Saturday, December 13, 2014

Recent articles of interest

13F filings

Matt Brice of The Sova Group argues that 13F filings and insider buying aren't useful signals for investors. Regarding 13Fs, he writes:

I truly disagree with looking for ideas in 13Fs.  It is a shortcut that short-circuits the thinking process.  Akin to copying off your neighbor’s test and then making up your work product to get the answer you copied.

Brice's previous article, Of Castles and Moats, is another great read.


Amazon

On Seeking Alpha, "Slim Shady" argues that Amazon overstates its cash flow. He writes that when a company emphasizes a particular financial metric, as Amazon does with cash flow, it has a strong incentive to manipulate it.

I've been meaning to review Mulford and Comiskey's Creative Cash Flow Reporting. Investors generally consider cash flow more reliable than earnings, but the book gives lots of examples of how it can be gamed.


CAPE

Philosophical Economics writes about how CAPE can be misleading. No valuation metric is perfect, but he makes a strong case that CAPE is less reliable than most.


Emerging Markets

According to the Bank for International Settlements, "Foreign-debt levels of companies in emerging markets from China to India and Brazil are underestimated, threatening financial stability."

In Barron's, Anne Stevenson-Yang claims that "Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term." I haven't been able to verify the number, but it's ominous if true.


The Farm Bubble

Country Guide writes that farm debt levels in Canada are extremely high:

Taking the $77.979 billion that Canadian farmers owed in 2013 and dividing it by $53.890 billion (the total cash receipts which Statistic Canada reported Canadian farmers received that year) we get a ratio of 144.7 per cent... the U.S. ratio of farm debt to total farm receipts is much lower at 69.4 per cent.

This indebtedness has contributed to a bubble in farmland prices:

[A]ccording to the 2013 FCC Farmland Values report, the average increase in farmland value in 2011 was 14.8 per cent, followed by increases of 19.5 per cent in 2012 and 22.1 per cent in 2013.

And the bubble isn't limited to Canada:

In Australia, Canada, and the U.S., land purchases have been a driver of rising farm debt... the USDA estimates the average increase of land values from 2012 to 2013 at 13 per cent.

Real farmland prices in the United States are at all-time highs, far above their historical average.

Country Guide mentions that "The Federal Reserve Bank of Kansas City... surveyed farmers to find out why farmers were buying land." Their top three reasons were 1. The interest rate environment, 2. Overall wealth level of the farm sector, and 3. Lack of alternative investment options. (I would argue that #3 is really a variation of #1.) This is classic bubble behavior: they're reaching for yield and using rising asset values as a reason to increase debt.


Greek banks

Following David Einhorn's recommendation of Greek bank stocks, Vienna Capitalist writes a more skeptical take on Greek banks in general and Piraeus Bank in particular. "davideinhornnyc" responds in the comments. Vienna then writes a two-part rejoinder to Einhorn's comments. The arguments are too complex to summarize, but Vienna makes a lot of good points. I think the funds that are buying things like Greek bank stocks and Puerto Rican debt are making a mistake.


Hertz

Dislocated Value offers some impressive commentary on Hertz. Like Vienna Capitalist's series on Greek banks, it's too detailed to summarize, but his opinion is that "I am not entirely convinced that HTZ is a good investment –  the bottomline is that, post the run-up, corporate EBITDA stands at 9.5-10x based on my assumptions, and the fix on pricing will take some time."


Industry consolidation

A VIC writeup recommends Pilgrim's Pride as a short. Making an analogy to poker, the write-up argues that partial industry consolidation actually worsens returns:

The worst hand in poker is the second-best hand.  This is the hand that incentivizes the player to bet heavily without the odds in his or her favor.  It is the poker hand that offers the player the greatest risk of loss.  Competent players know to fold a two-seven off. Gifted players know to fold the second-best hand.

A similar framework applies when thinking about industry structure in cyclical, commodity businesses... The worst industry structure is the second-best structure – an industry that is “almost-consolidated” with fewer participants, but not so few that pricing has become rational. 


Iron ore

The Wall Street Journal writes about Australia's iron ore miners. They're all expanding production while blaming each other for the resulting oversupply.


The Outsiders

Joe Magyer from Motley Fool Australia interviews William Thorndike, author of The Outsiders. Regular readers know that I dislike the book, but I still enjoyed the interview. Magyer makes a great point about how tax laws and regulations influence the feasibility of Outsider strategies.


Scams

Glenn Chan argues that investment managers' ability to identify scams is a good measure of their skill. (Chan has identified a lot of scams himself, particularly in energy and mining.) He mentions Jim Rogers, Prem Watsa, and "a famous Canadian money manager" as examples of prominent investors who have lost money on frauds and companies with flawed business models.

I've written about Rogers and the famous Canadian money manager before and agree they're overrated. I don't follow Watsa closely, but his largest stock investments over the past decade are an all-star list of value traps: Abitibi, Canwest, Dell, Exco, Frontier Communications, Research in Motion, Sandridge, and Torstar.


Treasuries

The Wall Street Journal recently polled institutional investors. 91% are bearish on Treasury bonds, and 95% see 10-year yields over 2.5% by the end of 2015 compared to 2.1% today. (I'm not sure about the 4% who expect rates to jump but aren't bearish.)


Whole Foods

Brattle Street Capital writes that Whole Foods is between a rock and a hard place: various WF clones are stealing market share by offering a similar concept with lower prices, and Whole Foods can't respond by cutting prices without damaging its premium brand.

Saturday, November 22, 2014

The American and Foreign Power Company

The American and Foreign Power Company was a publicly-traded utility that became a speculative favorite during the late 1920s. Benjamin Graham wrote about it in Security Analysis, using it as an example of the financial innovation and speculative excess that characterized that period.

AFPC issued a range of securities during the 1920s: bonds, common stock, two kinds of preferred stock, and "stock-option warrants." Stock-option warrants were essentially what we call warrants today: instruments created by the issuer that allowed investors to buy newly-issued stock at a certain price.

Graham wrote that warrants evolved from a niche instrument to a prominent security during the 1920s: they were originally attached to bonds and preferred stock as a way of giving them convertability into common stock. In this form, "the warrants themselves had little significance in relation to the company’s capitalization structure." But by the late '20s they had become widely-issued and widely-traded as discrete securities and were used as a popular way to speculate.

AFPC was at the vanguard of this change. In 1929 its common stock was worth $300 million, which by itself would have qualified the company as a major securities issuer, but its warrants were worth several times more:

The option warrants issued by a single company—American and Foreign Power Company—attained in 1929 an aggregate market value of more than a billion dollars, a figure exceeding our national debt in 1914.

AFPC's market capitalization was impressive not only compared to what preceded it but what followed:

It is an amazing fact that the option warrants created by one company, American and Foreign Power, reached an indicated market value in 1929 of over a billion dollars, a figure that exceeded the market value of all the railroad common stocks of the United States listed on the New York Stock Exchange in July 1932, less than three years later.

APFC itself wasn't immune to the Great Depression. At its nadir, the company "trembled on the brink of receivership, as shown by a price of only 15 1/4 for its 5% bonds."


Outside the Roaring Twenties

Graham used AFPC to illustrate financial trends during a specific period of time. In doing so, he gave only a small cross-section of the company's interesting history. Fortunately an article on Academia.edu, "The Rise and Fall of The American & Foreign Power Company," offers a more detailed description of the company and its experiences.

AFPC began life as part of a holding company called Electric Bond & Share, which itself began life as a subsidiary of Thomson-Houston, one of General Electric's predecessor companies.

Thomson-Houston sold electric equipment to utilities. In the late 1800s, when electrical transmission was still a recent invention, most utilities were small and thinly capitalized. Thomson-Houston provided them with a form of vendor financing, taking the utilities' debt and equity securities as partial payment for its equipment.

In 1905, it organized Electric Bond & Share as a subsidiary for the specific purpose of holding these securities. While EB&S was officially a utility holding company, in practice it was a financial intermediary, aggregating the securities of a number of tiny issuers into a holding company that could finance itself at better rates.

EB&S made its first foreign investment in 1917, buying electrical systems in two Panamanian cities. Investments in Guatemala, Brazil, and Cuba soon followed. In 1924, EB&S created AFPC as a subsidiary for holding these foreign investments. The following year, General Electric spun off EB&S and it became a separate publicly-traded company.

AFPC soon followed as a public company, and it pursued the same business model as EB&S, namely being a financial intermediary that operated as a utility. The United States ran large trade surpluses with the rest of the world during the 1920s, and AFPC, as a major international investor, helped to recycle those surpluses.

AFPC stepped up the pace of its investments as a public company, buying utilities in Argentina, Brazil, Chile, China, Costa Rica, Ecuador, and India. It also bought minority stakes in utilities in Canada, Italy, Japan and elsewhere. In 1929 it acquired Shanghai's municipal utility, making what at the time was the single largest American investment in China.

