Corporate Profits-to-GDP: Why Doesn't Buffett Care?

I haven't posted in a while but that's because I was busy with all the conference calls, annual reports, and of course, keeping up with all the stuff coming out of the Berkshire Hathaway annual meeting.

Anyway, there is plenty of stuff out there on the annual meeting and I don't have much to say about it; it seems like the usual, same old stuff.   It was great that Buffett invited a short to ask questions.  People have often complained about the softball questions that Buffett has gotten, and the often non-Berkshire-related questions over the years.  So he got journalists to sort out questions ahead of time and then invited professional securities analysts to ask questions that might satisfy the more hard core Berk-heads.  That was a good idea.  And to make it even more interesting and have tougher questions asked, he invited a short this year.  Unfortunately, I don't think any of the questions the short asked were very interesting and I could've answered those questions exactly as Buffett did (this is what happens when you follow Buffett for years; you tend to know what he is going to say before he says it).

OK, this is not the topic of this post.  Let's get back on topic.

Stock Market Overvalued Due to High Margins?
People have been saying for the past few years that the stock market is overvalued despite reasonable looking p/e ratios because earnings are abnormally high now.  The usual chart shown is the corporate profits-to-GDP ratio.  This has been trending up and it is unsustainable.  Even Buffett said a while ago that to think corporate profits can stay above 6% of GDP is fantasy (it is now over 11% according to the chart below from the St. Louis Fed).  Someone asked this question at the annual meeting and Munger said that just because Buffett said something a long time ago doesn't make it carved in stone (or something like that), and he added that he thinks 6% is a little low.

Despite this record high corporate profit-to-GDP ratio showing abnormally high margins at U.S. corporations, Buffett said that the stock market is reasonably valued.  Howard Marks said that too in one of his recent memos.    Are they blind?  Don't they see that current earnings are bloated and unsustainable?

I looked at this a while back and concluded that none of the big blue chips companies have this trend in profit margin (corporate profits-to-GDP is not the same as profit margin but is used as a macro proxy...); I made a post about this a while ago (see here). 

So I comforted myself by saying that if there is a stock I own that is showing rising and unsustainably high profit margins, I should watch out and lighten up.  Having not seen that in my companies, I didn't care.  In fact, since I was mostly interested in financials, most of them showed below trend profit margins.   This big chart of profit margins was not relevant to me at all.

I still don't care too much about it as I don't look at stocks as part of a stock market, but more as a piece of a business (would you sell the restaurant you love and built over the years just because the S&P 500 index is trading at, say, 50x p/e?  Nope.  If someone offered you 50x p/e for the restaurant itself, then you would have to think about it, of course!).  If I like the business, how it's doing and it's current valuation is reasonable, who cares what some GDP ratio shows?

Having said that, I was still curious how people can keep saying (including myself) that the stock market is reasonably valued despite this fact.

Actually, the question is more why people like Buffett are not more worried about the market (we know he ignores market predictions but still) with this crazy looking chart.   Why does he keep buying Wells Fargo every month (well, I told you he will keep buying WFC all the way up to $50/share. see Wells Fargo is Cheap!)?

Anyway, let's get to the picture:

There are a lot of these charts all over the internet; people have been talking about this for a long time now.  I'll use the St. Louis Fed's chart since they probably won't come after me for copyright issues.

After-Tax Corporate Profits / GDP Ratio

The chart is certainly staggering.  I too tend to get acrophobic when I see charts like this with something shooting way out of range.  Corporate profits has been in the range of 4-6% or maybe 5-7% for a very long time but is now above 11%.  This can't continue. The argument is that if profits went back to 5-6% instead of 11%, then the stock market p/e ratio of 15x (or whatever it is currently) would actually be 30x on a 'normalized' basis.

Scary for sure.  I do agree with the fact that these things do tend to mean-revert, and I also realize that there may be factors (international business of U.S. corporations) that might make this trend up over time. 

But I don't want to get into the details of that now. The point of this post is much simpler. 

