Sunday, August 31, 2014

More on Peter Lynch

My previous post was a critical review of two of Peter Lynch's books. I was critical because the books promote the idea that stocks, particularly "wonderful companies," are always great investments. (At one point he deems Micron Technology "a wonderful company from Idaho.")

Despite that, Lynch makes a lot of good points, and it was unfair of me not to mention them. His first book, One Up on Wall Street, offers a list of common-sense rules for when to buy and sell stocks, along with rules of thumb for how to analyze and value various kinds of companies like cyclicals, turnarounds, retailers, etc. Lynch also warns against mistakes that individual investors commonly make.

An experienced investor will be familiar with his ideas, although someone who's just starting out should find them useful. Some of his incidental observations are also quite good. E.g. Lynch writes a lot about the limits of growth and the danger of "diworsification":
"The period of the late 1960s discussed earlier ought to be remembered as the Bladder Years... [T]here is a propensity among corporate managers to piss away profits on ill-fated ventures"

Companies tend to diworsify when their growth slows:
"When The Limited had positioned itself in 670 of the 700 most popular malls in the country, then The Limited finally was.

At that point The Limited could only grow by luring more customers to its existing stores, and the story had begun to change. When The Limited bought Lerner and Lane Bryant, you got the feeling that the fast growth was over, and that the company didn’t really know what to do with itself."

Asset value varies with the type of assets:
"The closer you get to a finished product, the less predictable the resale value. You know how much cotton is worth, but who can be sure about an orange cotton shirt? You know what you can get for a bar of metal, but what is it worth as a floor lamp?"

Investors should avoid the urge to buy the dip:
"There’s a very human tendency to believe that things that have gotten a little bad can’t get any worse. In 1981 there were 4,520 active oil-drilling rigs in the U.S., and by 1984 the number had fallen to 2,200. At that point many people bought oil-service stocks, believing that the worst was over. But two years after that, there were only 686 active rigs, and today there are still fewer than 1,000.

Sometimes it’s always darkest before the dawn, but then again, other times it’s always darkest before pitch black."

...and the urge to buy the tip:
"Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up."

...and beware of Batesian mimics:
"Another stock I’d avoid is a stock in a company that’s been touted as the next IBM, the next McDonald’s, the next Intel, or the next Disney, etc. In my experience the next of something almost never is—on Broadway, the best-seller list, the National Basketball Association, or Wall Street. How many times have you heard that some player is supposed to be the next Willie Mays, or that some novel is supposed to be the next Moby Dick, only to find that the first is cut from the team, and the second is quietly remaindered? In stocks there’s a similar curse."

"The trouble is, the 'next' one rarely works... If you missed Toys 'R' Us, a great company that continued to go up, and then bought Greenman Brothers, a mediocre company that went down, then you’ve compounded your error...

The same thing happened if you missed Piedmont and bought People Express, or you missed the Price Club and bought the Warehouse Club. In most cases it’s better to buy the original good company at a high price than it is to jump on the 'next one' at a bargain price."

Curing patients isn't how drug companies make their money:
"A great patients’ drug is one that cures an affliction once and for all, but a great investor’s drug is one that the patient has to keep buying."

El Pollo Loco investors take note:
"If the [fast food] prototype’s in Texas, you’re smart to hold off buying until the company shows it can make money in Illinois or in Maine... Does the idea work elsewhere?"

Wednesday, August 27, 2014

Book reviews: "One Up on Wall Street" and "Beating the Street" by Peter Lynch

I recently finished two books by Peter Lynch: One Up on Wall Street, his late-1980s bestseller, and Beating the Street, which he published in 1993. One Up on Wall Street explains the investment principles that Lynch used during his market-beating tenure as the manager of Fidelity's Magellan Fund. Beating the Street fleshes out these principles by providing case studies of the stocks that Lynch recommended in the 1992 Barron's roundtable.