The Depression ensued, and AFPC nearly went bankrupt. It suspended dividends on its preferred stock in 1932 and didn't begin to pay them again until 1939. The unpaid dividends that accumulated during the interim were significant relative to AFPC's (admittedly diminished) market capitalization.

AFPC's problems during the Depression were political as well as financial. Mexico and Cuba forced it to reduce electricity prices, and many other countries prevented it from repatriating its subsidiaries' profits. It had to write off the Shanghai utility during World War II, and Argentina nationalized several of its utilities.

The company's fortunes seemed to improve during the 1950s, but that was a false dawn. Fidel Castro confiscated AFPC's Cuban properties in 1960, at which time they were its largest holdings. Brazil also expropriated one of its properties, and Mexico forced it to sell its utilities to the Mexican government at a cut-rate price. Exacerbating this theft, the government then refused to let AFPC repatriate the sale's proceeds.

AFPC responded to these misfortunes by gradually liquidating. It sold its foreign utilities throughout the 1960s and early 1970s and merged with Boise Cascade. The last remaining utility, a property in Ecuador, was sold in 1976.


Emerging markets

AFPC illustrates a big-- and in my opinion, under-appreciated-- risk of investing in emerging markets. Namely, that many of these countries have an opportunistic and predatory attitude toward foreign investors. In a period of globalization when foreign direct investment is increasing, they'll respect foreign investors' property rights because they know that doing so is necessary to receive foreign investment and its attendant benefits.

But if a depression or financial crisis shuts off the foreign-investment spigot, these countries will see no further reason to respect foreigners' rights. If their investments aren't confiscated, they'll be subject to actions that drastically limit their return on investment.

As the Academia.edu article notes, "[F]oreign adventures don't always work out as anticipated. In addition to the normal risks of business, including fluctuating exchange rates, there are unforeseen political risks that can seriously affect rates of return on investment."

Wednesday, November 12, 2014

Is industry consolidation overrated?

Recently, an investor I follow on Twitter wrote: "Most overplayed investment theme: bad industries consolidating leading to rational competition and price increases."

My sense is that he's right: industry consolidation is a precursor to oligopolistic pricing, but it's not enough by itself. In industries with minimal barriers to entry, the benefits of consolidation are usually temporary for a variety of reasons:

• If the industry is cyclical and has long lead times between capital investment and returns, it's easy for players to misjudge the cycle and overbuild regardless of how consolidated the industry is.

• Often the consolidation happens during an economic boom and merely amplifies pricing power that already existed. Once the boom ends, pricing discipline breaks down.

• If the industry consolidation is financed with debt, the newly-consolidated players may overproduce in order to generate the cash flow they need to meet their debt obligations.

• Price increases attract new entrants, and these entrants have no institutional memory of the hard times that would restrain them from overproducing.

There are also some circumstances in which consolidation actually worsens industry dynamics. In 2011, the coal-mining industry consolidated when coal prices were near their peak, and as Credit Bubble Stocks writes:

The mergers resulted in a funny kind of adverse selection where the most bullish managements with the worst historical sense and facility at market timing ended up controlling capital allocation for the whole industry.

Sometimes consolidation gives an industry greater financial resources: economies of scale, lower borrowing costs, etc. If it gains these resources but lacks pricing discipline, then consolidation really just gives the industry players more rope with which to hang themselves.


Examples of "bad oligopolies"

Iron ore is the quintessential bad oligopoly. A handful of companies dominate iron-ore mining, but it has minimal pricing and cap-ex discipline, there were a bunch of aggressive new entrants during the boom years, and the major players recently started a price war.

Several prominent hedge funds have invested in Greek bank stocks. Their belief is that the Greek banking system is poised to earn high returns on equity because it's consolidated into four players.  Vienna Capitalist has written an excellent post critiquing this assumption:

In real life it is difficult to count the “true” number of players. You could have a lot of players in one sector, some of which occupy a niche in that market allowing them to still earn high ROEs. Alternatively, you could have only one or two players but competitive prices and average profitability. How? Well, they might be so-called “Contestable Markets” where the threat of another player entering the market keeps prices down. Airline routes are a classic example for the latter. 

According to the Austrian School, a competitive market CANNOT be meaningfully defined by the number of buyers/sellers, as the classic perfect competition model suggests. What MATTERS instead is whether there is free entry/exit into a particular market. As value investors only know too well: without barriers to entry a business is poised to earn mediocre returns, no matter how many players…

The bull case for Greek bank stocks states that all the other European countries with consolidated banking systems have high ROEs. Vienna points out that those countries have all experienced large, secular increases in debt as a percentage of GDP, and this debt tailwind may be the real reason for their high returns. They're consolidated and they earn high ROEs, but the former didn't necessarily cause the latter.


Airlines and HDDs

In the past few years, the hard disk drive industry has consolidated into three players and the American airline industry has consolidated into four major players. Both industries are earning large profits right now, but I wouldn't be surprised to see either of them revert to being a bad oligopoly. (Note: I'm far from being an expert on these industries, so my opinions could be partly or totally wrong.)

My concern with airlines is that while the industry has consolidated and arguably become more rational in the United States, it seems to be much less rational elsewhere. Reuters has an article (hat tip to Jake Freifeld) describing how foreign budget airlines are ordering lots of planes they don't need so they can get into the leasing business. If these would-be lessors misjudge demand and create a glut of aircraft, that could make it cheaper for entrants in the American market to acquire new planes. It could also reduce the value of the assets the American incumbents use to secure loans.

The risk with hard disk drives is well-known: flash memory is taking share. The price difference between flash and HDDs seems to be decreasing both relatively and absolutely. I think absolute difference is the important one: if there's a $350 difference between similar-sized drives, few people will be interested in flash. But if that falls to only $30 or $40, flash may actually be the better deal considering speed and power consumption.

I switched to a flash drive a year ago and noticed a big improvement in speed. Notably, my old hard drive was 500 gigabytes but I was using very little of that, so I only needed to buy a 120-gigabyte flash drive. That narrowed the effective price difference between HDDs and flash.

Over the years I've read various articles about flash memory shortages, so I assume there are supply constraints that prevent flash from displacing HDDs quickly. I don't find that particularly reassuring, though. Aldi and Lidl are relatively small upstarts in the British supermarket industry, yet they seem to have seriously damaged the incumbents' profitability. That's a glib comparison-- there are big differences between supermarkets and HDDs-- nonetheless, disruptive competitors often have an outsized effect on pricing and margins.

Tuesday, November 11, 2014

Kill your investing gurus: Jim Rogers

Jim Rogers is another investing guru who's become famous as much for his personality as his ideas.

Rogers worked for George Soros's hedge fund during its early years, and after leaving Soros in 1980, he took two years-long around-the-world car trips. Each trip spawned a travelogue, Investment Biker for the first and Adventure Capitalist for the second, in which Rogers offers readers a Master of the Universe's view of foreign cultures. According to The New York Times, "One problem is that Mr. Rogers's writing is unexceptional and pedestrian. Another is that he is overimpressed by the depth of his insights."

While the books don't show him developing much curiosity about the places he visited, they do show him developing his public persona: whereas he was once merely a rich investor, today he's Jimmy Rogers, the straight-talking, globetrotting adventurer with a pink bow tie.

An Amazon reviewer for Rogers's more recent book Hot Commodities writes that "Rogers goes for a funny and folksy Warren Buffet style but can't quite pull it off," which is a sharp observation. While Buffett the showman has arguably eclipsed Buffett the investor, the latter remains an accomplished figure. With Rogers, there's no brilliant investor for the showman to eclipse. His public predictions have been very wrong.

It may seem unfair to criticize him for that, since even the best investors often make bad predictions and bad investments. Soros has whiffed his share of predictions over the years, and that hasn't stopped him from being a phenomenon. But the problems with Rogers's investing strategy go beyond a handful of bad calls.

First, Rogers practices what one might call the "stream of anecdotes" style of macro investing. The reasoning behind his investments is mostly ad hoc: in an interview he might say he's bearish on the US because its government is running large deficits, then he'll say he's bullish on Bolivia because he visited the country recently and its cellphone reception was better than he'd expected. (This was his actual rationale for investing in Bolivia in Adventure Capitalist.) While he has strong opinions about everything, those opinions don't amount to a coherent system in which different kinds of information are weighted according to their importance.

Second, two of his most vocal recommendations have been to buy commodities and short Treasuries, and I think his logic is flawed on both counts.


Treasuries

Rogers has been bearish on the US dollar and US government debt for at least the past fifteen years, and probably longer, although the rationale for his bearishness has changed over time. For many years, trade deficits and fiscal irresponsibility were going to generate a financial crisis. More recently, he's claimed that quantitative easing will generate an inflationary crisis.

