I highly recommend a visit to Mish's Economics blog.
It contains a very good and detailed account of just how long it might take before the US reaches the under 6% unemployment rate enjoyed in 2007 - and the results are NOT PRETTY to say the least.
Given the sheer drop in employed, and the trend in recent recessions for job losses to continue well past the end of the recession, Mish takes the long view and projects unemployment to 2020. With a set of what I believe are realistic projections, he concludes the US will not see 6% unemployment in the next decade. Period.
His report also includes a downloadable spreadsheet to play with the figures - essentially, we would have to create 150k jobs per month for the next ten years - without recession - to get the unemployment rate to 6% in 2020!
I won't repeat his analysis, suffice it to say, it is scary - and what if (as I believe likely) this turns into a double dip recession as the governments around the world find themselves with impossible fiscal situations and begin a process of cutting outlays and raising taxes - with more job losses rather than job gains?
Thanks to John Mauldin for pointing me to this.
Friday, December 18, 2009
Wednesday, March 11, 2009
Democrats and Taxes
This might be a bit behind the times, but still, I have to wonder: how can anyone take the Democrats seriously when they suggest that paying taxes is a civic duty, since it is clear that they do not believe that this duty applies to themselves?
Perhaps they assume that most people are cheating and underpaying because they do: they just assume most people cheat at least as much. After all, leftist fascism is at least well intentioned.
For a humorous commentary on exactly the kind of people I mean, listen to Tom Lehrer from 1964.
Like many in the investment blogging community, I am generally a liberatarian. I have voted for the Libertarian Party, although I often think it to be a bunch of wackos - but at least they stand on principle, if often incoherently. I am generally against government schemes to "help" people, because inevitably the politcally weak are fed to the politically powerful. This is done in the name of helping the economically "weak", though in actual fact this isn't necessarily the case either.
Perhaps they assume that most people are cheating and underpaying because they do: they just assume most people cheat at least as much. After all, leftist fascism is at least well intentioned.
For a humorous commentary on exactly the kind of people I mean, listen to Tom Lehrer from 1964.
Like many in the investment blogging community, I am generally a liberatarian. I have voted for the Libertarian Party, although I often think it to be a bunch of wackos - but at least they stand on principle, if often incoherently. I am generally against government schemes to "help" people, because inevitably the politcally weak are fed to the politically powerful. This is done in the name of helping the economically "weak", though in actual fact this isn't necessarily the case either.
Billionaires with Bad Advice (pt 1)
When someone makes it on the Forbes Billionaires list, people tend to take his or her thoughts on business seriously. This is even more the case when that same person became rich by owning a money management firm. Indeed, Forbes takes Kenneth Fisher’s view of the markets so seriously that it has made him its longest running columnist and commentator in its history. Forbes and certainly its readers should rethink the confidence they have placed in him.
Fisher’s latest commentary contains statements that are patently untrue and are likely to mislead investors in ways that will be quite damaging to their portfolios, so I have to respond.
Fisher regularly offers a free commentary to the investing public (“A suprising prediction by Kenneth Fisher”) which is used as a marketing tool for his asset management firm. (It is offered at no cost for answering a short questionnaire about how much money you have and how much 3rd party management interests you). His latest commentary attempts to explain why an investor who has his money with Fisher’s firm should continue to keep it there and fully invested, in spite of the dramatic losses such an investor has sustained following Fisher’s advice. He resorts to two basic claims arguing for remaining fully invested. One is simply false the other is questionable.
The first is a claim about how markets recover. The information implies that markets always recover over a reasonable amount of time and that the long term trend of the market is up. This is simply not true, as anyone who invested in Japan in 1989 can tell you. After the 1929 US market crash, the market took 25 years to regain its high, but at least it spent most of that stretch of 25 years well above the lows it made in 1932. What Japan suggests is that following a massive credit bubble, asset prices can keep falling indefinitely. 20 years after the Nikkei index peak, the market is still making new lows (prices are back to the same levels they were over 25 years ago). In fairness, the US has a few fundamental advantages that suggest that a true Japan scenario is unlikely. On the other hand, the US is also confronted with challenges Japanese firms did not have to deal with: Japan’s struggles to maintain output happened against a backdrop of robust global growth which supported profitable exports.
The key takeaway for the prudent investor is that counting on rising markets is dangerous. Big falls in asset prices do not guarantee that investments will produce satisfactory returns going forward. Lower prices do suggest higher earnings yields, provided that earnings mean-revert. Keynes had it right. “’We simply do not know” if earnings will return to previous trend growth. In Japan, they did not, which is why the market continues to languish more than 80% below its highs. Investors must be wary and continue to be selective in their investment choices as permanent loss of capital is still possible. The focus must be on “return of capital” more than on “return on capital”. They should keep a bias for “cash on the table” in the form of steady, well-protected dividends from firms that have non-cyclical earnings streams, coupled with solid balance sheets that could be financed from operating cash flow.
Fisher’s latest commentary contains statements that are patently untrue and are likely to mislead investors in ways that will be quite damaging to their portfolios, so I have to respond.