Both books have a dangerous "stocks are always a great investment" theme. In the introduction to Beating the Street, Lynch recommends that income-seeking investors put their money in stocks, since stocks produce higher long-term returns than bonds, and generate income by selling a portion of their shares each year.

Like Warren Buffett, Lynch is a talented investor, but like Buffett, he's created a folksy public persona that misleads investors into thinking investing is simpler than it really is.

Beyond that, much of Lynch's advice is vague and contradictory. At the beginning of One Up on Wall Street, he writes: "As I’ve noted on prior occasions: 'That’s not to say there’s no such thing as an overvalued market, but there’s no point worrying about it.'"

But later he points out that:
"[I]n the late 1920s that common stocks finally reached the status of 'prudent investments,' whereas previously they were dismissed as barroom wagers—and this was precisely the moment at which the overvalued market made buying stocks more wager than investment.

For two decades after the Crash, stocks were regarded as gambling by a majority of the population, and this impression wasn't fully revised until the late 1960s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments or dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not." (emphasis his)

Arguing that events like the October 1987 crash don't affect long-term returns, Lynch writes: "Whether it’s a 508-point day or a 108-point day, in the end, superior companies will succeed and mediocre companies will fail, and investors in each will be rewarded accordingly."

But he also claims that "wonderful companies become risky investments when people overpay for them... In 1972 [McDonald's] stock was bid up to a precarious 50 times earnings. With no way to 'live up to these expectations,' the price fell from $75 to $25."

In other words, stocks always go up in the long run, expect for the mediocre ones that don't, so you should stick to investing in wonderful companies that do go up, except when they're overvalued, but whether or not the market is overvalued doesn't matter.

Fortunately, some of Lynch's other advice is more straightforward. He argues that investors should avoid complexity and invest in companies they can understand, be wary of Wall Street's conflicts of interest, and be skeptical of analyst recommendations. He also points out that being able to invest in smaller, lesser-known stocks is a big advantage for individual investors.

Many people consider Beating the Street a poor relation of One Up on Wall Street, but I liked it somewhat better. (I generally enjoy this kind of "time capsule" book.) It's interesting to read about Lynch's logic for buying or not buying certain stocks. One company that he considered recommending at the Barron's roundtable, EQK Green Acres, had increased its dividend every quarter during the prior three years. In a quarterly earnings report, the company suggests that it might forgo additional dividend increases. Lynch interpreted that as a sign of deeper problems at EQK and decided not to recommend the stock.

Beating the Street also describes Lynch's foray into European investments. In 1984, the American stock market had rallied 50% from its lows but European stocks were still very cheap. Lynch traveled to Sweden and met with the management of Volvo, which was trading at $34 despite having $34/share in cash and several profitable subsidiaries.

Each book contains a list of stocks that significantly outperformed the market during the 1970s and '80s. Their subsequent performance doesn't seem to have followed any pattern. Some stocks continued to do well, some became mediocrities, and some crashed and burned. In both books Lynch highlights Hanes, the manufacturer of L'eggs, as a great business, but pantyhose went out of style a couple years after Beating the Street was published:
"From 1995 a steady decline [in pantyhose sales] began, levelling off in 2006 with American sales less than half of what they had once been. This decline has been attributed to bare legs in fashion, changes in workplace dress code, and the increased popularity of trousers."

Such is the risk of buying wonderful businesses-- most of them cease being wonderful at some point. To be fair, Lynch acknowledges that "The trick is figuring out when [fast growers will] stop growing, and how much to pay for the growth," but he doesn't give much advice on how to do this.

Monday, August 25, 2014

How Dell lost its edge

I found this comment about Dell very interesting. The author argues that Dell's competitive advantage was eroding even before smartphones ate into PC demand:

The shift from desktops to notebooks is bad for Dell long-term. Dell's big cost advantage comes from their "no inventory" system. They take your money today and buy all the parts necessary to build your custom desktop a day or two later. If you buy a HPQ desktop at BestBuy today, on the other hand, HPQ bought the parts eight weeks ago in Southeast Asia. The eight weeks is spent in manufacturing, shipping, sitting in inventory in the distribution center and finally on the retail shelf. Since PC components depreciate 1% per week, Dell has a built in 8% advantage. They also don't tie up capital in inventory and AR, but that's pretty minor these days. 