Here's his opinion from 2003:
The dollar is not just in decline; it’s a mess. If something isn’t done soon, I believe the dollar could lose its status as the world’s reserve currency and medium of exchange, something that would lead to a huge decline in the standard of living for U.S. citizens like nothing we’ve seen in nearly a century.

Here's last year's opinion:
All that money printing has Rogers bearish on U.S. Treasury debt. He said he's shorting government bonds and that if it's indeed the end of the 30-year bond bull market, those shorts will pay off. In particularly he said it's time to short long-dated U.S. government debt.

Notably, Rogers also said it was time to short long-dated U.S. government debt in 2005, when Steven Drobny interviewed him for Inside the House of Money.

Rogers's arguments have an intuitive appeal: everyone knows that large trade deficits and government deficits can't go on forever, and there's widespread skepticism of the Federal Reserve and its actions. These are valid concerns, so I don't mean to dismiss them blithely, but I think the financial crisis that Rogers expects will be neither as immediate nor as inflationary as he suggests.

First, having a reserve currency makes persistent deficits not only possible but likely: in order to accumulate reserves, other countries have to run current-account surpluses with the country that has the reserve currency. Its deficits are a byproduct of reserve currency status, not necessarily a sign that the status is about to end.

And while people tend to think of the United States's deficits as the result of Americans living beyond their means, to a great extent the arrow of causality flies the other way. China and many other countries try to grow by suppressing domestic consumption and subsidizing export-oriented industries, which produces trade surpluses with the US.

Second, quantitative easing isn't synonymous with money printing. (Note: that isn't an endorsement of QE.)

Third, in countries that finance themselves by borrowing in their own currency, there's a tendency for high total debt levels to suppress interest rates. If rates rise, the debt load becomes unmanageable, which pushes the economy into a recession and renews downward pressure on rates. Credit Bubble Stocks has called this idea the self-limiting hypothesis. We've seen this play out in Japan, and I think it will play out in the United States too.


Commodities

In 2004, Rogers published Hot Commodities, which advocates buying physical commodities as investments. The book endorses the idea of a commodity supercycle, stating that "stocks and commodities have alternated leadership in regular cycles averaging 18 years."

I'm not familiar enough with oil or farm commodities to generalize about their performance, but I've traded metals and mining stocks for a while, and my experiences with them make me very skeptical of the commodity supercycle idea.

There's a subscription site called The Chart Store that offers a wealth of historical charts. For widely-used metals, it has charts going back to late 1800s. Most of these charts show no trend in real prices. The price of aluminum has fallen significantly over the past century, but copper, lead, zinc, and nickel have shown little real change over time. Despite that, they've been quite volatile: metals price cycles tend to be the same length as overall economic cycle, and sometimes they're even shorter.

The mix of volatility and mean reversion means that the typical metal trades in a wide range. For instance, copper has normally traded between $1 and $3.50 in today's prices. On a few occasions, metals have overshot or undershot their range as a group. During the Great Depression, prices plunged far below the low end of their range. The same thing happened in the late 1990s, when many metals approached their Depression-era prices. By contrast, in 2006-07 prices broke above the range's high end.

So commodity prices started the 2000s near record low levels, and less than a decade later they were making record highs. Prima facie this looks like evidence of a supercycle, but that kind of price gain had actually never happened before. It was an unprecedented move rather than a manifestation of a price cycle that commodities repeatedly, inevitably go through. Moreover, there are specific identifiable reasons for both the record lows and record highs, so we don't need to invent the idea of a supercycle to explain the move.

In the 1990s, there was a series of emerging markets debt crises, the most prominent of which were the Tequila Crisis, the Asian Financial Crisis, and Russia's 1998 default and devaluation. The common features of these crises were that they 1) fostered a need for foreign currency, since the crises were generally the result of external debts and 2) crushed the local currency, making commodity production much cheaper. Essentially, the crises provided both a carrot (lower production costs) and a stick (the need for hard currency) for flooding the commodities markets.

During the same period Russia was recovering from the Soviet Union's breakup, and its legal regime was weak and unstable. Most of the people who seized control of newly-privatized companies in 1990s Russia did so through dubious means, and they realized that in the same climate their companies could just as easily be seized from them. This lack of ownership security gave them an incentive to maximize short-term profits. For mining and oil companies, that meant producing as much as they could as quickly as they could. Russia is a major commodity producer, so this dynamic led it to dump large amounts of commodities on the world market throughout the '90s and particularly after 1998.

By 1999, metals were near Great Depression levels. There was a bounce in 2000, but prices fell again in 2001 and 2002 and retested the lows. Yet five years later, many were at record highs.

The obvious cause of this price rise is China's (mal)investment spree and the associated demand for commodities. But financial speculation also played a role, as Frank Veneroso argued in his 2007 World Bank presentation.

Commodities prices surged in the 1970s, and this figures prominently in the commodity supercycle story. But Veneroso points out that the '70s aren't comparable to the more recent commodity price surge because inflation was so much higher in the '70s. To a large extent the commodity price gains during that period merely kept pace with inflation, with the real gains staying within historical norms. Commodities had similar nominal price increases during the 1970s and the 2000s, but the 2000s witnessed much larger real increases.

Veneroso also points out that the rise in commodity prices during the 2000s coincided with explosive growth in both the trading volume and outstanding notional value of commodity derivatives. Some mining executives have also commented on this speculation:

"There's a fair amount of financial money in commodities today," [Phelps Dodge CEO Steven Whisler said in 2006]. "Is that creating some froth? Yes. How much, I don't think anybody knows."

Despite price rises that would normally be associated with shortages, Veneroso claims, companies like the copper fabricator Nexans had no trouble obtaining metals, suggesting that financial demand rather than real demand was fueling the rise.

A few years ago, Howard Schultz from Starbucks made the same claim about speculation in the coffee market. According to a 2010 Reuters article:

"Starbucks Corp Chief Executive Officer Howard Schultz decried the commodity market on Wednesday, saying financial speculators, not product shortages, were to blame for recent price spikes in coffee."

More recently, there are reports of large amounts of copper being hoarded at Chinese port warehouses.

Veneroso devotes much of his presentation to refuting the bull arguments for commodities. He claims that these arguments, while superficially plausible, are really just the kind of new era arguments that are used to justify every bubble.


Whither commodities?

I think the mining industry is heading for a perfect storm in which: 1) Chinese demand will fall as they stop building empty cities, 2) there will be a supply glut as the industry finishes bringing enormous amounts of new capacity online, and 3) financial demand will disappear and metals stocks that have been hoarded will flood the market as prices fall. There will be a huge sell-off that pushes prices below the marginal cost of production and keeps them there for years, and that will put the commodity supercycle theory to rest.

Most commodities have fallen this year as the dollar has rallied, some significantly, and that's already led to a lot of skepticism about the commodity supercycle. So to many readers, the idea that commodities are mean-reverting and have a terrible outlook will be familiar if not obvious. Nonetheless it's worth repeating, because while commodities are down year-to-date, they're at risk of falling much more over the next few years. Ignore short men who tell tall tales about commodities: they are not a sound investment.

Sunday, November 9, 2014

Background on Wesray, the leveraged buyout pioneer

Wesray was a prominent private equity firm during the 1980s. It took its name from its two founders, William E. Simon and Ray Chambers. Prior to founding Wesray, Simon had a long career on Wall Street and in the federal government, culminating in his service as Treasury Secretary for several years under Richard Nixon and Gerald Ford. Chambers was fifteen years younger than Simon and had a more modest career: he was originally a tax accountant but became an early practitioner of the leveraged buyout during the 1970s, buying and selling several small companies.

Simon and Chambers met in 1980 through a mutual acquaintance, and Simon instantly recognized the potential of leveraged buyouts. He and Chambers became ad-hoc partners, teaming up to acquire a small business that supplied oysters to restaurants and another small business that rented musical instruments. A year later they became business partners on a more permanent basis, founding Wesray in September 1981.

Wesray's first major deal was its 1982 acquisition of Gibson Greetings, a greeting card printer, from RCA. The deal had an element of luck: Simon and Chambers had originally intended to buy a mobile communications company that RCA owned called Tactec Systems, and they ended up buying both Tactec and Gibson.

The Gibson acquisition was a phenomenal success. Wesray paid $81 million for the company even though its book value was $87 million, and most of that book value was tangible assets that Wesray could borrow against, which meant that it had to put up only $1mm of the purchase price as equity, with the other $80mm being borrowed money.

The acquisition coincided with the beginning of an enormous bull market, and Wesray was able to take Gibson Greetings public less than 18 months later at a $290mm valuation. Simon and Chambers each contributed a third of the equity investment, which meant that they each made $70mm on a $330k investment.

