, despite decent economics, get bought by long-term investors.? The hot stocks get bought by shorter-term investors, who follow the momentum.? This continues until the gravitational effects of relative valuations gets too great — the cash flows of the hot stocks do not justify the valuations.
Then performance reverts, and what was bad becomes good, and good bad, but as with almost every investment strategy you have to survive until the turn, and if the assets run from the prior migration, it is cold comfort to be right eventually.
As an aside, this is part of what fuels dollar-weighted returns being lower than time-weighted returns.? The hot money migration buys high, and sells low.
Thus I say to value investors, “Persevere.? I can’t tell you when the turn will be, but it is getting closer.”
There are at least eight reasons why taking a simple approach to investing is a wise thing to do.
Understandable
Explainable
Reduced “Too smart for you own good risk”
Clearer risk management
Less trading
Taxes are likely easier
Not Trendy
Cheap
Understandable
You have to understand your investments, even if it’s just at the highest overview level. ?If you don’t have that level of understanding, then at some point you will be tempted to change your investments during a period of market duress, and it will likely be a mistake. ?Panic never pays. ?How to avoid panic? ?Knowledge reduces panic. ?Whatever the strategy is, follow it in good times and bad. ?Understand how bad things can get before you start an investment program. ?Make changes if needed when things are calm, not in the midst of terror.
Explainable
You should be able to explain your investment strategy at a basic level, enough that you can convey it to a friend of equal intelligence. ?Only then will you know that you truly understand it. ?Also, in trying to explain it you will discover whether your investments are truly simple or not. ?Does your friend get it, even if he may not want to imitate what you are doing?
Take an index card and write out the strategy in outline form. ?Would you feel confident talking for one minute about it from the outline?
Reduced “Too smart for your own good risk”
If you have simple investments, you will tend not to get unexpected surprises. ?One reason the rating agencies did so badly in the last crisis was that they were forced to rate stuff for which they did not have good models. ?The complexity level was too high, but the regulators required ratings for assets held by banks and insurers, and so the rating agencies did it, earning money for it, but also at significant reputational risk.
Why did the investment banks get into trouble during the financial crisis? ?They didn’t keep things simple. ?They held a wide variety of complex, illiquid investments on their balance sheets, financed with short-term lending. ?When there was doubt about the value of those assets, their lenders refused to roll over their debts, and so they foundered, and most died, or were forced into mergers.
I try to keep things simple. ?Stocks that possess a margin of safety and high quality bonds are good investments. ?Stocks have enough risk, and high quality bonds are one of the few assets that truly diversify, along with cash. ?That makes sense from a structural standpoint, because fixed claims on future cash are different than participating in current profits, and the change in expectations for future profits.
Clearer risk management
When assets are relatively simple, risk management gets simple as well. ?Assets should succeed for the reasons that you thought they would in advance of purchase.? Risk assets should primarily generate capital gains over a full market cycle.? fixed Income assets help provide a floor, and limit downside, so long as inflation remains in check.
With simple asset allocations, you don’t tend to get negative surprises.? Does an income portfolio fall apart when the stock market does?? It probably was not high quality enough.? Does you asset allocation give large negative surprises close to retirement?? Maybe there were too many risk assets in the portfolio after a long bull run.
Cash and commodities (in small amounts) can help as well.? Those don’t have yield, and don’t typically provide capital gains, but they would help if inflation returned.
Less trading
Simplicity in asset allocation means you can sleep at night.? You’ve already determined how much you are willing to lose over the bear portion of a market cycle, so you aren’t looking to complicate your life through trying to time the market.? Few people have the disposition to sell near near top, and few?have the disposition to buy near near the bottom.? Almost no one can do both.? (I’m better at bottoms…)
Pick a day of the year — maybe use your half-birthday (as some of my kids would say — it is six months after your birthday).? Look at your portfolio, and adjust back to target percentages, if you need to do that.? Then put the portfolio away.? If you have set your asset allocation conservatively, you won’t feel the need to make radical changes, and over time, your assets should grow at a reasonable rate.? Remember, the more conservative asset allocation that you can live with permanently is far better than the less conservative one that you will panic over at the wrong time.
