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As sterling sinks to a 7-1/2 year low against the dollar, traders and investors are wondering who was the established political figure that made the following comments when Britain was kicked out of the Exchange Rate Mechanism in 1992. “A weak currency arises from a weak economy which in turn is the result of a weak [...]
Reuters - Global Investing Wed, 21 Jan 2009 12:12:52 +0000
People around the world watched Barack Obama's inauguration on Tuesday with anticipation and hope, but it was no surprise that the stock market took a bleaker view, with the major U.S. indices down more than 2 percent at midday. The stock market has historically fallen during inaugurations.
Reuters - Global Investing Tue, 20 Jan 2009 17:32:37 +0000
Business bosses, it seems, are as much in the dark as the investors who buy stocks in their companies. That is the worrying conclusion of a new survey from Booz & Co. After quizzing more than 800 senior managers, it found 40 percent doubted that their company’s leadership had a credible plan to address the economic crisis [...]
Reuters - Global Investing Tue, 20 Jan 2009 12:19:43 +0000
New year can get in the way of understanding what is happening on financial markets. Just because humans measure the year in 12 month tranches, it does not necessarily follow that markets do. Consider world stocks, for example. MSCI’s all-country world stock index is often cited as having fallen 43.5 percent in 2008. In fact, [...]
Reuters - Global Investing Mon, 19 Jan 2009 12:36:35 +0000
Equities may be having a stop-start kind of month, but investors do seem to be more willing to take on risk than before. The latest numbers from EPFR Global, a tracker of investment flows, show high-yield bond funds raking in the money in the second week of January. A net $766 million flowed into the [...]
Reuters - Global Investing Mon, 19 Jan 2009 09:41:06 +0000
Today marks the end of the Bush stock market. He has presided over the evisceration of more than $4.6 trillion of U.S. stock market wealth as measured by the S&P 500.
Reuters - Global Investing Fri, 16 Jan 2009 20:05:55 +0000
Who is next? After the Madoff and Satyam scandals, rattled investors are looking anxiously over their shoulders for the next big financial fraud. It is generally assumed that the downturn will expose more wrongdoings - but that doesn’t mean people become more dishonest when the economy is sick. In fact, quite the opposite, according to John Kenneth [...]
Reuters - Global Investing Wed, 14 Jan 2009 11:31:30 +0000
I haven't posted in a while and thought I might begin with some random thoughts. Rick Konrad of Value Discipline has posted after a (similarly) long absence. Value Discipline is one of the best investing blogs. If you've never read it - start now. 24/7 Wall St. recently posted on More Recession Carnage for Video Games. I would love to have posted on the video games industry (especially publishing) more often on this blog. I rarely have. The reason's simple: video game stocks have been pricey for much of the life of this blog (2006-present). That's not true anymore. Unfortunately, so many stocks are now so cheap on a normalized free cash flow ("earnings power") basis that it's hard to argue video game stocks deserve special mention. Take toys. A basket of three of the largest U.S. toymakers: Mattel (MAT), Hasbro (HAS), and Jakks Pacific (JAKK) looks real reasonable. Do the math on what kind of free cash flow these businesses have produced over the years and what kind of prices you can buy them at today. Answer: You're getting the American toy industry dirt cheap. Are their risks? In the long-run, their may be greater risks in toys than video games, because toy companies run a greater risk of becoming inflexible enterprises. Regardless, mankind's appetite for toys, video games, and just plain fun isn't going to be permanently impaired by a recession or depression (no matter how "great"). Are these businesses recession proof? Nothing's recession proof. But businesses that make products people are passionate about aren't a bad place to be in any economic environment. The fact that both industries can and have supported multiple, profitable players isn't a bad sign either. Toys and video game stocks are both worth buying (even if you can't separate the wheat from the chaff) when you can get an acceptable no-growth normalized FCF yield on your purchase price. Focus on free cash flow. Not earnings. I don't envy anyone who has to tell us what a video game company (or toy company) made this year much less what they'll make next year. Current sales and expected (normalized) FCF margins are a better way to value these businesses than EPS. Be conservative but realistic. And either buy the best or buy them all whenever you get the right price. In other words, don't rush out and buy a troubled, hurting quagmire (THQ) at the first twinkling of a turnaround. That's not necessary when real quality is on sale the way it is today. Note: Yes. THQ (THQI) is cheap. But ask yourself: do I really need that kind of cheap in my life, when real quality's on sale. Video game and toy stocks aren't the only ones being offered at low prices to demonstrated free cash flow. See Microsoft (MSFT) or Energizer Holdings (ENR) for evidence of this market wide phenomenon. But those are posts for another day.