While Gibson made their reputation, it was far from being their only profitable deal. Wesray purchased Avis Car Rental in 1986 and, as with Gibson, flipped it less than two years later for a huge profit.


Why was Wesray successful?

Simon's fame undeniably contributed to Wesray's success. His reputation as a political and financial leader gave him and Chambers access to deals they probably wouldn't have received otherwise.

Leverage and timing also played a role. Wesray borrowed 99% of the purchase price of Gibson Greetings, and it used similarly high leverage for its other leveraged buyouts. One article estimates that Wesray borrowed 98% of the money it used on its average deal. In the bull market of the 1980s, this gave Simon and Chambers a powerful tailwind.

But it would unfair to claim that their success was merely a result of luck, leverage, and fame. They also had a thoughtful strategy that allowed them to make investments with favorable risk/reward ratios. With Gibson Greetings, and again with many of their later deals, Simon and Chambers invested in companies that had both the potential for growth and valuable assets that they could use to secure loans. Essentially, the asset value allowed them to borrow money at lower rates and with less risk than they would otherwise have to take.

They also demonstrated a sense of perspective. Simon wanted to pull back in the mid-1980s as valuations rose and the competition for leveraged buyouts increased. He recognized, either explicitly or intuitively, that Wesray's investment strategy worked best when companies traded near their asset value and became less viable as prices rose. He also cared about his fiduciary duty and worried about Wesray's other investors losing money. In this regard he was the opposite of Henry Kravis, who was always eager to do more and bigger deals irrespective of valuation.


Sources

Pubic information about Wesray is scant, but I was able to dig up a few things. A 1986 article from Fortune describes the firm's history and investment strategy. Another article, from Cincinnati Magazine, profiles Simon. (Gibson Greetings had its headquarters in Cincinnati.) Simon's autobiography, A Time for Reflection, also discusses Wesray, although it emphasizes his conservative political philosophy more than his career as a buyout pioneer.

On Quora, someone asked "Why was the 1981 Gibson Greeting Cards LBO such a home run?" and "Ray Chambers" responded. I can't guarantee that this is really Chambers, but it has the ring of truth:

There were a number of factors that attracted us to purchase Gibson.  We had the opportunity to acquire the company at a discount from book value.  The management of Gibson, led by Tom Cooney and LR Jalenak, were inspired to turn in record performances because for the first time in their careers they had the chance to own a meaningful part of the equity of their company.  Because of the purchase price being a discount from book value, the lenders were willing to look to the liquidating value of the assets more than the historic cash flow as security for their loans.

When the Gibson transaction was completed in January, 1982, the prime lending rate of interest was 21 percent and economists were predicting it would go to 30 percent.  Thankfully, during 1982 it went the other way and Gibson's management performed splendidly.  The net profit for the year 1982 after interest on the significant amount of debt was the same as the previous year when the company had no debt.  In early 1983, the IPO window opened for a short time and Gibson was able to capitalize on that opportunity in the market.

Saturday, November 8, 2014

Kill your investing gurus: Charlie Munger

In Kill your investing gurus, I offered a skeptical opinion of Warren Buffett and his public persona. That post's comments became a discussion of his business partner, Charles Munger, which is appropriate because much of the criticism I directed at Buffett can also be directed at his partner.

I've never taken Munger or his persona seriously, for several reasons:

1. His ideas, while generally correct, aren't novel or profound. Most of his "worldly wisdom" is just common sense. I think people give Munger's ideas more credit than they deserve because of the halo effect: he's a billionaire, and he's associated with an even richer billionaire, so people assume his ideas must be important.

2. I disagree with his philosophy of investing and some of his advice on how to invest successfully. There's a lot of room for debate about the nature of investing, so I won't claim that he's wrong and I'm right, but this post will offer a few counterpoints to his ideas.

3. I find him arrogant, although I'm sure many people will find this article arrogant too. De gustibus.


Munger's ideas

Kill your investing gurus claimed that "many investment gurus are famous less for their ideas than for their personalities. They are famous for being themselves." I wrote that about Buffett, but it's even more true of Munger: he expresses his opinions much more bluntly than almost anyone else, and that appeals to a lot of people.

But when Munger's ideas are separated from his earthy manner and considered on their own merits, they become much less impressive. They're really just rehashes of other people's ideas or rehashes of common sense.

For example, Munger has argued that:

• We're creatures of habit, so having good habits is a prerequisite of success.
• Being articulate and persuasive isn't the same thing as being right.
• Envy and the desire for revenge can lead to irrational decisions with poor outcomes.
• Drugs are bad.

These things are all true, and understanding them could benefit a novice investor or someone who lacks common sense, but they're obvious to experienced investors. The obvious doesn't become profound just because a billionaire says it.

Munger's most famous idea is probably his "latticework of mental models." Poor Charlie's Almanack, which is a collection of his speeches and quotes, describes it as follows:

[Munger] calls the tools he uses [to evaluate investments] 'Multiple Mental Models.' They borrow from and neatly stitch together the analytical tools, methods, and formulas from such traditional disciplines as history, psychology, physiology, mathematics, engineering, biology, physics, chemistry, statistics, economics, and so on...

When properly collected and organized, his Multiple Mental Models (about one hundred in number, he estimates) provide a context or 'latticework' that leads to remarkable insights as to the purpose and nature of life.

The thing is, this is nothing new. "Mental models" are merely ideas or rules of thumb. The necessity of placing them in a "latticework" isn't new either: everyone knows that discretion is important in applying ideas. The power of compound interest and the law of large numbers could both be considered mental models, but they're obviously relevant to different situations.

Like Nicholas Nassim Taleb, Munger coins new terms for old ideas and claims them as original insights. Apart from his mental models, there's his "elementary world wisdom," which is really just common sense, his "availability-misweighing tendency," formerly known as the streetlight effect, and his "liking/loving tendency" formerly known as the halo effect. These ideas were fine in their original forms and didn't need him to re-brand them.


Reading widely is overrated...

The excerpt from Poor Charlie's Almanack about Munger's mental models makes it clear that he thinks that reading widely is important. Elsewhere, Almanack states that:

[Munger's] encyclopedic knowledge allows him to cite references from classical orators to eighteenth- and nineteenth-century European literati to pop culture icons of the moment. Where else would you find Demosthenes and Cicero juxtaposed against Johnny Carson or today's investment managers set against Nietzsche, Galileo, and a "one-legged man in an ass-kicking contest"?

I agree that knowledge is valuable: psychology plays a prominent role in financial markets, and human psychology changes very slowly if it changes it all, so reading about the financial markets of the past can help one understand the present. But reading widely is less important than being able to determine what information is meaningful and what isn't. Professional investors are constantly inundated with ideas and data, and most of those data are irrelevant, misleading, or trivial.

I'm skeptical that reading about "history, psychology, physiology, mathematics, engineering, biology, physics, chemistry, statistics, economics" makes people better investors. Apart from the psychological aspect of finance, I think that Wall Street is a discrete system with relatively few parallels to other fields. For example, famous economists are notoriously bad at making financial predictions even though economics is related to finance. By contrast, many of the most talented investors seem to be idiot savants: e.g. George Soros is a brilliant trader with an intutive understanding of the market, but no one takes his philosophy seriously.

Reading about biology or engineering might be useful in helping investors understand how systems withstand stress and exogenous shocks, but that's just one limited benefit. Reading extensively about art history or the human body or whatever won't make one a better stockpicker.


...so is acting rationally

Munger has talked and written a lot about the importance of acting rationally. I think this is just self-aggrandizement. When people give exhortations to act rationally, it's usually a way for them to say, "I am a superior thinker."

The Wall Street Journal has a Munger quote that demonstrates the absurdity of the "act rationally" rhetoric:

I don’t have the slightest interest in gold. I like understanding what works and what doesn’t in human systems. To me that’s not optional; that’s a moral obligation. If you’re capable of understanding the world, you have a moral obligation to become rational. And I don’t see how you become rational hoarding gold. Even if it works, you’re a jerk.

First, when one has to react to other people's irrationality, the rational response isn't always obvious. Panics, financial crises, and hyperinflations all involve people doing things that are beneficial individually but worsen the overall problem. When other people's irrational panic can damage you financially, it often makes sense to panic first, even if doing so isn't strictly rational. If Munger were really interested in understanding what works and what doesn't in human systems, he would respect this dynamic.

Second, I think it's important to separate morality from investing as much as possible. I don't mean that people should invest in companies that violate their ethical principles, but they should avoid seeing moral issues where they don't exist. Imagine a farsighted investor in Germany after World War One: he sees that crushing reparations payments will lead to hyperinflation, so he invests in gold. That lets him preserve his family's wealth while countless other people lose their life savings, but according to Munger he's a jerk who shirked his moral duty.