You won’t get caught in fads that eventually blow up if you keep things simple.? You may be pleasantly surprised that you buy low more frequently than your trendy neighbors.? Remember, people always brag about their wins, but they never tell you about the losses, particularly the worst ones.? Those who don’t lose much, and take moderate risks typically win in the end.
Cheap
Simple investment strategies tend to have lower management fees, and fewer “soft” costs because they don’t trade as much.? That can be a help over the long run.
That’s all for this piece.? For most investors, simplicity pays off — it is that simple.
In this series, I disclose my WORST investing mistakes ever. ?Personal errors: cellular auctions, mistiming small cap value, and small deal arbitrage. ?Professional error:?Manufactured Housing Asset Backed Securities ? Mezzanine and Subordinated Certificates.
How a stream of excess income during working years becomes a stream of income in retirement years. ?It’s harder to do than you might expect. ?Includes a list of strategies and pitfalls.
I feel stronger about this than when I originally wrote this. ?Bitcoin and the other cryptocurrencies are just a speculative crapshoot, and the attempt to have a currency without the legal structure of a government will fail, unless it is a commodity like gold. ?Also, the blockchain is an overrated resource hog that lacks the flexibility possessed by life insurance company policy management systems.
Like the prior article, there are people with too much time on their hands thinking up nutty and useless ideas. ?There is enough risk in the world already; we don’t have to add to it.
I think active managers have to grow up and accept that passive investing isn’t evil; it just cuts against the economic interests of active managers like me, at least for now. ?When it gets really big, the paradigm will shift…
A short and lonely post where I told you in advance that crude oil would hang around $50/barrel “for a few years.” ?And, my reasoning was on target as well.
The time that I?did a competitive study of the most aggressive life insurers, and how it did not dissuade my client’s management team from trying to imitate them.
With quotations and links to the source documents, I show what Ben Graham really said in the article commonly cited to say that he gave up on value investing.
The tech market washes out about every eight years or so.? The broad market, which is a more robust beast, washes out far less frequently.? My question: are these variants of the same phenomenon?
When do employee and corporate incentives line up?? Ideally, incentive schemes should reward people with a fraction of the additional profitability that resulted from the additional work that they did.? Difficulties: measurement impossible in many cases, people could receive a bonus when the firm is not profitable, neglects synergies (both positive and negative).
To my readers, for a little while, I am going to be doing some “best of” posts along with some smaller articles. ?You should see eleven “best of” articles before this is done. ?If this bugs you, just turn me off for a little while. ?These articles are important, because there are some re-publishers that mine these pieces for content, and sometimes translate highlighted articles into languages other than English.
This era probably had the greatest density of “Rules” posts. ?In my view, these were my best posts written between May and July?2013:
Thinking about the different streams of income in society, and which might be more likely to fail. ?Also, thoughts on how low interest rates fit into this picture.
On how life insurers compromise rules on reserving using reinsurers that they own as subsidiaries. ?Also examines other ways that insurers weaken solvency.
On how insurance has changed for investors over the past ten years, Price-to-Book vs Return on Equity Diagrams, and miscellaneous issues for those investing in insurance companies.
Really, it is not an insurable risk, which is why most companies underwriting LTC have lost money on it, and coverage has become less and less generous.
“As for those with long-term care policies, if they are old, keep paying on them, you will likely do well on them when you finally need to draw on the policies.? You have benefits that benefits that can no longer be purchased.? Enjoy the exclusive club you are in.”
“In summary, all news is not equal.? The reactions to news, and the lack thereof, can tell us a lot about the intentions of large market actors.? Do your homework well, and prosper off of the knowledge that it gives you regarding reactions, over-reactions, and under-reactions.”
The beginning of my arguments against the pointy-headed Financial Stability Oversight Commission [FSOC] and their inability to understand the solvency of non-bank financials.