Fisher regularly offers a free commentary to the investing public (“A suprising prediction by Kenneth Fisher”) which is used as a marketing tool for his asset management firm. (It is offered at no cost for answering a short questionnaire about how much money you have and how much 3rd party management interests you). His latest commentary attempts to explain why an investor who has his money with Fisher’s firm should continue to keep it there and fully invested, in spite of the dramatic losses such an investor has sustained following Fisher’s advice. He resorts to two basic claims arguing for remaining fully invested. One is simply false the other is questionable.
The first is a claim about how markets recover. The information implies that markets always recover over a reasonable amount of time and that the long term trend of the market is up. This is simply not true, as anyone who invested in Japan in 1989 can tell you. After the 1929 US market crash, the market took 25 years to regain its high, but at least it spent most of that stretch of 25 years well above the lows it made in 1932. What Japan suggests is that following a massive credit bubble, asset prices can keep falling indefinitely. 20 years after the Nikkei index peak, the market is still making new lows (prices are back to the same levels they were over 25 years ago). In fairness, the US has a few fundamental advantages that suggest that a true Japan scenario is unlikely. On the other hand, the US is also confronted with challenges Japanese firms did not have to deal with: Japan’s struggles to maintain output happened against a backdrop of robust global growth which supported profitable exports.
The key takeaway for the prudent investor is that counting on rising markets is dangerous. Big falls in asset prices do not guarantee that investments will produce satisfactory returns going forward. Lower prices do suggest higher earnings yields, provided that earnings mean-revert. Keynes had it right. “’We simply do not know” if earnings will return to previous trend growth. In Japan, they did not, which is why the market continues to languish more than 80% below its highs. Investors must be wary and continue to be selective in their investment choices as permanent loss of capital is still possible. The focus must be on “return of capital” more than on “return on capital”. They should keep a bias for “cash on the table” in the form of steady, well-protected dividends from firms that have non-cyclical earnings streams, coupled with solid balance sheets that could be financed from operating cash flow.
Sunday, March 08, 2009
Warren Buffett's Letter
Warren Buffett had his worst year ever in 2008. This is not surprising, since it was the worst year for the stock market in Buffett's investing life. Personally, I found the letter thinner on content than usual. There were not pithy observations on accounting rules, nor a simple explanation of the credit markets nor the currency markets. Even his discussion of Berkshire's businesses seemed a bid weak. Only in his explanation of his derivates book did his explanation of his thinking on how to price assets really shine. Nevertheless, I take four points from his letter.
1. Even investing geniuses are still human. Buffett acknowledges many mistakes this year, some are sins of commission and some of omission. As James B. Stewart of Smart Money observes, even Buffett can get caught up in the euphoria. I also made two sins of omission in 2008: not selling Bank of America stock when they acquired Merrill Lynch and not selling Bassett furniture immediately when it became clear that my outlook for the economy (that it would be dismal and that consumer durables would be particularly hard hit) was correct.
In the first case, I liked the strength of the commercial and retail banking franchise of BoA, and assumed that they had an idea of how to integrate Merrill Lynch retail broking and wealth management into their branches, which would be both cost saving and revenue raising at the same time. They may yet execute such a plan, but I suspect that the real hope was to vertically integrate along the asset backed security value chain: originating mortgages, bundling and selling Mortgage Backed Securities (MBS) all in house. That this will be difficult, if not impossible in the short term, is obvious, to say nothing of the credit quality of the combined balance sheet.
In the second case, I was simply blinded by my own assessment that BSET trades for far less than the value of its assets. Indeed, at this point, BSET may be more valuable dead than alive. The real problem was a conditional liability that I missed in the financial statements. Bassett has largely guaranteed their franchisees' leases, and this is a very large number. If, as the market clearly believes likely, many franchisees default, Bassett will be left to find a new tenant, or take over (loss-making) operations directly. Since retail storefronts are now a dime-a-dozen, the probability is quite high, that the company will be left holding the bag for a large amount of non-performing real estate. Ouch. Still, the new store format to which they are migrating does indeed seem to be helping sales, and with a strengthening dollar, the imported furniture that they sell may enable them to maintain margins and supported by cash flows from their investment portfolio, they may get through the next 24 months and recover. One can only hope.
So, sins of omission, but perhaps I shouldn't take it too hard.
2. Buy and hold of passive investments doesn't really work, even for great investors. Buffett has suffered huge declines on his public investments, including American Express, Coca-Cola, Burlington Northern and others. Many are treasured firms whose stock he has owned for years. It begs the question: if the best investor of all time cannot make money "buying and holding" then what should the rest of us do?
In my own portfolio, I have one "permanent" holding, and it is Colgate-Palmolive. This is a stock whose forward dividend yield is now at almost 3%, which continues to raise its dividend by 10% or more per year, which continues to repurchase stock in huge quantities and whose investor-friendly activities are backstopped by rising earnings that I project to be over $4.20 per share in 2009 (providing a dividend coverage ratio of 2.38). Plus, the stock is in a recession-proof business and has avoided making big acquistions. In short, it is the perfect investment.
But I have also watched the value of that investment decline from $80 a share to $56 (I purchased in the low $40s, so I have still had decent returns). Admittedly, at $80 a share in early 2008, it was a bit pricey at 20x forward earnings. Plus, it trades at 10x book (but earns about 90% on book). Why didn't I sell?