Munger's arrogance

Apart from philosophical disagreements, I find Munger's arrogance offputting. That doesn't automatically invalidate his ideas, but it takes a lot of chutzpah to claim, as Munger did, that "Ben Graham had a lot to learn as an investor."

Munger criticized Graham for practicing a very limited strategy of buying only net-nets, but that's a oversimplification of Graham's ideas. As Oddball stocks recently wrote, "Sprinkled throughout Security Analysis are recommendations that investors look for higher quality companies over lower quality companies.  At one point [Graham] even recommended that investors simply buy the best company in each industry when the entire industry hit its low point in the business cycle."

Munger also says that the Great Depression stunted Graham as an investor by making him overly conservative. He implies that Munger-Buffett strategy of buying quality GARP stocks is superior to Graham's strategy of buying cheaper, but lower-quality, companies with a margin of safety.

I think the issue is less clear-cut and that which kind of investment performs better is largely a function of the economic environment. Buying quality businesses with long-term growth prospects has been a phenomenal strategy for Munger and Buffett, but their careers have coincided with the longest bull market in history. Graham's approach may offer fewer rewards in an extended bull market, but it's arguably more robust during bear markets and periods of stagnation. It's a solid all-weather strategy.

Regardless of which is better, it's crazy to say that Graham "had a lot to learn." I've read several books by or about Graham, and the salient feature of his writing is the breadth of knowledge it displays. He wrote thoughtfully on numerous topics: valuation, financial history, competitive advantage, agent-principal conflicts, and many more. To Munger's credit, he acknowledges that Graham was "one of the only intellectuals — probably the only intellectual — in the investing business at the time."

The book I quoted from earlier, Poor Charlie's Almanack, is another example of Munger's hubris. It's primarily a compilation of his quotes and speeches, but it also includes a biography hagiography of Munger along with numerous blurbs from his friends testifying to his brilliance. Essentially it's a vanity project that Munger, to give a false appearance of modesty, couldn't compile himself.

The title is a takeoff of Benjamin Franklin's Poor Richard's Almanack, and the book frequently compares Munger to Franklin. Among other things, Peter Kaufman, the book's editor, calls Munger "this generation's answer to Ben Franklin" with no trace of irony, and the beginning of chapter two superimposes a picture of Munger on Franklin's engraved portrait.

Despite the constant comparisons, I can't imagine Franklin indulging in this kind of self-aggrandizement. As Peter Lynch astutely wrote, "In my experience the next of something almost never is—on Broadway, the best-seller list, the National Basketball Association, or Wall Street." Or the next Ben Franklin.

Sunday, October 26, 2014

Book review: "Merchants of Debt" by George Anders

Merchants of Debt is a history of Kohlberg, Kravis & Roberts, the leveraged-buyout firm. KKR was founded in 1976 and Merchants was was published in 1992, so it covers the first fifteen years of KKR's existence.

The three partners who founded KKR and gave it its name met at Bear Stearns. Jerome Kohlberg was a Bear partner, while Henry Kravis and George Roberts were new hires. Bear had already completed several several LBOs under Kohlberg's direction when Kravis and Roberts joined, but together they pushed the firm to do more and larger buyouts.

Bear's focus at the time was lower-risk short-term trading, but Kohlberg had enough influence that the firm let him, Kravis, and Roberts commit more of its capital to LBOs. Unfortunately, the trio's deals weren't very successful. One early acquisition, a for-profit technical school in San Francisco, went bankrupt. Another, a shoe company named Cobblers, met the same fate after its president committed suicide. Eagle Motor Lines, a trucking company, was a loser. Boren Clay suffered during the early-'80s recession, and while it was eventually a profitable investment, the returns were much lower than expected.

Kolhberg, Kravis, and Roberts also had several winners, but their overall record was mediocre. That, along with philosophical differences, led to an acrimonious departure from Bear and their decision to found their own company. Their timing was perfect: KKR began life in 1976, just a few years before interest rates peaked and the stock market began an unprecedented surge.

Apart from good timing, KKR was successful because it pioneered a new way of financing LBOs. Traditionally, the sponsor of an LBO financed the transaction by investing a small amount of its own money in the LBO and borrowing the rest from an insurance company at high rates. KKR changed how both the debt and equity were funded.

Instead of borrowing exclusively from insurance companies, KKR convinced banks to lend it money as well, and it began issuing junk bonds once they gained acceptance in the early '80s. KKR also didn't invest any of its own money in its buyouts: instead it created limited partnerships, which it earned large fees for managing, that purchased the buyouts' equity.

The biggest investors in these partnerships were public pension funds. KKR won the funds' investments through a mixture of client hand-holding and legal bribery. The book describes it as follows:

Investing pension money with KKR also provided civil servants with a ticket into a glamorous new world. They didn't need to be mere spectators in Wall Street's biggest, most exciting takeover battles. By allying themselves with KKR, the Walter Mitty types who ran big state pension funds could feel that they were players, too. Roberts, Kravis, and Kohlberg shrewdly cultivated this "fan club," playing tennis with their pension fund backers, sending them confidential briefing books, and inviting them to private two-day conferences at elegant hotels. At those sessions, modestly paid civil servants got the chance to rub shoulders with KKR's founders, and to address them as "Jerry" and "Henry" and "George."

Drawn closest to KKR was Roger Meier, the long-time chairman of the Oregon Investment Council. In conversations about the buyout firm, Meier sometimes would say "we," then pause, correct himself, and say: "I mean, KKR." In 1983, Meier joined the board of a KKR-controlled company, Norris Industries, based in Los Angeles. Several times a year, right before or after board meetings, Roberts and Meier played doubles tennis matches at the plush Beverly Hills Hotel, pairing up with the hotel pro, former Wimbledon champion Alex Olmedo. "It was delightful," Meier later recalled. "Here was a little yokel from Portland, Oregon, operating with really some pretty fantastic high fliers. I was pretty impressed."

Meier had even more reason to be impressed after he retired from OIC in 1986 and KKR let him buy stock in one of its portfolio companies at a below-market price.

So how did KKR's others investors-- the ones who weren't allowed to make below-market purchases-- do? Merchants of Debt has an appendix that lists all the KKR deals that had been completed by time the book was published, along with their internal rates of return. The appendix suggests that KKR's record was very similar to its founders' record at Bear Stearns: many winners, but also a number of investments that went to zero. Two late-'70s deal went bankrupt. KKR's first big deal, the buyout of Fortune 500 constituent Houdalille Industries, returned only 22% per year even though KKR had borrowed 97% of purchase price. The buyout firm had to shut down one of Houdalille's two divisions a few years after the acquisition because Japanese competition had made it structurally unprofitable.

Some later deals earned 50-60% annualized returns, but even that's not as impressive as it may seem:

As a mischievous exercise, Goldman, Sachs partner Leon Cooperman at one point devised on paper a crude variation on the principle of the leveraged buyout, involving taking out big loans to buy stocks. Cooperman's method: Buy a cross-section of the stock market, paying nine-tenths of the purchase price with borrowed money at a 15 percent interest rate. Then wait a few years, see how much the stock price has climbed, and tally up the profits on the one-tenth "equity" portion of the purchase price. For a few years, Cooperman pointed out, his method would have yielded annual profits of 74 percent, an even better showing that the returns that KKR's passive investors were collecting. 

The largest deal that Merchants covers-- and the all-time largest LBO when the book was published-- was KKR's purchase of RJR Nabisco, which nearly went bankrupt a year after KKR bought it. The reason for the near-bankruptcy is that RJR had issued toxic securities called reset bonds-- if the bonds traded down from their issue price, the interest rate would reset higher to compensate for the fall in price. Essentially, the yield to maturity at time of adjustment would become the new coupon yield.

The reset bonds plummeted when the junk-bond market seized up in 1989. KKR averted bankruptcy by injecting new equity into RJR, but it reportedly lost a billion dollars when it sold RJR years later. KKR had gotten into a bidding war for RJR, dramatically overpaid for the company, and financed the purchase recklessly.

KKR's experience during the last economic cycle was similar: it made a string of successful deals during the housing bubble, culminating in its acquisition of TXU, which replaced RJR as the largest LBO ever. TXU, which changed its name to Energy Future Holdings, declared bankruptcy earlier this year as low natural gas prices crippled its profitability. KKR and its partners lost $8 billion on the buyout.

KKR's unlevered returns during the 1980s seem to have been similar to the stock market's, so KKR was collecting large fees for providing beta. And some of those fees were egregious: In addition to earning carried interest and a 1.5% management fee on the partnerships it set up, KKR gave itself a transaction fee equal to 1% of purchase price on every company it bought. This was a source of controversy during its negotiations to purchase Houdaille and later RJR. KKR also took a large fee for selling RJR, even though its investors had lost money on the deal.