The above scenario doesn't really work with notebooks. The notebooks are pre-assembled in Asia and shipped over. Dell now gets hit with parts depreciation while the notebook is made, shipped and sitting in the distribution center. They still have an advantage in that parts don't continue to depreciate on the retail shelf, but we're now talking 3-4 weeks instead of 8. And this is partially offset by higher shipping cost. 


My take: Most high-quality companies aren't inherently high-quality. In a lot of cases, a competitive advantage is the byproduct of a specific business environment, as seems to have been the case with Dell. On the other hand, even a temporary, context-dependent competitive advantage can be quite valuable. Dell had a 10- or 15-year period during which its business model gave it a huge advantage, and those 10 or 15 years coincided with the explosive growth of PC sales.

Saturday, August 23, 2014

Some good comments on spinoffs

On Twitter, Credit Bubble Stocks writes that, "If anything, spinoffs will now probably underperform because they are too popular and being used as 'garbage barges'."

"Garbage barges" is a great turn of phrase, up there with  "value pretender" and "stuckvestor."

I think spinoffs have always been garbage barges to some extent, with many companies using them to separate a low-growth or low-ROIC division from one that has better metrics. But CBS is right that a lot of companies have taken advantage of hedge funds' (and other investors') enthusiasm for spinoffs to offload poor securities at rich prices.

One recent example is Murphy USA (MUSA), a gas-station owner that was spun out of Murphy Oil. Gas stations seem to be a bad business: paying credit- and debit-card fees on tons of small-ticket purchases really eat into returns. A bullish writeup on VIC even tacitly admits it's a bad business:

"Murphy recently entered into an agreement with Wal-Mart to build an additional 200 stores on Wal-Mart locations over the next three years...  Wal-Mart experimented with doing their own fuel sales but ultimately did not find it attractive, which led to the Murphy relationship."

Despite that, MUSA spun out at a high EBIDTA multiple and trades at an even higher multiple today.

I'm also wary of RESI and HLSS, which are dividend-paying spinoffs from Bill Erbey. I think Erbey is taking advantage of investors' thirst for yield to issue overvalued securities. A VIC writeup on RESI argues that "RESI aggressively reports earnings so that it can pay dividends.  Paying dividends allows RESI to pay huge fees to AAMC (payments to AAMC are determined by dividends).  AAMC is 28% owned by Altisource Residential’s Chairman Bill Erbey.  Effectively RESI is raising money from the capital markets (debt & equity) and paying it to AAMC as fees to enrich insiders, namely Bill Erbey."

Beware of "great capital allocators" bearing spinoff gifts.

Elsewhere on VIC, someone named aubrey makes a cogent argument that spinoffs don’t automatically generate higher returns:

"This is slightly off topic but it is interesting that you cite 'it is a spin off' as the first of your reasons for buying [Sears Hometown & Outlet Stores]. I have seen this in a number of places on this site. Why do 'we' think that a spin off is, prima facie, an attractive characteristic? My memory of Greenblatt's excellent book is that a spin off was supposed to deliver excess returns because of the possible presence of ignorant/indifferent institutional selling, lack of information and, quite possibly, attractive incentives for spin off management. I'm not saying that these characteristics might not be attractive but it is the presence of those things that would make a spin off attractive, not the fact that [it's] a spin off.

In this case the stock has gone up since the spin (so no forced/ignorant selling I guess), there is pretty good information (from memory) from the prospectus on float and I can't see anything in your write up to suggest that managment benefited from depressing the price (unless they got lots of rights other than those from holding SHLD shares?).