The truth is, Buffett has a good reason to have "permanent" holdings. In most cases, his ownership stake is so large and his portfolio so carefully monitored that he would have difficulty disposing of his positions. If Buffett is selling, after all, how exceptional can the value be? Retail investors, myself included, lack this rationale. Even if we hold a few blocks, and few of us do, our transactions are unlike to affect the markets, unless the stocks involved are very thinly traded. So, I conclude that the focus on "permanent" holdings, indeed the very idea of "buy and hold" is mostly the result of a desire for reassurance. Psychologically, we want to believe that we are "right" and that means keeping that which we own.
At these prices though, I am looking to add to my CL holdings, not reduce them. I still believe this is a $100 stock in 24 months, unless equity valuations completely implode, which is possible, but then, it will simply mean that I will have a rising annuity with higher yields than most bonds and insurance products. Not too shabby. More on this in another post.
3. Management counts. The secret of Buffett's success has always been in his ability to recruit the right people. As a investor, he has sought in most cases to have them in situ. He does mention that he has developed a few of his best managers, though obviously they were already natural talents.
As a passive investor, I pay a huge amount of money to professional managers who run my businesses for me. How they do it is probably the single biggest determinant of success or failure. But here, I think point one still applies. Even great managers make mistakes. Ken Lewis is a natural deal-maker - it is how he built BoA into the powerhouse that it is. He made a mistake buying Merrill, and sadly, this was a mistake that was driven by ego.
Lewis always wanted to show the New York crowd that a hick from North Carolina was at least as good as they were. They always looked down on him for building a commercial and retail bank, since everyone in banking knows that the "big swinging dicks" of banking are all "investment" bankers. Acquiring Merrill was Lewis' way to do it. But Lewis' careful and steady build-up of a leading commercial/retail bank was stupendously profitable. Even the disaster with Countrywide was manageable given the strength of the cashflows from the retail network. It remains to be seen if a universal bank can truly be made to function - the economics and compensation may simply be too far apart. For the forseeable future, though, Lewis will be out of dealmaking and will instead have to focus on operations. Is he the right manager for that?
4. Panic and fear are my friends. In spite of my losses on a few securities, I managed to liquidate most of my holdings in April of 2007, when the Dow was at 12,500. I missed the October top, but I have not regretted sitting in cash, where my interest earned actually afforded my a mild gain in 2008. Now, I sit confidently and wait for values to keep coming my way, confident in the meantime that I can suffer no major permanent impairment to capital. Low interest rates now make solid dividend yielding stocks the ideal area to look, though this does expose one to at least temporary capital loss.
In January, I did reenter the market, buying HELE aggressively, only to suffer another loss. However, the stock trades at a clear discount to intrinsic value and I may very well purchase more soon. The problem is, there are even more attractive values now than there were in January.
So, while I believe that the economic bottom will be reached at the earliest sometime in 2010, I continue to watch for individual values, knowing that the market is likely to continue downward movement due to panic selling of index funds by retail investors. I look forward to having a chance to make some significant gains in the next few years.
1. Even investing geniuses are still human. Buffett acknowledges many mistakes this year, some are sins of commission and some of omission. As James B. Stewart of Smart Money observes, even Buffett can get caught up in the euphoria. I also made two sins of omission in 2008: not selling Bank of America stock when they acquired Merrill Lynch and not selling Bassett furniture immediately when it became clear that my outlook for the economy (that it would be dismal and that consumer durables would be particularly hard hit) was correct.
In the first case, I liked the strength of the commercial and retail banking franchise of BoA, and assumed that they had an idea of how to integrate Merrill Lynch retail broking and wealth management into their branches, which would be both cost saving and revenue raising at the same time. They may yet execute such a plan, but I suspect that the real hope was to vertically integrate along the asset backed security value chain: originating mortgages, bundling and selling Mortgage Backed Securities (MBS) all in house. That this will be difficult, if not impossible in the short term, is obvious, to say nothing of the credit quality of the combined balance sheet.
In the second case, I was simply blinded by my own assessment that BSET trades for far less than the value of its assets. Indeed, at this point, BSET may be more valuable dead than alive. The real problem was a conditional liability that I missed in the financial statements. Bassett has largely guaranteed their franchisees' leases, and this is a very large number. If, as the market clearly believes likely, many franchisees default, Bassett will be left to find a new tenant, or take over (loss-making) operations directly. Since retail storefronts are now a dime-a-dozen, the probability is quite high, that the company will be left holding the bag for a large amount of non-performing real estate. Ouch. Still, the new store format to which they are migrating does indeed seem to be helping sales, and with a strengthening dollar, the imported furniture that they sell may enable them to maintain margins and supported by cash flows from their investment portfolio, they may get through the next 24 months and recover. One can only hope.
So, sins of omission, but perhaps I shouldn't take it too hard.
2. Buy and hold of passive investments doesn't really work, even for great investors. Buffett has suffered huge declines on his public investments, including American Express, Coca-Cola, Burlington Northern and others. Many are treasured firms whose stock he has owned for years. It begs the question: if the best investor of all time cannot make money "buying and holding" then what should the rest of us do?
In my own portfolio, I have one "permanent" holding, and it is Colgate-Palmolive. This is a stock whose forward dividend yield is now at almost 3%, which continues to raise its dividend by 10% or more per year, which continues to repurchase stock in huge quantities and whose investor-friendly activities are backstopped by rising earnings that I project to be over $4.20 per share in 2009 (providing a dividend coverage ratio of 2.38). Plus, the stock is in a recession-proof business and has avoided making big acquistions. In short, it is the perfect investment.