Merchants of Debt has an impressive level of detail about KKR's strategy and its investments, and its treatment of the company and its principals seems very balanced. Unfortunately, the book suffers somewhat from a lack of context. For example, while it implies that reset bonds were common among junk issuers, it doesn't quantify this or give any examples other than RJR. (In retrospect, it's amazing that anyone issued them.)

The book also doesn't compare KKR with its rivals. Although KKR became the most prominent buyout firm during the 1980s, Merchants mentions that the single most prominent deal was Wesray's 1982 acquisition of Gibson Greetings. Wesray sold Gibson less than eighteen months later for a $200mm profit on a $1mm equity investment, demonstrating the enormous potential rewards of LBOs. But the book doesn't describe any of Wesray's other deals or compare their record to KKR's.

Kill your investing gurus

Dwight MacDonald was a prominent cultural critic during the 1950s. In Masscult & Midcult, he argued that a common feature of bad art is an emphasis on the artist, his personality, and his supposed genius rather than on the art itself. He mentioned Lord Byron as an example of this:

Byron's reputation was different from that of Chaucer, Spenser, Shakespeare, Milton, Dryden and Pope because it was based on the man--or what the public conceived to be the man-- rather than on his work. His poems were taken not as artistic objects in themselves but as expressions of their creator's personality.

There is a similar phenomenon in investing, in which many investment gurus are famous less for their ideas than for their personalities. They are famous for being themselves.

Warren Buffett is the most prominent example of this. Buffett was originally known for making a string of great investments and publishing shareholder letters that explained his philosophy of investing. Today, he's known for being "Uncle Warren," a down-to-earth Midwesterner who dispenses homespun advice in the manner of Will Rogers.

Buffett's ideas are no longer discussed or debated on their own merits; instead, public discussion of Buffett revolves around his witty sayings, personality quirks, and past successes. To the extent his ideas are mentioned, they're cast as pronouncements from "the Oracle of Omaha"-- i.e., Buffett doesn't deserves respect because his ideas are good, his ideas automatically deserve respect because they're his and he's Buffett.

MacDonald claimed that Byron's private writing was different from-- and much more cynical than-- what he wrote for public consumption: "Of course it wasn't really Byron himself but a contrived persona which fitted into the contemporary public's idea of a poet."

Likewise, there's a wide chasm between Buffett's public persona and his more cynical private beliefs. It wasn't always this way: one need only compare Buffett's letters from the 1970s to his CNBC interviews today to see how much his persona has changed.


A parable

The prologue to The New Market Wizards, Jack Schwager's trader interview book, includes a story from Ed Seykota:

One cold winter morning a young man walks five miles through the snow. He knocks on the Jademaster's door.

The Jademaster answers with a broom in his hand. "Yes?"

"I want to learn about Jade."

"Very well then, come in out of the cold."

They sit by the fire sipping hot green tea. The Jademaster presses a green stone into the young man's hand and begins to talk about tree frogs. After a few minutes, the young man interrupts.

"Excuse me, I came here to leam about Jade, not tree frogs."

The Jademaster takes the stone and tells the young man to go home and return in a week. The following week the young man returns. The Jademaster presses another green stone into the young man's hand and continues the story. Again, the young man interrupts. Again, the Jademaster sends him home. Weeks pass.

The young man interrupts less and less. The young man also learns to brew the hot green tea, clean up the kitchen and sweep the floors. Spring comes. One day, the young man observes, "The stone I hold is not genuine Jade."


Ostensibly, the moral of this story is that patience precedes wisdom. If a trader wants to become successful, he can't depend on other people for tips and easy answers. He must learn how to think for himself.

I have a different interpretation. Like the story itself, my interpretation is hokey and not entirely serious, but like the story I think it makes a valid point.

The story's real message is that many respected gurus are full of crap. The young would-be apprentice thought the jademaster would teach him valuable lessons. Instead, the jademaster exploited the young man's adulation and got him to perform free domestic labor, all while pulling his leg with a ridiculous story about tree frogs.

Warren Buffett is a modern-day jademaster. Buffett has carved a lot of jade over the course of his career, but many of the stones he's pressed into the public's hands are merely quartz.

When Buffett describes how Rose Blumkin was thrifty and dedicated to her business, he may as well be talking about tree frogs. Everyone knows that thrift, industriousness, and dedication are good qualities. The obvious doesn't become profound just because a guru says it.

When Buffett bemoans Corporate America's ethical lapses, he's fingering a particularly cheap lump of quartz. Buffett has treated Berkshire's minority shareholders admirably, but he's also used his image as an honest outsider to cut insider deals. His reputation as a man of strong principles has given him cover to violate some of them.

When Buffett praises quality businesses, he may as well be talking about tree frogs again. Like the jademaster, Buffett can talk interminably about his favorite subject without ever revealing the foundation of his success. Like the would-be apprentice, investors have to endure lots of diversionary stories before they figure it out for themselves.

I don't think anyone has interpreted the jademaster story this way before, but my whimsical interpretation does have one thing in common with the original: it argues that people can't depend on a guru for easy answers. That's true whether the guru is a long-forgotten gem carver or the world's richest investor.

Wednesday, October 22, 2014

Two great posts from Credit Bubble Stocks

Credit Bubble Stocks has two older posts that deserve to be reposted.

The first is a review of Benjamin Graham: Building a Profession, which is a collection of Graham's articles and speeches.

The book's highlight is its discussion of Computing-Tabulating-Recording Co., which was a predecessor of International Business Machines. Graham liked C-T-R because he had extensive experience using its products, which knew were high-quality, and because its stock traded at only 7x earnings. He urged his boss to buy C-T-R's stock, but his boss flatly refused:

So early in 1916 I went to the head of my firm, known as Mr. A.N., and pointed out to him that C.-T.-R. stock was selling in the middle 40s (for 105,000 shares); that it had earned $6.50 in 1915; that its book value-- including, to be sure, some nonsegregated intangibles-- was $130; that it had started a $3 dividend; and that I thought rather highly of the company's products and prospects.

Mr. A.N. looked at me pityingly. "Ben," said he, "do not mention that company to me again. I would not touch it with a ten-foot pole. (His favorite expression.) Its 6% bonds are selling in the low 80s, and they are no good. So how can the stock be any good? Everybody knows there is nothing behind it but water."

By water, Graham's boss meant that its tangible assets had been written up to make its property, plant & equipment look more valuable than they really were.

I find this fascinating because it shows how much valuation standards can change over time. Today, a company is praised for earning a high return on equity (ROE). In Graham's time, companies were praised for having significant assets, even if reporting significant assets depressed their stated ROE. Then, 7x earnings was considered too expensive for a company that had minimal real assets. In 2011, when Graham's most famous disciple invested in IBM, it traded at 13x earnings and its tangible book value was negative. These days, a company with negative tangible equity and low-rated bonds is considered to have an efficient capital structure.

CBS's second post presents a theory of why breadth declines at the end of bull markets:

The problem with low-information momentum investing is that since you don't have a theory of the value of your holdings, you have to put a lot of thought into stop loss rules that get you out of the position when the momentum fades. Mr. UES has a stop loss rule to dump anything that goes down 10 percent from his purchase price or subsequent high price. 

I've noticed that when he blows out of a stock that "isn't working" anymore, he'll push most of the proceeds into ideas that are "still working" - going up.

This is what creates narrowing breadth at the end of a rally!

This reminds me of a story I read in high school, Joseph Addison's The Vision of Mirza. The story describes a bridge that's shrouded in mist at both ends. The length of the bridge that's visible has numerous trap doors: as people walk from one end to the other, they gradually fall through the traps and into the water below. Many people start at the beginning of the bridge, but no one reaches the end.

The Vision of Mirza was meant to be a metaphor for death and the evanescence of human life. Less dramatically, it's also a metaphor for the stock market. The beginning and end of a bull market are often impossible to identify in advance. They're shrouded in mist, if you will. And few of the stocks that have strong momentum at the beginning of the bull market maintain that momentum for the bull's entire duration.

Monday, October 6, 2014

Andy Beal's business model

Andy Beal is an unconventional banker who avoided participating in the housing bubble and made a lot of money buying distressed loans in its aftermath. In 2009, Forbes published an article about him called The Banker Who Said No. The article emphasizes Beal's foresight and maverick personality, but it also describes his business model, and I would argue that this has been equally important to his success.