Gannon On Investing Wed, 10 Dec 2008 07:41:26 -0500
It might not feel like it, but yesterday marked the Dow's return to normal. Normal valuations that is. A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, "In Defense of Extraordinary Claims", I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high: Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century. That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: '96, '97, '98, '99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than '65. As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 - 2007. We were in unchartered territory. Not any more. Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%. So at yesterday's close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year. That may not sound like much to those weaned on the 1982 - 1999 bull market. However, it's a lot better than the "new paradigm" market that began in 1996. Since we broke into unchartered territory twelve years ago, we've done something like 3.4% in point terms. And over the last ten years: zilch. Here's what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained: Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold. I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear. If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean - future returns can be adjusted down, allowing current prices to remain high. That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear). At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option - though it's theoretically possible if long-term interest rates are very, very close to zero. But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall - they could simply offer much lower returns than they had in the past. This could continue indefinitely - in theory. I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data. Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 - 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41. So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm? Maybe. If we really are in a new era, the old historical return data isn't relevant - it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant - and normalized P/E ratios must fall. And they have fallen. Like a rock. And saved us a lot of time. Eight and a half years by my calculation. Without a severe multiple contraction, the Dow would have had to move sideways for something like eight and a half years to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580. Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money. What about earnings power impairment? Won't the current financial panic and the (possible) resulting global recession cause a major contraction in earnings power? Not really. Actual earnings will be impaired. However, "normalized" earnings won't move much (certainly nothing like the 40% drop in price) - unless we see conditions considerably worse than anything post 1935. The Dow has been outperforming its expected earnings for a very long time (since the early 90s). That was never going to last. The Dow's actual earnings overshoot and undershoot its "expected" (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here: From 1935-2005, the percentage difference between the Dow's actual earnings and its 15-year normalized earnings ranged from (62.12%) to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%. The swings have been huge, but their net effect has been small. Basically, the Dow's EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that's ending now) it's basically a mirror image of underperformance and overperformance. The Dow gives you 6% earnings growth. What you get depends on what you pay. Starting today, you're paying par. You haven't had that chance in over ten years. What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935 - 2005, your long-term returns should match the Dow's long-term EPS growth. Both should be around 6% (ex-dividends). Long-term future returns should once again be similar to long-term historical returns. Could the future be different from the past? Maybe. But I wouldn't bet on it. The last ten years turned out to be nothing new. Just a detour on the road to normalcy. P.S. All this brings up an interesting question - and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years - but assuming the Dow's normalized P/E had to revert to the mean for it to offer its historical returns once again. Which would you rather lose: Forty percent or eight and a half years?
Gannon On Investing Fri, 10 Oct 2008 02:30:57 -0500
I wrote a response to Jason Zweig's column on Ben Graham and bank stocks. Now, Tom Brown of Bankstocks.com has done the same. I have to admit, Tom's article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn't be a buyer of bank stocks today. However, Tom's post does a better job of presenting the opportunities and challenges in analyzing bank stocks today: Zweig's premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution's assets--particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock's valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true. Graham saw every investment as a black box - and that didn't trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own - Graham never did. He didn't look inside the "system", i.e. the company itself; instead he looked only at the outputs - the financial statements. He spent almost no time worrying about a business's management, corporate culture, or future prospects. He didn't worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what "normal" earnings might look like. Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would've worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things - and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham's most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career. Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham's principles were. What Graham Practiced In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 - 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments. Control Investments Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment. Arbitrage Buffett has discussed this techniques in some detail. See especially Buffett's discussion of Berkshire's purchase of Arcata shares. Both Buffett and Graham had stellar results in the arbitrage field, as Buffett explains in his 1988 letter to shareholders: In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There's plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. That's a long history of success. From 1926-1988, unleveraged arbitrage returns from Graham's partnerships, Buffett's partnerships, and Berkshire averaged better than 20% a year. Since some leverage was employed, actual returns over this sixty-three year period were even better than 20% per annum. Arbitrage works. Liquidations Liquidati... are the simplest type of investment there is. You simply buy the stock below the expected final payout and wait for things to wind down. Buffett has invested in liquidations several times - most are not well-known. For a recent example, see Comdisco Holdings (CDCO). For a less recent example, see the Kaiser liquidation (from the 1970s). Net/Nets Net current asset issues are not well-known, even today. However, the technique itself is well-known. Jonathan Heller of Cheap Stocks created an index to track (some) NCAV stocks. Since inception the Net/Net index has outperformed the relevant benchmark. However, it is a very young index. Related Hedges Related hedges are not appropriate for individual investors. They belong to a category of techniques that Graham employed with some success, but which have subsequently become far less fertile ground for investors, because modern theory and practice is better able to efficiently price a variety of more complex securities. Basically, Graham would go long a certain company's convertible senior security and go short that same company's common stock. If the stock rose, he would take a small loss. If it dropped sharply, he would make a nice gain. Obviously, these related hedges would provide a performance boost when the rest of Graham's portfolio was struggling (since stock prices in general would be falling) and vice versa. The first real coup of Graham's career belongs to this category of mispriced special securities. Graham was a low-level employee of Newburger, Henderson, and Loeb when he brought up the idea of investing in the bankrupt Missouri, Kansas, and Texas Railway. The company's bankruptcy plan gave owners of the old common stock the right (but not the obligation) to buy shares in the new company. This went mostly unnoticed at the time - or, if it was noticed, speculators were not using the old common stock as a way to play the new MKT. As a result, the old stock traded at just fifty cents. Graham figured that during a strong period for railroads the old common stock could easily rise three or four dollars - while the maximum loss on each share would still be just fifty cents. The firm bought into Graham's idea and ended up making $15,000 on its $2,500 investment in less than a year (this was back in 1915 when $15,000 was real money - perhaps something like $300,000 today). Graham's partnership was a prototypical hedge fund. For starters, Graham actually hedged. He was short some securities and long others. For a while, he tried a basic long/short value approach, where he went long clearly cheap stocks and when short clearly expensive stocks. However, he found riding out the speculative surges in the stocks he was short to be an extremely unpleasant experience. He also found, over time, that he wasn't especially good at finding stocks to short - certainly not good enough to get a better overall result (an investor has to be a lot more skilled at going short than going long to make it worth his while to short- if volatility and consistency aren't as important to him as long-term results). Also, since Graham was always invested in an unusual mix of cheap stocks, liquidations, and related hedges, he was able to deliver rather consistent results without resorting to a more conventional long/short strategy. Eventually, Graham took the technique of shorting overpriced stocks out of his repertoire. What Graham Preached This is where Zweig comes in. Very little of what he writes has anything to do with what Graham practiced; generally, he writes about what Graham preached. These two things are quite different. Why? Graham liked rules, methods, and standards. Whether he was writing for professional security analysts or amateur investors, his goal was the same: to provide a practical, workable approach to the field of investments. He may have underestimated the common man; but, I doubt it. Even in The Intelligent Investor, he included a small section describing the actual techniques employed by his partnership. He also gave a separate set of rules for the enterprising investor to follow. Graham didn't divide investors by their risk appetite; rather, he divided them by their work appetite. Those who would work harder and be more businesslike - more like true professionals - would naturally come closer to the methods Graham himself employed. So, if we were to use Graham's own actions as our sole source for determining what he would do today, we'd have to say he'd invest in almost nothing that makes it into Barron's, The Wall Street Journal, CNBC, or Bloomberg. Graham would mostly do what he always did. There are still some NCAV stocks today; arbitrage still exists; liquidations still occur (e.g., I participated in what was essentially the liquidation of an Icahn controlled company last year - Atlantic Coast Entertainment Holdings, see Joe Cit's post for details). But, wouldn't all of this be too small for Graham? Yes and no. No, Graham never needed big cap ideas, because Graham always kept his partnership small - much, much smaller than it could have been. He could have managed a lot more money; he was always much more famous than his assets under management would lead you to believe. He returned capital gains instead of allowing them to accrue in his favor. Overall, he tended to keep his operation very small by any standards - and infinitesimally so by the standards of today. However, yes, Graham would need some other ideas. The most likely answer is that he'd rather change venues than change standards. Therefore, I doubt he'd be investing in even moderately pricey names in the United States whenever there were opportunities to buy ridiculously cheap stuff abroad. He'd probably have been in Korea after the Asian contagion; he'd certainly have been in Japan at some point, where there were some overcapitalized and underpriced public companies. I know these aren't exactly the most exciting answers. It's a lot more interesting to argue over whether or not Graham would be buying bank stocks today than it is to consider what he'd actually be doing in modern times. My best guess is that if Graham were around today we'd consider him a very strange, very boring investor with a taste for odd and obscure securities in unappealing industries and out of favor countries. Grahamian Theory So where does that leave us regarding Graham and bank stocks? All we have