But I have also watched the value of that investment decline from $80 a share to $56 (I purchased in the low $40s, so I have still had decent returns). Admittedly, at $80 a share in early 2008, it was a bit pricey at 20x forward earnings. Plus, it trades at 10x book (but earns about 90% on book). Why didn't I sell?
The truth is, Buffett has a good reason to have "permanent" holdings. In most cases, his ownership stake is so large and his portfolio so carefully monitored that he would have difficulty disposing of his positions. If Buffett is selling, after all, how exceptional can the value be? Retail investors, myself included, lack this rationale. Even if we hold a few blocks, and few of us do, our transactions are unlike to affect the markets, unless the stocks involved are very thinly traded. So, I conclude that the focus on "permanent" holdings, indeed the very idea of "buy and hold" is mostly the result of a desire for reassurance. Psychologically, we want to believe that we are "right" and that means keeping that which we own.
At these prices though, I am looking to add to my CL holdings, not reduce them. I still believe this is a $100 stock in 24 months, unless equity valuations completely implode, which is possible, but then, it will simply mean that I will have a rising annuity with higher yields than most bonds and insurance products. Not too shabby. More on this in another post.
3. Management counts. The secret of Buffett's success has always been in his ability to recruit the right people. As a investor, he has sought in most cases to have them in situ. He does mention that he has developed a few of his best managers, though obviously they were already natural talents.
As a passive investor, I pay a huge amount of money to professional managers who run my businesses for me. How they do it is probably the single biggest determinant of success or failure. But here, I think point one still applies. Even great managers make mistakes. Ken Lewis is a natural deal-maker - it is how he built BoA into the powerhouse that it is. He made a mistake buying Merrill, and sadly, this was a mistake that was driven by ego.
Lewis always wanted to show the New York crowd that a hick from North Carolina was at least as good as they were. They always looked down on him for building a commercial and retail bank, since everyone in banking knows that the "big swinging dicks" of banking are all "investment" bankers. Acquiring Merrill was Lewis' way to do it. But Lewis' careful and steady build-up of a leading commercial/retail bank was stupendously profitable. Even the disaster with Countrywide was manageable given the strength of the cashflows from the retail network. It remains to be seen if a universal bank can truly be made to function - the economics and compensation may simply be too far apart. For the forseeable future, though, Lewis will be out of dealmaking and will instead have to focus on operations. Is he the right manager for that?
4. Panic and fear are my friends. In spite of my losses on a few securities, I managed to liquidate most of my holdings in April of 2007, when the Dow was at 12,500. I missed the October top, but I have not regretted sitting in cash, where my interest earned actually afforded my a mild gain in 2008. Now, I sit confidently and wait for values to keep coming my way, confident in the meantime that I can suffer no major permanent impairment to capital. Low interest rates now make solid dividend yielding stocks the ideal area to look, though this does expose one to at least temporary capital loss.
In January, I did reenter the market, buying HELE aggressively, only to suffer another loss. However, the stock trades at a clear discount to intrinsic value and I may very well purchase more soon. The problem is, there are even more attractive values now than there were in January.
So, while I believe that the economic bottom will be reached at the earliest sometime in 2010, I continue to watch for individual values, knowing that the market is likely to continue downward movement due to panic selling of index funds by retail investors. I look forward to having a chance to make some significant gains in the next few years.
Friday, January 09, 2009
A Bad Year. A New Year. Where do we go from here?
Well, I have continued to be relatively silent about the markets, because I believe that successful investing requires insight and I haven't had much until this past week.
First off, let me start by saying that I hope everyone had a relaxing holiday period. I have been on a nearly forced vacation for the past three weeks, but return to my "normal" life as a management consultant on Monday. My girlfriend already started working this week, which has given me a chance to really catch up on reading, particularly reading about the markets. It is a fun time to read, because everyone in the commentariat has an opinion (guilty as charged). So without further ado let us get started.
2008 Review
2008 will go down in history as one of the worst years in market history. Apart from the collapse of the NASDAQ in 2001, the (American) markets have not seen a year like this since the Hoover Administration. Emerging markets, extolled by the commentariat between 2004 and 2007 as "risk reduction" through greater diversification and protection against a weak dollar, turned out to have even worse years than the US, with the BRICs, (Brazil, Russia, India and China) all suffering massive declines - Russia dropped near 80% or so. Since the dollar has recovered, the losses, in dollar terms are worse still. Dollar terms matter, because most readers of this blog have their expenses and more importantly, their liabilities in US Dollars. In all, I have heard estimate of $30 trillion were lost. I cannot verify this number, but if 1000 points on the Dow is a good proxy for $1 trillion in market value, then the US is down $6 trillion since the October 2007 highs. [Note: found the source for the $30 trillion, Bennett Sedacca via John Mauldin]
The year has been particularly bad for banks and for those who work for them. Investment banking is all but dead; since there is no market for most corporate paper - whether debenture, asset-backed, convertible, preferred or common. There was exactly one flotation of high-yield paper in Q4 of 2008. Likewise, commercial lending is supine. Most small- and medium-sized firms are simply not creditworthy. Those that are are mostly looking to reduce the outstanding balances on their loans and credit lines. Sure, these have to be renegotiated on a regular basis (every 3-5 years normally) but the fees from this are tiny, and many firms are reducing the size of the lines to cut the fee expense.