It’s easier for a generation to become prosperous if they push the bills onto their children and grandchildren. ?Eventually it catches up with a nation, and reduces opportunity for average people.
There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.
The trouble with VAR and other mathematical models of risk is that if it becomes the dominant paradigm, and everyone begins to use it, it creates distortions in the market, because institutions gravitate to asset classes that the model makes to appear artificially cheap.? Then after a self-reinforcing cycle that boosts that now favored asset class to an unsupportable level, the cashflows underlying the asset can no longer support it, the market goes into reverse, and the VAR models encourage an undershoot.? The same factors that lead to buying to an unfair level also cause selling to an unfair level.
Benchmarking and risk control through VAR only work when few market participants use them.? When most people use them, it becomes like the portfolio insurance debacle of 1987.? VAR becomes pro-cyclical at that point.
“Unions create inefficiency.? This creates an opportunity for new technologies that perform the same function, but aren?t as labor-intensive.? (E.g. integrated steel vs. mini-mills)”
If businesses anticipate a flow of financing, they will depend on it.? Then a diminution or increase in the flow of investable funds will affect markets, even if the flow of investable funds remains positive or negative.
During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.
Market rents are typically fixed in size.? When a strategy to exploit a particular market inefficiency gets too big, returns to the rent disappear, or even go negative prospectively, even if they appear exceedingly productive retrospectively.
If an asset-backed security can produce a book return less than zero for reasons other than default, that asset-backed security should not be permitted as a reserve investment.
A somewhat humorous article of mistakes that I have made in job interviews. ?Also a comment on making sure that you fit the culture of the firm at which you are interviewing.
So you think that the market is overvalued? ?How do you adapt to that condition, while still leaving some room for opportunity if the market continues to rise.
I didn’t originate this rule, and I am not sure who did. ?I learned it at Provident Mutual from the Senior Executives of Pension Division when I worked there in the mid-’90s. ?There is a broader rule behind it that I will get to in a moment, but first I want to explain this.
There are many efforts in business, particularly in sales, where some?want to hide what they are truly making, so that they can make an above average income off of the unsuspecting. ?At the Pension Division of Provident Mutual, the sales chain worked like this: our representatives would try to sell our investment products to pension plans, both municipal and corporate. ?We preferred going direct if we could, but often there would be some fellow who had ingratiated himself with the plan sponsor, perhaps by providing other services to the pension plan, and he would become a gateway to the pension plan. ?His recommendation would play a large role in whether we made the sale or not.
Naturally, he wanted a commission. ?That’s where the rule came in, and from what I?remember at the time, many companies similar to us did not play by the rule. ?When the sale was made, the client would see a breakdown of what he was going to be charged. ?If we were paying disclosed compensation to the “gatekeeper,” we would point it out and mention that that was *all* the gatekeeper was making. ?If the compensation was not disclosed, the client would see the bottom line total charge, and he would have to evaluate if that was good or bad deal for plan participants.
Our logic was this: the plan sponsor would have to analyze the total cost anyway for a bundled service against other possible bundled and unbundled services. ?We would bundle or unbundle, depending on what the gatekeeper and client wanted. ?If either wanted everything spelled out we would do it. If neither wanted it spelled out, we would only provide the bottom line.
What we would never do is provide a breakdown that was incomplete, hiding the amount that the gatekeeper was truly earning, such that client would see the disclosed compensation, and think that it was the entire compensation of the gatekeeper.
We were the smallest player in the industry as far as life insurers went, but we were more profitable than our peers, and growing faster also. ?Our business retention was better because compensation surprises did not rise up to bite us, among other reasons.
Here’s the broader rule:
“Don’t be a Pig.”
Some of us?had a saying in the Pension Division, “We’re the good guys. ?We are trying to save the world for a gross margin of 0.25%/year on assets, plus postage and handling.” ?Given that what we did had almost no capital requirements, that was pretty good.
Most scandals over pricing involve some type of hiding. ?Consider the pricing of pharmaceuticals. ?Given the opaqueness is difficult to tell who is making what. ?Here is another?article on the same topic?from the past week.