Beal owns 100% of Beal Bank, which funds itself is by issuing certificates of deposit. Many CD buyers are "hot money" depositors who seek out the CDs with the highest interest rates, and this gives Beal a lot of flexibility in borrowing money: if he sees opportunities to make profitable investments, Beal Bank can quickly raise money by offering high-interest CDs. Conversely, if its existing loans are being repaid and he can't find any new investments, it can reduce its liabilities by letting its outstanding CDs mature.

Few mainstream investors have the same flexibility. It would be very difficult for a hedge fund manager to sit out a boom the way Beal sat out the housing bubble and stay in business. (Michael Burry foresaw the housing bust, but he faced an investor revolt when his housing bets initially lost money.) Even if the manager's clients didn't leave him for underperforming the market, they wouldn't be willing to pay him management fees for holding cash. It would also be very difficult for the typical fund to find new investors during a crisis, whereas FDIC insurance lets Beal raise money with ease.

For a typical bank with a low-yielding portfolio, issuing high-interest CDs is a tough way to raise money, but a high cost of deposits is less of an issue for Beal because he specializes in buying distressed loans that have both higher interest rates and the potential to appreciate. The downside to Beal's business model is that he can't invest widely, e.g., regulators wouldn't let him issue CDs in order to trade stocks or currencies. But Beal's focus is debt– according to the Forbes article, he's bought only one stock in past 15 years– and for that it seems like a fantastic model.

Avoiding value traps

Although I panned Daniel Strachman's book about Julian Robertson in my last post, the book has one great quote that's worth sharing:

Robertson’s mantra was, as long as the story around the investment remained the same, the position should get bigger. As soon as the story changed, it was time to get out...

To understand the concept of story, consider this example. Say you are interested in a solid oak wooden table. [An] analyst could tell you that he had checked out the market for tables, evaluated the information, and come to the conclusion that the table was a good buy at $100 because it was well made, solidly built, and would not fall apart. This is the story. So you go to the shop, prepared to buy the table. And then, just as you are running your hand over the table, a corner falls off. Well, now the seller is desperate to get rid of the broken table and is willing to sell it for $20. To the analyst, this seems like a steal. He sees an incredible opportunity to buy something for $20 that is really worth $100 and needs just a bit of fixing to get it there. But in Robertson’s eyes, the story is now flawed, and now he would say that you should want no part of the deal. How could something so well built, made of the finest oak, break?


This is a simple analogy, but it conveys a profound truth about value traps and how to avoid them.

When a company with a long record of success starts performing badly, investors tend to view the present in light of the past and assume its problems are temporary. If the stock goes down, they'll see it as a buying opportunity-- witness the numerous VIC writeups on Dell, Staples, and Tesco. Instead, investors should ask if the bad performance indicates that the company's competitive position has permanently deteriorated. If it has, then the company's historical performance and the fact that its stock is cheaper than it used to be are meaningless.

The same principle applies to valuation standards. One of my first posts on Young Money was about gold miners. Although they were trading far below their historical valuations, I argued that they were value traps: since the price of gold had been low for years, investors historically had ignore the miners' low earnings and valued them on the profits they would earn if gold surged. But when I wrote that post, gold had already surged and the miners' earnings were still low. The assumptions that investors had historically used to value the miners had been disproven, so it didn't matter where they traded relative to historical levels.

I used to be a hardcore statistical value investor, and it took me years of experience to realize how important this is. If a business is declining or its competitive environment is changing in a way that will permanently impair its profitability, there's almost no price at which it's worth buying.

The problem goes beyond falling earnings. When a company's business model deteriorates, management typically doesn't know how to respond. If they're used to running a growing company, they won't know how to run a shrinking company. If they're used to dominating their industry, they won't know how to compete from a position of weakness. In many cases, they'll do things that exacerbate the company's problems.

Their capital allocation also typically worsens: it's common for structurally-declining businesses to try to grow their way out of their problems by making overpriced acquisitions in growth markets. See HP and Autonomy, Kodak, Post Holdings, etc. Other structurally-challenged businesses try to maintain their earnings per share by buying back stock. This often starves their operations of necessary cash and can actually lower EPS in the long run.

For a company with a durable business model and long-lived assets, bad capital allocation isn't necessarily fatal. If the company wastes the next few years' earnings on overpriced acquisitions, that impairs only a small part of its present value. By contrast, the next few years represent a huge share of present value for companies that are in decline or that face a step down in profitability because of new competitive pressures. It's a sad irony that the companies for which capital allocation is most important tend to have the worst capital allocation.

As an example of this, Best Buy, Gamestop, and Western Union are all buying back lots of stock. These business face existential threats and could go out of business within the next decade. In my opinion, a company like that should never buy back stock-- it should try to dividend as much of its cash to shareholders as possible before it goes to business heaven. I feel the same way about retailers and tech companies-- most of them operate in an environment of constant change and have no residual asset value, so the surest way for them to reward shareholders is to pay dividends or special dividends while business is good.

Wednesday, October 1, 2014

Julian Robertson

I've been reading as much as I can about Julian Robertson. He interests me not only because he's been very successful but because his style of investing is different from mine. I'm always trying to learn new ways to invest, and whom better to learn from than a legend?

One biography of Robertson has been published, Daniel Strachman's Julian Robertson: A Tiger in the Land of Bulls and Bears. The book gets terrible reviews on Amazon, and unfortunately they're justified. The book is riddled with solecisms and awkward metaphors, but its worst flaw is its extreme repetition, which includes gems like "The firm would need to diversify its assets to ensure that it did not put all of its eggs in one basket" and "Winning, you see, is everything to Robertson. Robertson is all about keeping score. To the victor goes the spoils, and he always wants to be the victor."

John Train provides a much better-written profile of Robertson in Money Masters of Our Time. Robertson has also given numerous interviews over the years. The best of these are his two Barron's interviews from the late 1980s, and his 2006 interview with Value Investor Insight. In 1996, Businessweek published a hatchet job on Robertson called "The Fall of the Wizard." Below is what I've been able to piece together about his career.


Tiger's early years

After serving in the Navy, Robertson worked at Kidder Peabody for two decades as a stockbroker. Unlike many brokers, he tried to understand securities instead of merely selling them, and he began trading stocks as a sideline. Early success as a trader attracted the attention of his colleagues at Kidder, and he agreed to manage money informally for several of them.

One of those colleagues was Robert Burch, the son-in-law of hedge-fund pioneer Alfred Jones. Burch and Jones probably gave Robertson idea of starting a hedge fund. In any case, when Robertson left Kidder and set up the Tiger Fund in 1980, they were among its first investors, and Tiger employed the strategy that Jones had pioneered, buying some stocks while shorting others as a hedge.

Robertson founded Tiger with Thorp McKenzie, another broker from Kidder, but McKenzie left the fund in 1982. From then on, Robertson ran Tiger as a glorified one-man shop: while he depended on numerous analysts to research potential investments, he made all the trading decisions personally.


The 1987 crash

Tiger's performance during its first five years was phenomenal: despite being partially hedged in a roaring bull market, it consistently beat the market indices. Returns slackened in 1986, however, and the 1987 crash blindsided Robertson. Two weeks before Black Monday, he wrote to Tiger's investors that "I do not see great danger of a drastic market decline until we all get a great deal more complacent."

He had assumed that the overvalued Japanese stock market would peak first, providing a warning signal for any downturn in the US market. In fact, Japan held up comparatively well during the crash, and since Tiger's largest shorts were Japanese stocks while its longs were mostly American companies, its hedging strategy failed dramatically.

Robertson was bullish after the crash, partly as a reaction to what he saw as near-universal bearishness. He told Barron's in December 1987 that "there are so few bulls that I can’t imagine who’s going to impregnate the cows." He also thought that the crash would have a limited effect on the general economy-- it might even help it by lowering mortgage rates, which he considered more important to most Americans than the stock market-- and that many stocks were cheap. In Barron's he touted Ford Motor trading at 4x earnings, thrifts at 4-6x earnings and a discount to tangible book value, and PVC manufacturers at 6x earnings.


Japan's bubble

Robertson became bearish on Japan in 1986. Japanese companies traded at astronomical valuations even though, contrary to popular perception at the time, they were earning much worse returns than their American counterparts. In the 1987 Barron's interview, he mentioned Nippon Telegraph and Telephone and Japan Airlines as being particularly overvalued. Incidentally, although Japan's Nikkei index rose 70% from the time of Robertson's interview to its peak on the last day of 1989, JAL was flat during that period. NTT also peaked long before the Nikkei.

During the 1990s, Tiger profitably shorted Japanese bank stocks. By then Japan's economy had slowed and the banks' problems with bad debt had become well-known, but they continued to trade at much higher valuations than American and European banks before belatedly crashing.

Not all of Robertson's predictions proved correct. During the late '80s, he assumed that the Japanese stock market would plunge and that this would spur the Japanese to invest more abroad. While the market did plunge, it had the opposite effect, as Japanese businesses curtailed their foreign investments.