Trading, which has been the lifeblood of many heretofore profitable financial institutions is a mixed bag. The incredible volatility in the markets means that there is real opportunity to make big money in trading (if you know what you are doing). On the other hand, most of the risk management strategies that had been used, swaps and other "exotic" derivatives, are now extremely expensive. But much of the leverage that made trading so profitable is being bled out of the system. Trades that make you a fraction of 1% per year aren't so attractive at 10x leverage as they are at 30x.
Asset management doesn't look good either. Many, many investors are discovering the pain of "relative performance" or "benchmark" performance. They are paying bonuses to managers who are "only" losing them 30% instead of 44%. And they are pulling their money out, becoming convinced that maybe buying and holding is not always the best strategy, except for asset managers for whom it generates nearly annuity-like management fees. Of course, even where investors are not pulling out their cash, the balances are declining, which means lower Assets-under-Management (AuM, in industry parlance). I have good friends in the Asset Management business, and I know they and their firms are struggling. Sure, the pure-play asset managers will still make money, but bonuses will be much smaller than expected and asset gathering will be difficult as long as investors fear losing money in the markets.
But the trouble didn't stop with banks, or stocks. Bonds (excepting sovereign debt) also performed miserably. Investors appetite for loaning money to anyone, reinforced by an investing environment where debt coverage ratios and debt equity ratios are moving in the wrong direction, saw flight from anything with default risk.
Even alternative asset classes are getting clobbered - this article notes that Venture Capital is basically dead, since the two most common exits - flotation and sale - are both crippled by a lack of buyers. Equity floatation is nearly impossible and without financial buyers in the mix and even most strategic buyers looking to improve the asset quality of their balance sheets, high prices that produce the 20%+ returns are hard to come by.
Hedge funds, particularly those based on "quantitative" strategies that make estimate of fair value of an asset based on the value of other assets - and of course, apply healthy leverage - have imploded left and right. And that was before Maddow's Ponti scheme emerged.
Elsewhere on main street, housing has continued to decline with the anticipated recovery date pushed back again and again. Now I increasingly see that my prediction of price declines into 2011 are becoming more accepted. The reason is based on two factors - 1) most real estate is purchased with debt and 2) people do not like to make leveraged purchases of assets declining in value. After all, as Lehman Brothers showed us, leverage cuts two ways and even small declines in the value of the asset can quickly wipe out the equity in a leveraged investment.
Thus, demand for such assets does not increase until buying becomes attractive compared to other alternatives - in housing this means - prices will only stop falling once it becomes far more attractive to own than to rent. So far, prices have fallen enough to restore the historical ratio of housing and rental prices, instead, owning has to offer a very attractive rental yield before there is a sufficient margin of safety for most investors/buyers to make such an investment.
Consumption is way down - whether on gasoline, consumer durables or even basics. The commentariat seems dismayed by the fact that even Wal*Mart, a discounter, had a bad Xmas season, suggesting that other retail chains will do far worse (how can SHLD still trade at 20x earnings then? True, it is trading at a discount to book and it does have lots of cash, but I think this is the Eddie Lampert premium. The margins and returns are awful and the core operating business is worthless). But I digress.
John Mauldin, whose columns have become a must read for over 1 million of his subscribers, notes that all of the economic indicators look bad. .
Personal performance 2008
There is a saying in German which goes says that anticipation in the best form of happiness and that schadenfreude is the most beautiful form of happiness. "Vorfreude ist die beste Freude, aber Schadenfreude ist die schönste Freude". It is funnier in German, because the words for anticipation and schadenfreude share the same root.
It was with more than a bit of schadenfreude (glee, one might say) that I was relating to a banker friend that my personal performance in 2008 was actually positive. There were only two places to be, actually, cash and sovereign debt. I can congratulate myself for having had the smarts to be in one of the two, but before I really count myself a genius, I must admit that I picked the inferior one. CASH has long been a favorite because I believed that asset prices were simply too high and that there was no reason to take any risk of capital loss while waiting for a good time to move my money back into cheaper assets.
However, a better strategy would have been to buy Treasuries, which have rallied, and on which I could have earned a nice capital gain. (An even better strategy would have been to short the market and use the proceeds to buy Treasuries, but ... hindsight is 20/20). However, at the time, I could not tell if deflation or inflation were likely to be the bigger problem. I certainly did not expect that the Federal Reserve would act to reduce long term rates so aggressively, and I did not want to take the interest rate risk associated with 10- or 30- year government paper.
So, it was nice to be up, if only fractionally. I earned over 2.5% on my holdings of (now FDIC insured!) money markets and managed not to lose too much on my few equity positions. I outperformed the market by over 40% with less risk! Talk about generating alpha!
I must admit that my equity positions were hardly winners. Both of my big losers were stocks I purchased and held in part as hedges against my cash position. My own view was that the markets would tank. But in the event that I was seriously overreading events, I decided that I would hold some investments that would perform well in a mild recession/strong recovery environment backstopped by, in the first case, a strong operating business nad in the second, by a strong investment portfolio worth more than the company itself.