to go on are Graham's principles. And this is where I think Zweig failed in his most recent column. His reasoning is all wrong. It paints an entirely inappropriate, almost stereotypically stodgy picture of Graham. Zweig confuses the conservatism of modern financial advisors with the conservatism of Graham. They are two very different things. Graham would not have avoided bank stocks, because of falling real estate prices. He would avoid bank stocks, because there is an insufficient margin of safety (many are still trading above book value). He might demand a greater discount to book, because many banks have businesses and recent records built upon boom times. Graham always wanted to see how a business had performed under a variety of different circumstances, and this need for a solid past record would be even more important for banks, because of the nature of credit "cycles". However, the mere fact that something unusual or even unprecedented is occurring in real estate and thus in financials would not have deterred Graham. His conservatism was not of that sort. He could buy in the midst of the storm. He could catch a falling knife. Quite frankly, these weren't his concerns. If a stock was sufficiently cheap and a business cleared a series of hurdles regarding its past performance and current financial position, Graham would buy it. Zweig seems to be arguing that you can't really know anything about a bank's current financial position. When applied to Graham this makes little sense. Graham worked at a time when there was less disclosure and more fraud than there is today. Consider the case of Northern Pipeline. The company provided investors with almost no financial data. Graham found the stock was trading for far less than the value of its investments per share by digging up the company's filing with the ICC (Interstate Commerce Commission). Had he not done so, he never would have known. Most investors didn't know. While the balance sheets of banks may prove inaccurate (both on the way down and the way up), this wouldn't have stopped Graham, because Graham always demanded a margin of safety. The precise financial condition of a bank becomes more important as it becomes more precarious. Likewise, the precise earnings power of a bank becomes more important the higher the multiple you're willing to pay. But, if (as Graham would), you insist on both extraordinary financial strength and extraordinary cheapness, the importance of both concerns lessens. It never vanishes entirely. However, you can put yourself in a position, where your analysis can be more wrong than many analysts and yet your investment results can be better. The key of course, is to add a margin of safety everywhere. You have to start with a strong past record and then you have to buy it on the cheap. That's why I brought up Valley National (VLY). Not because I think it's the best bank out there, but because I think it's the sort of place Graham would start if he were going to apply his principles to bank stocks. He wouldn't look for the fastest growing, highest quality company. He would look for the stodgiest bank he could find as shown by the bank's past earnings history, as well as its credit quality, historical losses, etc. He wouldn't be looking at the management - maybe he should - but he wouldn't. Graham would be looking at the numbers. If ever a bank like Valley National were selling at two-thirds of book, then Graham's principles would clearly allow the buying of a bank stock. Now, you might rightly argue that Valley National is trading nowhere near two-thirds of book and might never do so, while other banks - lesser banks (in Graham's eyes) - are trading at lower price-to-book ratios. That's true. And that's where Buffett and Brown come in. Buffett and Brown When it comes to bank stocks, Tom Brown may be closer to Warren Buffett than Warren Buffett is to Ben Graham. Why? Graham did not specialize in financial service stocks. Tom Brown does. Warren - strictly speaking - doesn't. However, he knows a great deal about them and has a long history with them. True, Buffett probably knows more about insurance than he does about banks, but his knowledge of banks is probably more useful to him as an investor. Let's not forget, Berkshire once owned a bank. Buffett's partnership also owned banks at times. For instance, he had a large position (10-20% of his portfolio) in a New Jersey bank (Commonwealth Trust) back in 1958. He bought twelve percent of the bank at an average of five times earnings. Buffett conservatively estimated the bank was worth $125 per share. He ended up selling it for $80 per share (a 60% profit) to free up capital for the partnership's large investment in Sanborn Map (a Northern Pipeline style investment). Why bring up something Buffett did fifty years ago - when his more recent investments, like Berkshire's purchase of Wells Fargo are more applicable to today? Because, in 1958, Buffett's approach was closer to Graham's than it is today. Also, his description of the Commonwealth Trust investment better resembles the way Graham might think about bank stocks, if he were forced into that field. Buffett's Wells Fargo investment is further from the way Graham would have operated, if only because Buffett's thinking had moved further from Graham's over the years. Buffett and Brown approach bank stocks very differently from the way Graham would have. They are more focused. They do more of a 360 degree analysis. They place greater emphasize on intangibles. There are a lot of differences. They may have the better approach. It may be better to find the right stocks - even at today's prices - than to look for the most statistically conservative stocks at the most statistically cheap prices. Graham was ill-suited to investing in banks. However, Zweig's reasoning isn't right. In fact, it's downright confusing for investors who know little of what Graham preached and what he practiced. Very few investors wouldn't be deterred by the "perfect storm" in financials. Ben Graham was one of the few who wouldn't be. Whether Graham would have invested in bank stocks or not, he would have made his decision based on past results and current prices - not real estate prices, or the credit climate, or any other macro-concern. At the right price, Graham would buy past earnings today assuming they would eventually materialize again tomorrow - and (as Brown says) the stocks might well bounce back first. So, again, Zweig may be right about Graham not buying bank stocks. But, his reasons are all wrong. Simply put, a smart guy wrote a stupid article.