What Are We To Do?!
The question is, with this ratio at such abnormally high levels, what the heck are we investors supposed to do?  "Experts" tell us to get out of stocks or lighten up as profit margins are unsustainable and the market is expensive on an 'adjusted' basis.

As I said before, my personal reaction is to do nothing and just look at my holdings and see if I have a problem with any of them.  If I owned a company that typically earned 10% operating margins and that went up to 20% due to some supply constraint that made the product prices spike up and input costs were lower than usual and the stock price reacted and is priced as if 20% margins is 'normal', then I might lighten up or sell out completely.  If that is not the case, I would hold on.  Who cares what the 'national' level profit margins are?

If you owned Berkshire Hathaway in August 1987 and were convinced that the market would crash soon, would you sell out?  How many times would you have sold due to various reasons over the past few decades?  And out of those times you would have sold, would you have gotten back in? 

Anyway, let's get back to the above chart.  Profit margins seemed high back in the late 40s and into 1950.  Interest rates were probably below 2.5% back then, and profit margins were pretty high.  If you knew for a fact that the corporate profits-to-GDP ratio is going to head down, would it have made sense to stay out of the market and wait for it to get to a level that is more comforting?

Here is the S&P 500 index from 1950 or so onwards:

 S&P 500 Index 1950 - 2013

...and just for fun here's the Dow in the last century:

Dow Jones Industrial Average 100 Years (1900-2012)

So, check this out; from 1950 on, corporate profits as a percentage of GDP headed straight down all the way until it bottomed out in the mid-1980s.  You can draw dots in February 1950, 1955, 1960, 1970, 1980 and 1985 and except for 1980, the ratio is lower than it was the dot before.   I am eye-balling this so I may be off a little here and there.  But the basic message is the same.  Corporate profits-to-GDP went down all throughout that period.

OK, so here's the fun part.  You saw the S&P 500 and Dow charts so you already know where I'm going with this.  Let's see what happened to the stock market since February 1950.  I used February since that was the earliest datapoint on Yahoo Finance for the S&P 500 index.  I do have complete data somewhere, but I didn't bother to look for it as I think this is good enough.

Let's look at what happened from February 1950 onwards to the S&P 500 index:

                               S&P 500               annualized
                               level                      return since 1950
February 1950         17.22
February 1955         36.76                   +16.4%
February 1960         55.49                   +12.4%
February 1970         89.50                     +8.6%
February 1980       113.66                     +6.5%
February 1985       182.19                     +7.0%

Keep in mind these returns exclude dividends.  It's only the change in the index.

So if you somehow had perfect foresight and you knew that the profits-to-GDP would head down in future years (back in 1950) and waited, when would you have bought stocks?  If you waited until it bottomed out in 1985 (actually, I think it bottomed a little later, but...), you would have had to pay 11x as much as you could have paid for stocks in 1950.

If you waited five years, you would have missed out on +16.4%/year in returns.  If you waited a decade, you would have missed +12.4%/year in returns etc.

So even if you knew for certain that profits-to-GDP would head down in the future, you still would have had no idea what the stock market will do.  This is the essence (or one of many) of Buffett's approach to these macro things; even if you knew exactly what the unemployment number would be one year from now and what the GDP would be, you would still have no idea where the stock market would be.  There are just too many unpredictables, or what he calls unknowables.

Please excuse my very rough eye-balling, but let's look at what happened during the time that profits- to-GDP went down versus the time it went up.  As we saw in the above table, in the 35 years between 1950 and 1985, the ratio went down a lot, but stock prices rose 7%/year.  Since 1985 through February of this year when profits-to-GDP went straight up to the current, obscene, unsustainable level, (just to keep the Feb-to-Feb comp constant), the S&P 500 index went up 7.9%/year. 

So the market went up during the years when profits-to-GDP went down, and the market went up when this ratio went up.  Is the profits-to-GDP really such a good indicator for stock market timing?

You can also try plotting the highs and lows of the profit-to-GDP chart and match it to the stock market.   Maybe you would have gotten out in 2006 or 2007 and then gotten back in in 2009.  But then maybe you sold out in 2010 or 2011.   Not bad.  But then, over time, you might have bought in 1970 and then sold in 1978 only to get back in in 1985 or 1986.   You get my point.