First, I badly stumbled with Bank of America. I have been savoring the massive yield for the past several years. I rationalized holding it by looking at relative performance, rather than at the facts on the ground. To date, the company has not had a loss making quarter, even when it has taken huge write downs. But the truth is, deciphering the balance sheet of any financial institution today is a lot of guesswork. As such, earnings estimates are really more estimated than usual. So, rather than sell at $52 in August of 2007 when I seriously thought about it, I still hold it at $14.
My other mistake was of a similar mold, BSET. This is a struggling furniture maker (that's a redundancy, right?) whose strength is mostly that they have a massive investment portfolio that they can use to ride out the downturn. The stock, now trading at $3, trades for much less than the value of this investment portfolio. At the time, the company appeared to be looking to undertake several investor-friendly steps to return cash in the form of a special dividend and buybacks. They are also in the process of overhauling their retail network with a new concept that has shown significant progress, or was showing it before the fourth quarter.
The company may very well survive the downturn. It has an established brand name, knows its customer base, has developed an attractive "mass-customization" design studio (pick your style, pick your size, pick your fabrics) as a retail concept and has cut expenses, if not ruthlessly. It also has ample financing from its still large investment portfolio and its share of profits from a major real estate investment. The company trades at a significant discount to assets. Further, assets are understated, because the company carries the value of its real estate holdings as a net liability, because of dividends in excess of profits from the real estate partnership.
But the company competes in an extremely difficult segment - consumer durables - where spending is largely discretionary and strapped consumers are simply not doing major remodelling, so the core business is likely to struggle for some time yet. And there are the contingent liabilities for the retail rentals for its franchisees.
I should consider selling both of these investments - but I believe the prospects for both are not that bad. BAC is consolidating the industry. Much will depend on how effectively it integrates the Merrill Lynch asset management business with the retail banking where it is already dominant. BSET would be worth much more than $3 per share if it were simply to exit the furniture business, except that it cannot do so, because of the status of its franchisees.
I brighter (or perhaps less dim) spot was CL. Colgate is still my favorite stock purchase ever. This company, though it trades at 10x book, is still a value. Dividends can be increases by 8-12% practically forever. Indeed, with a dividend of 40 cents per quarter and earnings of $1 per quarter, the company would still earn its dividend a decade from now while hiking payouts 10% each year, even if earnings growth were zero. Since it also buys back stock regularly and has seen growth in most markets, including growth in share, while being able to raise prices, earnings will likely continue to grow by about 8% per share nearly indefinately, supporting dividend increases of 10% or more, also indefinately. If the yield on the stock remains constant at 2.5% and the dividend increases 10% per year, this is a near "risk-free" 12.5% return. It amazes me that the stock is not at $100, but I believe it will be there before the end of 2010.
Conclusions and outlook
First, 2008 has taught us that fundamentals matter. Diversifying is simply not an adequate risk management strategy, because in major crisis periods, all markets tend to move together - down. And the possibility of suffering major and permanent loss of capital is large.
Second, relative performance can kill you. If the first rule of investing is "don't lose money" and the second rule, is "don't forget rule number 1" then investors must think in terms of absolute returns. This means, unfortunately, that some years, we may "underperform" incredibly frothy speculative markets. But the old saw about the correlation of risk and return, usually used to encourage risk-averse investors to move further out the risk curve, must be inverted. Taking more risk can kill you - and systemmic risk in particular - can wipe out a portfolio. Every risk, every position, needs to be constantly evaluated to determine if the upside is adequately backstopped by a margin of safety.
Third, markets have done a poor job of "pricing-in" events. As early as February 2007 it was clear that the financial markets were going to have problems. I exited the markets largely later that spring. Even after the extreme stress of August 2007, the markets made new highs in October! Earnings estimates continue to decline for the S&P500 for 2009, although, most people are still believing that things will improve in about six months. This has been the argument since 2007! The nice thing about this is that it means that we can profit from these "inefficiencies".
Fourth, markets do not always go "up". Japan made new post-bubble lows this year. Stock prices in Japan have returned to levels not seen since the early 1980s. Read this carefully. We are talking about having no capital gains in over 25 years. Investors who purchased the index in the 2nd half of that decade are still underwater, by as much as 80%. Of course, investment yields in Japan are so strong, who needs capital gains .... oh, wait.
The long and short is that we are in an incredible investing environment in which fortunes can be made and lost. Decisions will have long lasting and incredible impact. In part two, I will discuss the outlook for 2009.
First off, let me start by saying that I hope everyone had a relaxing holiday period. I have been on a nearly forced vacation for the past three weeks, but return to my "normal" life as a management consultant on Monday. My girlfriend already started working this week, which has given me a chance to really catch up on reading, particularly reading about the markets. It is a fun time to read, because everyone in the commentariat has an opinion (guilty as charged). So without further ado let us get started.