In situations like this, it is better to take the high road, and make make your pricing more transparent than your competitors, if not totally transparent. ?In this world where so much data is shared, it is only a matter of time before someone connects the dots on what is hidden. ?Or, one farsighted competitor (usually the low cost provider) decides to lay it bare, and begins winning business, cutting into your margins.
I’ll give you an example from my own industry. ?My fees may not be the lowest, but they are totally transparent. ?The only money I make comes from a simple assets under management fee. ?I don’t take soft dollars. ?I make money off of asset management that is?aligned with what I myself own. ?(50%+ of my total assets and 80%+ of my liquid assets are invested exactly the same as my clients.)
Why should I muck that up to make a pittance more? ?It’s a nice model; one that is easy to defend to the regulators, and explain to clients.
We probably would not have the fuss over the fiduciary rule if total and prominent disclosure of fees were done. ?That said, how would the brokers have lived under total transparency? ?How would life insurance salesmen live? ?They would still live, but there would be fewer of them, and they would probably provide more services to justify their compensation.
Even as a bond trader, I learned not to overpress my edge. ?I did not want to do “one amazing trade,” leaving the other side wounded. ?I wanted a stream of “pretty good” trades. ?An occasional tip to a broker that did not know what he was doing would make a “friend for life,” which on Wall Street could last at least a month!
You only get one reputation. ?As Buffett said to the Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives back in 1991 regarding Salomon Brothers:
I want the right words and I want the full range of internal controls. But I also have asked every Salomon employee to be his or her own compliance officer. After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends, with the reporting done by an informed and critical reporter. If they follow this test, they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.
This is a smell test much like the Golden Rule. ?As Jesus said, “Therefore, whatever you want men to do to you, do also to them, for this is the Law and the Prophets.” (Matthew 7:12)
That said, Buffett’s rule has more immediate teeth (if the CEO means it, and Buffett did), and will probably get more people to comply than God who only threatens the Last Judgment, which seems so far away. ?But I digress.
Many industries today are having their pricing increasingly disclosed by everything that is revealed on the Internet. ?In many cases, clients are asking for a greater justification of what is charged, or, are looking to do price and quality comparison where they could not do so previously, because they did not have the data.
Whether in financial product prices, healthcare prices, or other places where pricing has been bundled and secretive, the ability to hide is diminishing. ?For those who do hide their pricing, I will offer you one final selfish argument as to why you should change: given present trends, in the long-run, you are fighting a losing battle. ?Better to earn less per sale with happier clients, than to rip off clients now, and lose then forever, together with your reputation.
I wrote about this last in October 2009 in a piece lovingly entitled:?At Last, Death!?(speaking of the holding company, not the insurance subsidiaries). ?I’m going to quote the whole piece here, because it says most of the things that I wanted to say when I heard the most recent news about Penn Treaty, where the underlying insurance subsidiaries are finally getting liquidated. ?It will be the largest health insurer insolvency ever, and second largest overall behind Executive Life.
Alas, but all good things in the human sphere come to an end.? Penn Treaty is the biggest insurer failure since 2004.? Now, don?t cry too much.? The state guaranty funds will pick up the slack.? The banks are jealous of an industry that has so few insolvencies.? Conservative state regulation works better than federal regulation.
Or does it?? In this case, no.? The state insurance regulator allowed a reinsurance treaty to give reserve credit where no risk was passed.? The GAAP auditor flagged the treaty and did not allow credit on a GAAP basis, because no risk was passed.? No risk passed? No additional surplus; instead it is a loan.? I do not get how the state regulators in Pennsylvania could have done this.? Yes, they want companies to survive, but it is better to take losses early, than let them develop and fester.
A prior employer asked me about this company as a long idea, because it was trading at a significant discount to book.? I told him, ?Gun to the head: I would short this.? Long-term care is not an underwritable contingency.? Those insured have more knowledge over their situation than the insurance company does.?? He did nothing.? He could not see shorting a company that was less than 50% of book value.