I wonder whether we are falling into the trap of looking at historic spin off returns (which may well have had these nice characteristics) and assuming it is the name 'spin off' which delivered them, not the characteristics. I think investors (and the parent company management) has got wise to this 'hidden' value. I haven't found a straight spin off attractive in 3 years. Though I am pretty hard core value it has to be said."

I think spinoffs have become the beneficiaries of a self-fulfilling prophecy: hedge funds pile into spinoffs because they expect them to outperform the market, and the act of piling in sends them higher and makes them outperform. This may continue for a little while longer, but it isn’t sustainable.

Friday, August 22, 2014

Bearish on Post Holdings, even after its decline

Eric Falkenstein has tried to explain market cycles by drawing an analogy with Batesian mimicry: he argues that investors look for shortcuts in assessing investment quality, and if securities with a certain feature have historically been safer or produced higher returns than other securities, investors will assume that feature is a marker of high quality. Entrepreneurs will then take advantage of this assumption by issuing securities that have the feature but differ in substance, i.e. securities that look high-quality but are really low-quality.

Post Holdings (POST), the cereal maker, is a great example of this dynamic. Cereal sales are declining, and POST is at a disadvantage to competitors like Kellogg and General Mills because it's much smaller and has historically underinvested in its business. POST has tried to escape its poor competitive position by buying faster-growing food companies, but it's paid very high EBITDA multiples for these acquisitions and financed them with junk bonds. Essentially, POST has overpaid for its acquisitions and bet that artificially low interest rates will make them economical.

Objectively POST is a pretty bad investment, but it trades at a rich valuation because it has two features that investors associate with high returns:
• Its CEO, Bill Stiritz, is an "outsider CEO" with a long record of success
• It's a spinoff, and Joel Greenblatt's popular book You Can Be a Stock Market Genius has glorified spinoffs

I think these things are a lot less meaningful than investors assume, both for POST and in general.


Outsider CEOs

One of Buffett's famous quotes is that "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

Buffett is correct, and CEOs who are skilled at capital allocation aren't exempt from this general rule. The soft positive of an outsider CEO is unlikely to overcome the hard negative of a structurally handicapped business or an enormous debt load. More generally, a CEO who's been successful in the past won't necessarily be successful in the future if the circumstances are different. And the circumstances are very different for POST compared to Stiritz's previous companies.

A comparison between POST and Agribrands, a company Stiritz ran in the late 1990s and early 2000s, illustrates this. Like POST, Agribrands was spun out of a larger company that Stiritz controlled, but the similarities end there. Agribrands had significant net cash, traded at single-digit P/E ratio, and disavowed acquisitions because it couldn't find any that met its return hurdle. POST has significant debt and deeply negative tangible equity, trades at a double-digit EBITDA multiple, and grows through high-priced acquisitions.


Spinoffs

Like outsider CEOs, spinoffs don't magically impart higher returns. Traditionally, spinoffs outperformed other stocks because they were neglected and under-owned. Many investors were effectively prohibited from owning spinoffs. E.g., a mutual fund that specialized in owning large-caps would have to sell any shares of a small-cap spinoff that it received.

The situation is radically different today. Everyone knows that spinoffs have historically outperformed the market, and buying them is a popular strategy among hedge funds. When I was active on SumZero a few years ago, it gave users the option of listing their favorite book in their profile. You Can Be a Stock Market Genius was by far the most popular choice. It's a mistake to expect spinoffs to outperform the way they traditionally have when the reason for their outperformance no longer exists.

Great capital allocators who ultimately weren't

I believe that the market environment is the main determinant of which investors achieve outsized returns. For example, Market Wizards profiles trend followers who achieved great success during the 1970s. The '70s were the perfect time for trend following-- the CRB doubled in less than 12 months on two separate occasions and experienced no major corrections, not even during 1973-74 recession. The "Market Wizards" would have been far less successful in any other period.