2008 Review
2008 will go down in history as one of the worst years in market history. Apart from the collapse of the NASDAQ in 2001, the (American) markets have not seen a year like this since the Hoover Administration. Emerging markets, extolled by the commentariat between 2004 and 2007 as "risk reduction" through greater diversification and protection against a weak dollar, turned out to have even worse years than the US, with the BRICs, (Brazil, Russia, India and China) all suffering massive declines - Russia dropped near 80% or so. Since the dollar has recovered, the losses, in dollar terms are worse still. Dollar terms matter, because most readers of this blog have their expenses and more importantly, their liabilities in US Dollars. In all, I have heard estimate of $30 trillion were lost. I cannot verify this number, but if 1000 points on the Dow is a good proxy for $1 trillion in market value, then the US is down $6 trillion since the October 2007 highs. [Note: found the source for the $30 trillion, Bennett Sedacca via John Mauldin]
The year has been particularly bad for banks and for those who work for them. Investment banking is all but dead; since there is no market for most corporate paper - whether debenture, asset-backed, convertible, preferred or common. There was exactly one flotation of high-yield paper in Q4 of 2008. Likewise, commercial lending is supine. Most small- and medium-sized firms are simply not creditworthy. Those that are are mostly looking to reduce the outstanding balances on their loans and credit lines. Sure, these have to be renegotiated on a regular basis (every 3-5 years normally) but the fees from this are tiny, and many firms are reducing the size of the lines to cut the fee expense.
Trading, which has been the lifeblood of many heretofore profitable financial institutions is a mixed bag. The incredible volatility in the markets means that there is real opportunity to make big money in trading (if you know what you are doing). On the other hand, most of the risk management strategies that had been used, swaps and other "exotic" derivatives, are now extremely expensive. But much of the leverage that made trading so profitable is being bled out of the system. Trades that make you a fraction of 1% per year aren't so attractive at 10x leverage as they are at 30x.
Asset management doesn't look good either. Many, many investors are discovering the pain of "relative performance" or "benchmark" performance. They are paying bonuses to managers who are "only" losing them 30% instead of 44%. And they are pulling their money out, becoming convinced that maybe buying and holding is not always the best strategy, except for asset managers for whom it generates nearly annuity-like management fees. Of course, even where investors are not pulling out their cash, the balances are declining, which means lower Assets-under-Management (AuM, in industry parlance). I have good friends in the Asset Management business, and I know they and their firms are struggling. Sure, the pure-play asset managers will still make money, but bonuses will be much smaller than expected and asset gathering will be difficult as long as investors fear losing money in the markets.
But the trouble didn't stop with banks, or stocks. Bonds (excepting sovereign debt) also performed miserably. Investors appetite for loaning money to anyone, reinforced by an investing environment where debt coverage ratios and debt equity ratios are moving in the wrong direction, saw flight from anything with default risk.
Even alternative asset classes are getting clobbered - this article notes that Venture Capital is basically dead, since the two most common exits - flotation and sale - are both crippled by a lack of buyers. Equity floatation is nearly impossible and without financial buyers in the mix and even most strategic buyers looking to improve the asset quality of their balance sheets, high prices that produce the 20%+ returns are hard to come by.
Hedge funds, particularly those based on "quantitative" strategies that make estimate of fair value of an asset based on the value of other assets - and of course, apply healthy leverage - have imploded left and right. And that was before Maddow's Ponti scheme emerged.
Elsewhere on main street, housing has continued to decline with the anticipated recovery date pushed back again and again. Now I increasingly see that my prediction of price declines into 2011 are becoming more accepted. The reason is based on two factors - 1) most real estate is purchased with debt and 2) people do not like to make leveraged purchases of assets declining in value. After all, as Lehman Brothers showed us, leverage cuts two ways and even small declines in the value of the asset can quickly wipe out the equity in a leveraged investment.
Thus, demand for such assets does not increase until buying becomes attractive compared to other alternatives - in housing this means - prices will only stop falling once it becomes far more attractive to own than to rent. So far, prices have fallen enough to restore the historical ratio of housing and rental prices, instead, owning has to offer a very attractive rental yield before there is a sufficient margin of safety for most investors/buyers to make such an investment.
Consumption is way down - whether on gasoline, consumer durables or even basics. The commentariat seems dismayed by the fact that even Wal*Mart, a discounter, had a bad Xmas season, suggesting that other retail chains will do far worse (how can SHLD still trade at 20x earnings then? True, it is trading at a discount to book and it does have lots of cash, but I think this is the Eddie Lampert premium. The margins and returns are awful and the core operating business is worthless). But I digress.
John Mauldin, whose columns have become a must read for over 1 million of his subscribers, notes that all of the economic indicators look bad. .
Personal performance 2008
There is a saying in German which goes says that anticipation in the best form of happiness and that schadenfreude is the most beautiful form of happiness. "Vorfreude ist die beste Freude, aber Schadenfreude ist die schönste Freude". It is funnier in German, because the words for anticipation and schadenfreude share the same root.
It was with more than a bit of schadenfreude (glee, one might say) that I was relating to a banker friend that my personal performance in 2008 was actually positive. There were only two places to be, actually, cash and sovereign debt. I can congratulate myself for having had the smarts to be in one of the two, but before I really count myself a genius, I must admit that I picked the inferior one. CASH has long been a favorite because I believed that asset prices were simply too high and that there was no reason to take any risk of capital loss while waiting for a good time to move my money back into cheaper assets.