Gannon On Investing Tue, 29 Jul 2008 13:48:32 -0500
1 2 Older >>
As sterling sinks to a 7-1/2 year low against the dollar, traders and investors are wondering who was the established political figure that made the following comments when Britain was kicked out of the Exchange Rate Mechanism in 1992. “A weak currency arises from a weak economy which in turn is the result of a weak [...]
Reuters - Global Investing Wed, 21 Jan 2009 12:12:52 +0000
People around the world watched Barack Obama's inauguration on Tuesday with anticipation and hope, but it was no surprise that the stock market took a bleaker view, with the major U.S. indices down more than 2 percent at midday. The stock market has historically fallen during inaugurations.
Reuters - Global Investing Tue, 20 Jan 2009 17:32:37 +0000
Business bosses, it seems, are as much in the dark as the investors who buy stocks in their companies. That is the worrying conclusion of a new survey from Booz & Co. After quizzing more than 800 senior managers, it found 40 percent doubted that their company’s leadership had a credible plan to address the economic crisis [...]
Reuters - Global Investing Tue, 20 Jan 2009 12:19:43 +0000
New year can get in the way of understanding what is happening on financial markets. Just because humans measure the year in 12 month tranches, it does not necessarily follow that markets do. Consider world stocks, for example. MSCI’s all-country world stock index is often cited as having fallen 43.5 percent in 2008. In fact, [...]
Reuters - Global Investing Mon, 19 Jan 2009 12:36:35 +0000
Equities may be having a stop-start kind of month, but investors do seem to be more willing to take on risk than before. The latest numbers from EPFR Global, a tracker of investment flows, show high-yield bond funds raking in the money in the second week of January. A net $766 million flowed into the [...]
Reuters - Global Investing Mon, 19 Jan 2009 09:41:06 +0000
Today marks the end of the Bush stock market. He has presided over the evisceration of more than $4.6 trillion of U.S. stock market wealth as measured by the S&P 500.
Reuters - Global Investing Fri, 16 Jan 2009 20:05:55 +0000
Who is next? After the Madoff and Satyam scandals, rattled investors are looking anxiously over their shoulders for the next big financial fraud. It is generally assumed that the downturn will expose more wrongdoings - but that doesn’t mean people become more dishonest when the economy is sick. In fact, quite the opposite, according to John Kenneth [...]
Reuters - Global Investing Wed, 14 Jan 2009 11:31:30 +0000
I haven't posted in a while and thought I might begin with some random thoughts. Rick Konrad of Value Discipline has posted after a (similarly) long absence. Value Discipline is one of the best investing blogs. If you've never read it - start now. 24/7 Wall St. recently posted on More Recession Carnage for Video Games. I would love to have posted on the video games industry (especially publishing) more often on this blog. I rarely have. The reason's simple: video game stocks have been pricey for much of the life of this blog (2006-present). That's not true anymore. Unfortunately, so many stocks are now so cheap on a normalized free cash flow ("earnings power") basis that it's hard to argue video game stocks deserve special mention. Take toys. A basket of three of the largest U.S. toymakers: Mattel (MAT), Hasbro (HAS), and Jakks Pacific (JAKK) looks real reasonable. Do the math on what kind of free cash flow these businesses have produced over the years and what kind of prices you can buy them at today. Answer: You're getting the American toy industry dirt cheap. Are their risks? In the long-run, their may be greater risks in toys than video games, because toy companies run a greater risk of becoming inflexible enterprises. Regardless, mankind's appetite for toys, video games, and just plain fun isn't going to be permanently impaired by a recession or depression (no matter how "great"). Are these businesses recession proof? Nothing's recession proof. But businesses that make products people are passionate about aren't a bad place to be in any economic environment. The fact that both industries can and have supported multiple, profitable players isn't a bad sign either. Toys and video game stocks are both worth buying (even if you can't separate the wheat from the chaff) when you can get an acceptable no-growth normalized FCF yield on your purchase price. Focus on free cash flow. Not earnings. I don't envy anyone who has to tell us what a video game company (or toy company) made this year much less what they'll make next year. Current sales and expected (normalized) FCF margins are a better way to value these businesses than EPS. Be conservative but realistic. And either buy the best or buy them all whenever you get the right price. In other words, don't rush out and buy a troubled, hurting quagmire (THQ) at the first twinkling of a turnaround. That's not necessary when real quality is on sale the way it is today. Note: Yes. THQ (THQI) is cheap. But ask yourself: do I really need that kind of cheap in my life, when real quality's on sale. Video game and toy stocks aren't the only ones being offered at low prices to demonstrated free cash flow. See Microsoft (MSFT) or Energizer Holdings (ENR) for evidence of this market wide phenomenon. But those are posts for another day.