The same is true of leveraged buyouts: the people who started private equity firms in the 1980s got rich because of rising valuations and falling interest rates. If interest rates had stayed high and valuations hadn't risen so much, their returns would been low and the PE industry would have remained small. That's not to say that trend followers and PE players aren't skilled, but their skills are much more valuable in some environments than in others.

There are a few investors like Buffett, Soros, and Druckenmiller who have been successful in a variety of different market environments, but they are exceptional.

Investors should keep this in mind when they read books like The Outsiders that lionize successful capital allocators. The Outsiders suffers from hindsight bias. It profiles people who have been successful in a period of steadily rising asset prices and doesn't consider how their fortunes will change if the environment changes. It also excludes people who pursued similar strategies during the same period but failed for various reasons.

Below is a short list of people who were once considered great capital allocators but aren't any longer. In a way, they are the real outsiders.

• Eddie Lampert
When Kmart and Sears merged, many investors believed that Lampert's capital-allocation skills would enable Sears to earn high returns despite its weak competitive position. Sears hasn't earned high returns, and Lampert's leadership seems to have exacerbated its problems.

• Ian Cummings and Joseph Steinberg
Leucadia made many bad investments in the years leading up to the Global Financal Crisis and has yet to recover. The stock is barely higher than it was a decade ago.

• Steven Feinberg
Feinberg threw away a lengthy track record by piling into housing and automotive investments during the Crisis's early stages.

• Bill Miller
Like Feinberg, Miller threw away a lengthy track record by buying the dip.

• Timothy Collins
Collins once had a lot of success doing leveraged buyouts in Japan, but his investment company's stock is down 80% since 2005 amid repeated investment losses.

• Chad Wasilenkoff
I wrote about Wasilenkoff in my review of The Outsiders. He's followed the Outsiders playbook to a T, and it's been a disaster.

• Hank Greenberg
After years of success, AIG floundered at the end of Greenberg's tenure. Later, Greenberg's investment company was the largest shareholder of a blatant reverse-merger fraud.

• Gray Pruitt
Pruitt was the CEO of McClatchy, the newspaper publisher. For most of his tenure, McClatchy significantly outperformed other newspaper companies. Then it acquired Knight Ridder right before the industry collapsed. McClatchy's stock went from $70 to $.50 in a couple of years.

A follow-up on Credit Acceptance

About a month ago, I wrote a pessimistic post about Credit Acceptance (CACC). Glenn Chan, who had written about CACC previously, replied in the comments. William Knecht, who had written CACC up at Corner of Berkshire and Fairfax, also commented.

In contrast to my pessimism, Chan and Knecht are bullish and own the stock. They both make good points that are worth responding to. I'd actually meant to respond much sooner, but life got in the way... better late than never.

I think the difference of opinion is partly philosophical. Chan and Knecht look at the company from bottom-up and see that it's historically been a superior lender. I care less about a business's quality and focus on the macroeconomic picture. I think macro is particularly important for CACC because lending is a commodity business and depends on access to the financial markets.

I also focus on the big picture because CACC doesn't disclose much information about its business. This reply to a shareholder inquiry, although a decade old, is typical:
We have not found portfolio delinquency rates to be useful in running our business, primarily because portfolio delinquency rates are influenced to a significant degree by the rate of growth in loan originations. Since we do not find the metrics you requested useful, we do not believe adding these metrics to our disclosures is appropriate at this time.

Chan and Knecht make a persuasive case that CACC is better than many of its competitors and that there are structural reasons why it's better. They're probably right about this. When I'm bearish about a sector for macro reasons, I like to avoid the good companies and short the bad ones. Since CACC seems to be a good company, I'm not short the stock, but I wouldn't buy it at anywhere near today's price.

An anonymous commenter asked what i thought about America's Car-Mart (CRMT). I'm less familiar with CRMT, so I don't have a strong opinion about it, but from what I've read it seems to be very similar to CACC: a strong player in a sector I dislike for macro reasons.

Returing to CACC, here are some of the points on which I disagree with Chan and Knecht.