It was not as if I did not have some trust in the management team.? I knew the CEO and the Chief Actuary from my days at Provident Mutual.? Working against that was when I called each of them, they did not return my calls.? That made me more skeptical.? It is one thing not to return the call of a buyside analyst, but another thing not to return the call of one who was once a friend.
Aside from Penn Treaty, the only other company that I can think of as being at risk in the long term care arena is Genworth.? Be wary there.? What is worse is that they also underwrite mortgage insurance.? I can?t think of a worse combo: long term care and mortgage insurance.
The troubles at Penn Treaty are indicative of the future for those who fund long term care.? Be wary, because the troubles of the graying of the Baby Boomers will overwhelm those that try to provide long term care.? That includes government institutions.
Note that Genworth is down 60% since I wrote that, against a market that has less than tripled. ?If their acquirer doesn’t follow through, it too may go the way of Penn Treaty. ?(Give GE credit for kicking that “bad boy” out. ?They bring good things to “life.” 😉 )
Okay, enough snark. ?My main point this evening is that Pennsylvania should have had Penn Treaty stop writing new business by 2004 or so. ?As I wrote to a reporter at Crain’s back in 2008:
On your recent article on PennTreaty, one little known aspect of their treaty with Imagine Re is that it doesn’t pass risk.? Their GAAP auditors objected, but the State of Pennsylvania went along, which is the opposite of how it ordinarily works. ? Now Imagine Re takes advantage of the situation and doesn’t pay, knowing that PennTreaty is in a weak position and can’t fight back, partially because of the accounting shenanigans. ? It is my opinion that PennTreaty has been effectively insolvent for the past four years.? I don’t have any economic interest here, but I had to investigate it as an equity analyst one year ago.? Things are playing out as I predicted then.? What I don’t get is why Pennsylvania hasn’t taken them into conservation.
Another matter was that Imagine Re was an Irish reinsurer, and they have weak reserving rules. ?That also should have been a “red flag” to Pennsylvania. ?The deal with Imagine Re was struck in late 2005, leading to upgrades from AM Best that were reversed by mid-2006.
It was as if the state of Pennsylvania did not want to take the company over for some political reason. ?Lesser companies have been taken over over far less. ?Pennsylvania itself had worked out Fidelity Mutual a number of years earlier, so it’s not as if they had never done it before.
Had they acted sooner, the losses would never have been as large. ?I remember looking through the claim tables in the statutory books for Penn Treaty because the GAAP statements weren’t filed, and concluding that the firm was insolvent back in 2005 or so. ?Insurance regulators are supposed to be more conservative than equity analysts, because they don’t want companies to go broke, harming customers, and bringing stress to the industry through the guaranty funds.
The legal troubles post-2009 probably?had a small effect on the eventual outcome — raising premiums might have lowered the eventual shortfall of $2.6 billion a little. ?But raising premiums would make some healthy folks surrender, and those on benefit are not affected. ?It would likely not have much impact. ?Maybe some expenses could have been saved if the companies had been liquidated in 2009, 2012, or 2015 — still, that would not have been much either.
Some policyholders get soaked as well, as most state guaranty funds limit covered payments to $300,000. ?About 10% of all current Penn Treaty policyholders will lose some?benefits as a result.
Regulatory Policy Recommendations
Often regulators only care that premiums not be too high for the insurance, but this is a case where the company clearly undercharged, particularly on the pre-2003 policies. ?For contingencies that are long-lived, where payments could be made for a long time, regulators need to spend time looking at premium adequacy. ?This is especially important where the company is a monoline and in a line of business that is difficult to underwrite, like long-term care.
The regulators also need to review early claim experience in those situations (unusual business in a monoline), and even look at claim files to get some idea as to whether a company is likely to go insolvent if practices continue. ?A review like that might have shut off Penn Treaty’s ability to write business early, maybe prior to 2002. ?Qualitative indicators of underpricing show up in the types of claims that arrive early, and the regulators might have been able to reduce the size of this failure.
But wave goodbye to Penn Treaty, not that it will be missed except by policyholders that don’t get full payment.
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.
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.
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