Gannon On Investing Wed, 10 Dec 2008 07:41:26 -0500
It might not feel like it, but yesterday marked the Dow's return to normal. Normal valuations that is. A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, "In Defense of Extraordinary Claims", I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high: Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century. That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: '96, '97, '98, '99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than '65. As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 - 2007. We were in unchartered territory. Not any more. Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%. So at yesterday's close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year. That may not sound like much to those weaned on the 1982 - 1999 bull market. However, it's a lot better than the "new paradigm" market that began in 1996. Since we broke into unchartered territory twelve years ago, we've done something like 3.4% in point terms. And over the last ten years: zilch. Here's what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained: Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold. I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear. If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean - future returns can be adjusted down, allowing current prices to remain high. That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear). At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option - though it's theoretically possible if long-term interest rates are very, very close to zero. But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall - they could simply offer much lower returns than they had in the past. This could continue indefinitely - in theory. I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data. Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 - 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41. So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm? Maybe. If we really are in a new era, the old historical return data isn't relevant - it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant - and normalized P/E ratios must fall. And they have fallen. Like a rock. And saved us a lot of time. Eight and a half years by my calculation. Without a severe multiple contraction, the Dow would have had to move sideways for something like eight and a half years to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580. Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money. What about earnings power impairment? Won't the current financial panic and the (possible) resulting global recession cause a major contraction in earnings power? Not really. Actual earnings will be impaired. However, "normalized" earnings won't move much (certainly nothing like the 40% drop in price) - unless we see conditions considerably worse than anything post 1935. The Dow has been outperforming its expected earnings for a very long time (since the early 90s). That was never going to last. The Dow's actual earnings overshoot and undershoot its "expected" (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here: From 1935-2005, the percentage difference between the Dow's actual earnings and its 15-year normalized earnings ranged from (62.12%) to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%. The swings have been huge, but their net effect has been small. Basically, the Dow's EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that's ending now) it's basically a mirror image of underperformance and overperformance. The Dow gives you 6% earnings growth. What you get depends on what you pay. Starting today, you're paying par. You haven't had that chance in over ten years. What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935 - 2005, your long-term returns should match the Dow's long-term EPS growth. Both should be around 6% (ex-dividends). Long-term future returns should once again be similar to long-term historical returns. Could the future be different from the past? Maybe. But I wouldn't bet on it. The last ten years turned out to be nothing new. Just a detour on the road to normalcy. P.S. All this brings up an interesting question - and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years - but assuming the Dow's normalized P/E had to revert to the mean for it to offer its historical returns once again. Which would you rather lose: Forty percent or eight and a half years?
Gannon On Investing Fri, 10 Oct 2008 02:30:57 -0500
I wrote a response to Jason Zweig's column on Ben Graham and bank stocks. Now, Tom Brown of Bankstocks.com has done the same. I have to admit, Tom's article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn't be a buyer of bank stocks today. However, Tom's post does a better job of presenting the opportunities and challenges in analyzing bank stocks today: Zweig's premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution's assets--particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock's valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true. Graham saw every investment as a black box - and that didn't trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own - Graham never did. He didn't look inside the "system", i.e. the company itself; instead he looked only at the outputs - the financial statements. He spent almost no time worrying about a business's management, corporate culture, or future prospects. He didn't worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what "normal" earnings might look like. Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would've worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things - and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham's most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career. Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham's principles were. What Graham Practiced In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 - 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments. Control Investments Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment. Arbitrage Buffett has discussed this techniques in some detail. See especially Buffett's discussion of Berkshire's purchase of Arcata shares. Both Buffett and Graham had stellar results in the arbitrage field, as Buffett explains in his 1988 letter to shareholders: In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There's plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. That's a long history of success. From 1926-1988, unleveraged arbitrage returns from Graham's partnerships, Buffett's partnerships, and Berkshire averaged better than 20% a year. Since some leverage was employed, actual returns over this sixty-three year period were even better than 20% per annum. Arbitrage works. Liquidations Liquidati... are the simplest type of investment there is. You simply buy the stock below the expected final payout and wait for things to wind down. Buffett has invested in liquidations several times - most are not well-known. For a recent example, see Comdisco Holdings (CDCO). For a less recent example, see the Kaiser liquidation (from the 1970s). Net/Nets Net current asset issues are not well-known, even today. However, the technique itself is well-known. Jonathan Heller of Cheap Stocks created an index to track (some) NCAV stocks. Since inception the Net/Net index has outperformed the relevant benchmark. However, it is a very young index. Related Hedges Related hedges are not appropriate for individual investors. They belong to a category of techniques that Graham employed with some success, but which have subsequently become far less fertile ground for investors, because modern theory and practice is better able to efficiently price a variety of more complex securities. Basically, Graham would go long a certain company's convertible senior security and go short that same company's common stock. If the stock rose, he would take a small loss. If it dropped sharply, he would make a nice gain. Obviously, these related hedges would provide a performance boost when the rest of Graham's portfolio was struggling (since stock prices in general would be falling) and vice versa. The first real coup of Graham's career belongs to this category of mispriced special securities. Graham was a low-level employee of Newburger, Henderson, and Loeb when he brought up the idea of investing in the bankrupt Missouri, Kansas, and Texas Railway. The company's bankruptcy plan gave owners of the old common stock the right (but not the obligation) to buy shares in the new company. This went mostly unnoticed at the time - or, if it was noticed, speculators were not using the old common stock as a way to play the new MKT. As a result, the old stock traded at just fifty cents. Graham figured that during a strong period for railroads the old common stock could easily rise three or four dollars - while the maximum loss on each share would still be just fifty cents. The firm bought into Graham's idea and ended up making $15,000 on its $2,500 investment in less than a year (this was back in 1915 when $15,000 was real money - perhaps something like $300,000 today). Graham's partnership was a prototypical hedge fund. For starters, Graham actually hedged. He was short some securities and long others. For a while, he tried a basic long/short value approach, where he went long clearly cheap stocks and when short clearly expensive stocks. However, he found riding out the speculative surges in the stocks he was short to be an extremely unpleasant experience. He also found, over time, that he wasn't especially good at finding stocks to short - certainly not good enough to get a better overall result (an investor has to be a lot more skilled at going short than going long to make it worth his while to short- if volatility and consistency aren't as important to him as long-term results). Also, since Graham was always invested in an unusual mix of cheap stocks, liquidations, and related hedges, he was able to deliver rather consistent results without resorting to a more conventional long/short strategy. Eventually, Graham took the technique of shorting overpriced stocks out of his repertoire. What Graham Preached This is where Zweig comes in. Very little of what he writes has anything to do with what Graham practiced; generally, he writes about what Graham preached. These two things are quite different. Why? Graham liked rules, methods, and standards. Whether he was writing for professional security analysts or amateur investors, his goal was the same: to provide a practical, workable approach to the field of investments. He may have underestimated the common man; but, I doubt it. Even in The Intelligent Investor, he included a small section describing the actual techniques employed by his partnership. He also gave a separate set of rules for the enterprising investor to follow. Graham didn't divide investors by their risk appetite; rather, he divided them by their work appetite. Those who would work harder and be more businesslike - more like true professionals - would naturally come closer to the methods Graham himself employed. So, if we were to use Graham's own actions as our sole source for determining what he would do today, we'd have to say he'd invest in almost nothing that makes it into Barron's, The Wall Street Journal, CNBC, or Bloomberg. Graham would mostly do what he always did. There are still some NCAV stocks today; arbitrage still exists; liquidations still occur (e.g., I participated in what was essentially the liquidation of an Icahn controlled company last year - Atlantic Coast Entertainment Holdings, see Joe Cit's post for details). But, wouldn't all of this be too small for Graham? Yes and no. No, Graham never needed big cap ideas, because Graham always kept his partnership small - much, much smaller than it could have been. He could have managed a lot more money; he was always much more famous than his assets under management would lead you to believe. He returned capital gains instead of allowing them to accrue in his favor. Overall, he tended to keep his operation very small by any standards - and infinitesimally so by the standards of today. However, yes, Graham would need some other ideas. The most likely answer is that he'd rather change venues than change standards. Therefore, I doubt he'd be investing in even moderately pricey names in the United States whenever there were opportunities to buy ridiculously cheap stuff abroad. He'd probably have been in Korea after the Asian contagion; he'd certainly have been in Japan at some point, where there were some overcapitalized and underpriced public companies. I know these aren't exactly the most exciting answers. It's a lot more interesting to argue over whether or not Graham would be buying bank stocks today than it is to consider what he'd actually be doing in modern times. My best guess is that if Graham were around today we'd consider him a very strange, very boring investor with a taste for odd and obscure securities in unappealing industries and out of favor countries. Grahamian Theory So where does that leave us regarding Graham and bank stocks? All we have to go on are Graham's principles. And this is where I think Zweig