Is subprime auto lending a bubble?

In my original post, I drew a parallel between the housing bubble and the current boom in subprime auto lending. Knecht writes, "I don't think comparisons to sub prime housing super appropriate" and gives several reasons why.

I didn't mean to make a strict comparison between subprime auto loans and subprime mortgages. Certainly, many of the details are different. The big similarity, in my opinion, is that historical performance has given lenders and ABS buyers a false sense of security and encouraging them to take excessive risk.

When the tech bubble burst, house prices performed very well, and many investors assumed that was an inherent feature of the housing market ("housing has never gone down on a nationwide basis"). When the housing bubble burst, auto loans performed very well, and now many investors assume that's an inherent feature of auto lending ("people need to drive to work, so they pay off their auto loans first").

One sign of a bubble is that subprime auto borrowers' average FICO score is at a record low, although the average loan-to-value ratio is still a few percent below its record high.

Another sign is that subprime auto lenders have been able to raise money on very favorable terms. 70% of one recent Americredit ABS deal is rated AAA and has interest rates below .7%. Similar deals from other lenders have 60-80% rated AAA with rates below 1%. Borrowing at a ~2% blended rate and lending at 20%+ has inflated the ROEs of CACC and its competitors, but it comes close to "return-free risk" for ABS buyers.


Is CACC participating in the bubble?

CACC's annual loan volume and outstanding loan balance are multiples of their 2006-07 levels. Part of this may be a superior operator taking share, but it's also a result of the company leveraging itself: CACC's loans net of reserves were 150% of tangible equity at YE2006 and 300% at YE2013.

All of this growth has come from new dealers, however: per-dealer volumes are lower than during '06-07. This seems to indicate underwriting discipline on CACC's part. As Knecht writes, "CACC has exhibited strong discipline, walking away from business without a margin of safety. Witness the dealer attrition they experience and infrequent pricing changes." On the other hand, the new dealers present a risk of adverse selection.

Chan writes that "Loans with longer terms would be a sign of potentially dangerous lending." CACC has extended its average loan term from ~3 years in 2006 to ~4 years today. In the company's defense, most of its competitors offer longer terms. As the industry has loosened standards, so has CACC, but it's stayed more disciplined than most other lenders.


To what extent does CACC share credit risk with dealers?

Chan writes, "If the lender is like Credit Acceptance or Westlake, then the lender gives an advance for only part of the loan. That's not so problematic."

Knecht writes, "CACC sweeps all the money until it's advance is paid off. In other words, the dealer is in the first loss position."

I don't think that dealers take the first loss. Dealers must pay to join CACC's lending program and then pay monthly fees to stay in, and I doubt they would do this if the program also forced them to retain credit risk.

As I understand it, CACC measures its anticipated collections and dealer advances against the total expected payments from the loan. For a car with a purchase price of $10,000, the loan may call for the borrower to pay $20,000 in principal and interest. For 2013, the advance rate was 47.6%, which would amount to $9520 on this hypothetical $20,000 loan. If the loan was made at an LTV greater than 100%, as subprime auto loans typically are, then the dealer should be able to lock in a profit.

For comparison, here are CACC's loan statistics for 2006:
Average consumer loan (principal + interest) $15,016
Average purchase price $ 7,374
Purchase price  49.1%
Forecasted collection rate 70.9%

On the other hand, dealers receive significant profit-sharing payments if losses on the loans they've originated stay below a certain level. They can also get kicked out of CACC's lending program if they originate too many bad loans. So they do have incentives to keep credit quality high.


Can subprime auto borrowers refinance their loans?

In my initial post, I suggested that subprime auto borrowers can refinance their loans and that may be suppressing loan losses. Chan writes that he "[doesn't] believe it's easy for deep subprime borrowers to effectively refinance."

After doing further research, I think that Chan is correct: subprime auto refinancings seem to be relatively uncommon, although Westlake, one of CACC's direct competitors, offers them.