A move to macro

As Tiger's assets under management grew from a few hundred million in the late 1980s to $22 billion at its peak in 1998, Robertson's interest in macro trading grew commensurately: "I think, without actually realizing it, we put more and more into those types of trades because we realized that they were more liquid than anything else, so we became—sort of by osmosis—more involved in macro."

Although his macro returns seem to have matched his stock-picking returns, they were much lumpier. Tiger had a phenomenal 1993, followed by two disappointing years and then a roaring comeback in 1996-97. In October 1998, Tiger fell 18% because of a wrong-way bet on the Yen. Around the same time its original long-short strategy began to fail as the Internet mania reached a fever pitch, and Robertson had to shut Tiger down in March 2000 after it fell 43% in the preceding eighteen months.


Since 2000

Robertson supposedly quintupled his money in the eight years after closing Tiger. In 2006, he predicted the housing bubble and drew an important distinction between debt and equity bubbles:

"I actually think the insanity of the late 1990s is repeating itself... There’s a more serious bubble today than there was then... The Internet bubble affected a few of us, but the vast majority of Americans were not fazed by that. Now you’ve got people living on the refinancing of equity in their homes and almost all of us own homes."

In the same interview, he described how his idea of value has evolved:

"When I started in the business and for a long time, my concept of value was absolute value in terms of a price-earnings ratio. But I would say my concept of value has changed to a more relative sense of valuation, based on the expected growth rate applied against the price of the stock. Something at 30x earnings growing at 25% per year – where I have confidence it will grow at that rate for some time – can be much cheaper than something at 7x earnings growing at 3%."

I suspect that, as with Robertson's increasing reliance on macro trading, necessity motivated this change in philosophy. The statistically cheap stocks that Robertson had been buying in the '80s had all but disappeared by the late '90s, and they remain rare today.

Sunday, September 28, 2014

Value investing in tech and retail

While value investing is usually a great investing strategy, I think it's much less likely to succeed for technology and retail companies than for other kinds of businesses. The past few years have given us numerous examples of tech and retail value traps: BBRY, DELL, NOK, ARO, BODY, RSH, SHLD, and TSCO.uk among others. Each of these stocks had a low P/E ratio during its decline, or it was cheap on some other metric like price to book or price to sales.

To accurately value a business, investors need a guide as to what margins and economic returns it will earn. Past results are often the best guide: if an industry has earned a 10% average return on equity over multiple economic cycles, but it's currently losing money because of a recession or overcapacity, then it's likely to earn a 10% ROE again at some point. Some companies in the industry may go bankrupt, but the survivors will profit when supply and demand adjust. In other words, the typical industry reverts to the mean.

By contrast, new technology standards and products replace old ones all the time. Instead of reverting to the mean, struggling tech companies usually revert to non-existence. The same is true for retail: what people like to buy and where they like to buy it change constantly.

This means that tech and retail investors can't assume that earnings will revert to prior levels. They also can't assume that asset value will give them a margin of safety. In tech, finished products that have become obsolete or non-standard may be impossible to sell, and raw materials tend to depreciate rapidly.

Many retailers have the same problem: if a product goes out of style, its market value will be only a small fraction of its carrying value. Likewise, the typical retailer has a lot of its asset value in leasehold improvements, and these have minimal liquidation value.

Some people who invest in declining retailers think that the retailers' real estate value provides a margin of safety. In an interview with The Manual of Ideas, Guy Spier offers several counterpoints to that idea:

• It's difficult to liquidate a large collection of properties at once. A retailer's real estate may be worth a certain amount, but the present value of that real estate in a liquidation will be much less.
• Real estate in city centers is extremely valuable, but in many parts of the country there's no shortage of land and property.
• Retailers' real estate is heavily customized. This includes not only leasehold improvements but the layout of the property itself. One kind of store can differ significantly from another, and all stores differ from the typical office building.
• Real estate often has contingent liabilities that lower its liquidation value.
• Real estate values are cyclical. If a retailer needs to liquidate property because an economic downturn has curtailed its business, that property will sell for much less than under normal circumstances.

Nate Tobik has described many of the same problems of liquidating real estate:

"Land can be valuable, if you own the only empty plot in Midtown Manhattan you're sitting on a fortune.  But those cases are rare.  More likely for a net-net is a company owns a plot of land in Altoona, PA or Eaton, OH where land is in ample supply... 

The curse of real estate is that to sell incurs a high transaction cost and takes a long time. It's hard to unload a lot of real estate quickly at market rates.  If a seller tries to liquidate their real estate holdings quickly it's likely they'll only realize fire sale values."


Consumer discretionary

What's true for retail seems to be true for other kinds of discretionary spending. As Carlo Cannell says about restaurants:

"Look at the restaurant industry... which is characterized by a high rate of mortality. It’s just a fact that almost all restaurants that come public go out of business. If you opened randomly a Fortune magazine from 1947, or 1973, and read any stories about restaurants that were hot growth companies, it would make you laugh –  in hindsight it seems so clear why they didn’t make it."

Bruce Greenwald has made a similar argument about brands. He says that while top consumer brands may appear to be durable and uniquely valuable, this appearance is misleading. For every brand that was introduced fifty or a hundred years ago and remains popular today, there are many others brands that were introduced at the same time, became popular, but ultimately lacked staying power.

Wednesday, September 17, 2014

Random thoughts about investing

Specialization
The Wall Street Journal has a fascinating interview with a venture capitalist, Bill Gurley, who says that "the venture-capital community or startup community is taking on an excessive amount of risk right now," i.e. it's a bubble, but that his firm continues to invest in startups because "choosing not to play the game on the field doesn't work."

Many investing gurus laud the benefits of specializing and developing extensive knowledge of one specific industry or asset class, but Gurley's interview demonstrates that specialization has at least one big drawback: if an investor defines himself as doing one thing, he'll have to keep doing that one thing regardless of how unfavorable market conditions become. Gurley is a venture capitalist, so he feels compelled to keep investing in startups even though he knows the risk/reward is terrible.


VIC writeups
I'm wary of VIC recommendations that get high ratings (6+) on a large number of votes. It suggests that all of the event-driven and value funds that would be interested in buying the stock have already bought it. My guess is that the best-performing recommendations have above-average ratings (5.3-5.7) and relatively few votes-- most people don't know about them yet, but the ones who know about them like them.


The housing market
Contrary Investor has a great article describing how investors are fueling the US housing market's rebound. It's a perfect example of reflexivity: investors have piled into "undervalued" real estate because they think it's bottomed, and their piling in has creating the price rise they anticipated.


Lehman Brothers
The Lehman Brothers bankruptcy examiner's report is eye-opening. Lehman's risk limits were meaningless: whenever management wanted to increase risk, the raised the limits or simply ignored them. During 2006, Lehman began dramatically increasing its exposure to leveraged loans but excluded them from its risk calculations. Then management belatedly included them and realized it had exceeded its risk controls for the previous several months.

Lehman's CEO was routinely unaware of important business and balance-sheet issues until other people brought them to his attention. Even if he had tried to stay informed, it would have been difficult for him to understand everything Lehman was doing because "At the time of its bankruptcy filing, Lehman maintained a patchwork of over 2,600 software systems and applications... Many of Lehman’s systems were arcane, outdated or non‐standard."

It's tough for investors to analyze large banks when their own managers can't.


Fifth Third Bank
John Hempton has an older article about Fifth Third Bank that's worth reading. He argues that 5/3 was able to dominate the Midwestern banking market because it had an entrepreneurial culture that rewarded managers for limiting operating costs and loan losses. This let 5/3 undercut its competitors in offering loans to the highest-quality borrowers and still make a lot of money. Eventually 5/3 saturated the Midwest, which left it with two choices: lower its loan standards or expand geographically. It chose both, buying a lot of brokered home equity loans from outside its home market, and suffered the consequences when the housing bubble burst.

My takeaways are that:
• Even the best companies face limits to their growth strategy.
• When they reach those limits, they often make bad decisions in an effort to continue growing at the same rate.


Ebay and Bill Me Later
Ebay's acquisition of Bill Me Later may be another example of a company reaching its growth limits and recklessly pushing past them. Two things give me pause. First, it looks like Ebay seriously overpaid for BML in 2008, which raises the risk that it's growing BML's loans too quickly in order to justify the purchase price.

Second, Ebay finances BML with its offshore cash. Apparently it can do this without paying repatriation taxes. A Reuters article quotes the CEO as saying, "BML is a really productive use of the offshore cash. It earns a lot more than just 1 percent... [We're] taking every opportunity to repatriate cash when we can." Reading between the lines, it seems that being able to use the stranded offshore cash has induced Ebay to make loans it wouldn't otherwise make.