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.