failed in his most recent column. His reasoning is all wrong. It paints an entirely inappropriate, almost stereotypically stodgy picture of Graham. Zweig confuses the conservatism of modern financial advisors with the conservatism of Graham. They are two very different things. Graham would not have avoided bank stocks, because of falling real estate prices. He would avoid bank stocks, because there is an insufficient margin of safety (many are still trading above book value). He might demand a greater discount to book, because many banks have businesses and recent records built upon boom times. Graham always wanted to see how a business had performed under a variety of different circumstances, and this need for a solid past record would be even more important for banks, because of the nature of credit "cycles". However, the mere fact that something unusual or even unprecedented is occurring in real estate and thus in financials would not have deterred Graham. His conservatism was not of that sort. He could buy in the midst of the storm. He could catch a falling knife. Quite frankly, these weren't his concerns. If a stock was sufficiently cheap and a business cleared a series of hurdles regarding its past performance and current financial position, Graham would buy it. Zweig seems to be arguing that you can't really know anything about a bank's current financial position. When applied to Graham this makes little sense. Graham worked at a time when there was less disclosure and more fraud than there is today. Consider the case of Northern Pipeline. The company provided investors with almost no financial data. Graham found the stock was trading for far less than the value of its investments per share by digging up the company's filing with the ICC (Interstate Commerce Commission). Had he not done so, he never would have known. Most investors didn't know. While the balance sheets of banks may prove inaccurate (both on the way down and the way up), this wouldn't have stopped Graham, because Graham always demanded a margin of safety. The precise financial condition of a bank becomes more important as it becomes more precarious. Likewise, the precise earnings power of a bank becomes more important the higher the multiple you're willing to pay. But, if (as Graham would), you insist on both extraordinary financial strength and extraordinary cheapness, the importance of both concerns lessens. It never vanishes entirely. However, you can put yourself in a position, where your analysis can be more wrong than many analysts and yet your investment results can be better. The key of course, is to add a margin of safety everywhere. You have to start with a strong past record and then you have to buy it on the cheap. That's why I brought up Valley National (VLY). Not because I think it's the best bank out there, but because I think it's the sort of place Graham would start if he were going to apply his principles to bank stocks. He wouldn't look for the fastest growing, highest quality company. He would look for the stodgiest bank he could find as shown by the bank's past earnings history, as well as its credit quality, historical losses, etc. He wouldn't be looking at the management - maybe he should - but he wouldn't. Graham would be looking at the numbers. If ever a bank like Valley National were selling at two-thirds of book, then Graham's principles would clearly allow the buying of a bank stock. Now, you might rightly argue that Valley National is trading nowhere near two-thirds of book and might never do so, while other banks - lesser banks (in Graham's eyes) - are trading at lower price-to-book ratios. That's true. And that's where Buffett and Brown come in. Buffett and Brown When it comes to bank stocks, Tom Brown may be closer to Warren Buffett than Warren Buffett is to Ben Graham. Why? Graham did not specialize in financial service stocks. Tom Brown does. Warren - strictly speaking - doesn't. However, he knows a great deal about them and has a long history with them. True, Buffett probably knows more about insurance than he does about banks, but his knowledge of banks is probably more useful to him as an investor. Let's not forget, Berkshire once owned a bank. Buffett's partnership also owned banks at times. For instance, he had a large position (10-20% of his portfolio) in a New Jersey bank (Commonwealth Trust) back in 1958. He bought twelve percent of the bank at an average of five times earnings. Buffett conservatively estimated the bank was worth $125 per share. He ended up selling it for $80 per share (a 60% profit) to free up capital for the partnership's large investment in Sanborn Map (a Northern Pipeline style investment). Why bring up something Buffett did fifty years ago - when his more recent investments, like Berkshire's purchase of Wells Fargo are more applicable to today? Because, in 1958, Buffett's approach was closer to Graham's than it is today. Also, his description of the Commonwealth Trust investment better resembles the way Graham might think about bank stocks, if he were forced into that field. Buffett's Wells Fargo investment is further from the way Graham would have operated, if only because Buffett's thinking had moved further from Graham's over the years. Buffett and Brown approach bank stocks very differently from the way Graham would have. They are more focused. They do more of a 360 degree analysis. They place greater emphasize on intangibles. There are a lot of differences. They may have the better approach. It may be better to find the right stocks - even at today's prices - than to look for the most statistically conservative stocks at the most statistically cheap prices. Graham was ill-suited to investing in banks. However, Zweig's reasoning isn't right. In fact, it's downright confusing for investors who know little of what Graham preached and what he practiced. Very few investors wouldn't be deterred by the "perfect storm" in financials. Ben Graham was one of the few who wouldn't be. Whether Graham would have invested in bank stocks or not, he would have made his decision based on past results and current prices - not real estate prices, or the credit climate, or any other macro-concern. At the right price, Graham would buy past earnings today assuming they would eventually materialize again tomorrow - and (as Brown says) the stocks might well bounce back first. So, again, Zweig may be right about Graham not buying bank stocks. But, his reasons are all wrong. Simply put, a smart guy wrote a stupid article.
Gannon On Investing Tue, 29 Jul 2008 13:48:32 -0500
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