However, a better strategy would have been to buy Treasuries, which have rallied, and on which I could have earned a nice capital gain. (An even better strategy would have been to short the market and use the proceeds to buy Treasuries, but ... hindsight is 20/20). However, at the time, I could not tell if deflation or inflation were likely to be the bigger problem. I certainly did not expect that the Federal Reserve would act to reduce long term rates so aggressively, and I did not want to take the interest rate risk associated with 10- or 30- year government paper.
So, it was nice to be up, if only fractionally. I earned over 2.5% on my holdings of (now FDIC insured!) money markets and managed not to lose too much on my few equity positions. I outperformed the market by over 40% with less risk! Talk about generating alpha!
I must admit that my equity positions were hardly winners. Both of my big losers were stocks I purchased and held in part as hedges against my cash position. My own view was that the markets would tank. But in the event that I was seriously overreading events, I decided that I would hold some investments that would perform well in a mild recession/strong recovery environment backstopped by, in the first case, a strong operating business nad in the second, by a strong investment portfolio worth more than the company itself.
First, I badly stumbled with Bank of America. I have been savoring the massive yield for the past several years. I rationalized holding it by looking at relative performance, rather than at the facts on the ground. To date, the company has not had a loss making quarter, even when it has taken huge write downs. But the truth is, deciphering the balance sheet of any financial institution today is a lot of guesswork. As such, earnings estimates are really more estimated than usual. So, rather than sell at $52 in August of 2007 when I seriously thought about it, I still hold it at $14.
My other mistake was of a similar mold, BSET. This is a struggling furniture maker (that's a redundancy, right?) whose strength is mostly that they have a massive investment portfolio that they can use to ride out the downturn. The stock, now trading at $3, trades for much less than the value of this investment portfolio. At the time, the company appeared to be looking to undertake several investor-friendly steps to return cash in the form of a special dividend and buybacks. They are also in the process of overhauling their retail network with a new concept that has shown significant progress, or was showing it before the fourth quarter.
The company may very well survive the downturn. It has an established brand name, knows its customer base, has developed an attractive "mass-customization" design studio (pick your style, pick your size, pick your fabrics) as a retail concept and has cut expenses, if not ruthlessly. It also has ample financing from its still large investment portfolio and its share of profits from a major real estate investment. The company trades at a significant discount to assets. Further, assets are understated, because the company carries the value of its real estate holdings as a net liability, because of dividends in excess of profits from the real estate partnership.
But the company competes in an extremely difficult segment - consumer durables - where spending is largely discretionary and strapped consumers are simply not doing major remodelling, so the core business is likely to struggle for some time yet. And there are the contingent liabilities for the retail rentals for its franchisees.
I should consider selling both of these investments - but I believe the prospects for both are not that bad. BAC is consolidating the industry. Much will depend on how effectively it integrates the Merrill Lynch asset management business with the retail banking where it is already dominant. BSET would be worth much more than $3 per share if it were simply to exit the furniture business, except that it cannot do so, because of the status of its franchisees.
I brighter (or perhaps less dim) spot was CL. Colgate is still my favorite stock purchase ever. This company, though it trades at 10x book, is still a value. Dividends can be increases by 8-12% practically forever. Indeed, with a dividend of 40 cents per quarter and earnings of $1 per quarter, the company would still earn its dividend a decade from now while hiking payouts 10% each year, even if earnings growth were zero. Since it also buys back stock regularly and has seen growth in most markets, including growth in share, while being able to raise prices, earnings will likely continue to grow by about 8% per share nearly indefinately, supporting dividend increases of 10% or more, also indefinately. If the yield on the stock remains constant at 2.5% and the dividend increases 10% per year, this is a near "risk-free" 12.5% return. It amazes me that the stock is not at $100, but I believe it will be there before the end of 2010.
Conclusions and outlook
First, 2008 has taught us that fundamentals matter. Diversifying is simply not an adequate risk management strategy, because in major crisis periods, all markets tend to move together - down. And the possibility of suffering major and permanent loss of capital is large.
Second, relative performance can kill you. If the first rule of investing is "don't lose money" and the second rule, is "don't forget rule number 1" then investors must think in terms of absolute returns. This means, unfortunately, that some years, we may "underperform" incredibly frothy speculative markets. But the old saw about the correlation of risk and return, usually used to encourage risk-averse investors to move further out the risk curve, must be inverted. Taking more risk can kill you - and systemmic risk in particular - can wipe out a portfolio. Every risk, every position, needs to be constantly evaluated to determine if the upside is adequately backstopped by a margin of safety.
Third, markets have done a poor job of "pricing-in" events. As early as February 2007 it was clear that the financial markets were going to have problems. I exited the markets largely later that spring. Even after the extreme stress of August 2007, the markets made new highs in October! Earnings estimates continue to decline for the S&P500 for 2009, although, most people are still believing that things will improve in about six months. This has been the argument since 2007! The nice thing about this is that it means that we can profit from these "inefficiencies".
Fourth, markets do not always go "up". Japan made new post-bubble lows this year. Stock prices in Japan have returned to levels not seen since the early 1980s. Read this carefully. We are talking about having no capital gains in over 25 years. Investors who purchased the index in the 2nd half of that decade are still underwater, by as much as 80%. Of course, investment yields in Japan are so strong, who needs capital gains .... oh, wait.
The long and short is that we are in an incredible investing environment in which fortunes can be made and lost. Decisions will have long lasting and incredible impact. In part two, I will discuss the outlook for 2009.
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