Buffett has this sort of long term perspective on things and that's why he is not alarmed or overly concerned with these things.   It's not always easy to do, but sometimes you have to look at the whole picture, not just the big picture.  People, myself included, sometimes get mesmerized by certain graphs and charts and make them overly weight it and distract us from making good, rational decisions.

Interest Rates
We can make a similar argument about interest rates too.  People say correctly that the stock market had a massive wind at its back with interest rates going down from double digits in 1980-82 all the way until today.  They say that this wind at its back is now a headwind.  Combine that with the abnormally high profits-to-GDP and the stock market is dead money, at least, for a very long time.

But again, in 1950, interest rates were 2% or whatever.  That went up to double digits.  I think rates peaked out in 1982, but since we already did the work for 1980, let's look at that.  The S&P 500 index went up by 6.5%/year from 1950 to 1980 despite interest rates going from 2% to 10% or so.  And that 6.5%/year includes the stock market being flat pretty much since 1965 through 1980.   And remember, these stock market return figures exclude dividends.

Conclusion
So here we are today with interest rates at unsustainably low levels and profits-to-GDP at unsustainably high levels.  Putting those two together, it's hard to imagine the stock market moving higher.  At best, it seems like it will be flat for a long time to come.

But looking at the whole picture and not just at cherry-picked charts here and there that look scary, we see why Buffett says that the market will keep going up and will be substantially higher over the next few years even though he admits he has no idea what the market will do next week, next month or next year.

I am not arguing that stocks will go straight up and will always do so.  I look at these charts and do believe in mean reversion and all that, and I don't entirely disagree with the bears out there.  But I just like to take one step further and ask myself, well, what would have happened if I used this as an indicator to get in and out of the market?  Would I do better than just holding on to great businesses or buying special situations? A little digging shows that maybe not.

I don't think these charts are irrelevant either.  It's just that there are so many factors that are not knowable that we can't really predict what is going to happen based on one or two (or even five to ten) really, really convincing charts.

Newton's Apple

So Apple has fallen below $400 and it seems like most people still talk about how cheap it is. Yes, it does look really cheap.  But others have pointed out that Apple is only cheap if they can maintain their sky-high margins.

I decided to take a quick look at this since I sort of follow Apple and have posted about it before.  I still don't like Apple as a long term hold and am short the stock off and on (I did flip long once after my Apple LEAPs post, but sold out of it deciding that it doesn't make sense to go long a stock I didn't like just because the stub/LEAP idea was interesting).  

Anyway, my views on Apple hasn't changed much (see Apple is No Polaroid).  The JC Penney fiasco (I followed JCP too but fortunately stayed away from the stock as I thought it was 'too hard') sort of reinforces the idea that Jobs was indeed an incredible talent and people who have done well with Jobs may not be able to retain that 'magic' without him.  Of course, this probably has nothing to do with JCP as Ron Johnson was a successful retail executive before going to Apple.  But anyway, that's whole other topic.

Back to Apple.

Apple Looks Cheap
First of all, a quick look at the cheapness of this stock.  As of the end of the last quarter, Apple had $137 billion of cash and marketable securities.  Taking 75% of that (net of taxes), we get $103 billion and with 939 million shares outstanding, that comes to around $110/share in cash and marketable securities.

Analysts estimate that Apple will earn $44/share in the year ended September 2013.  10x that gives us $440 (interest rate income should be deducted from this, but since rates are so low I won't bother).  At 10x that, we get $550/share in total value for Apple.  With Apple trading at $400/share, that would be a 30% discount to what it's worth.

Margins
One of the keys in the Apple story is the margin.  Can this be sustained?  Of course, what Apple comes out with next is the big story for the long term of Apple; if they can't keep coming up with hit products like the iPod / iPhone / iPad, then Apple is not worth anywhere near what it is today.

But never mind that for a second.  Let's just look at what they have now.  In 2012, their gross margin was 43.9% and their operating margin was 35.3%.

People say that this can't be maintained as their competitors operate with half those margins.  If the gap between products keep closing, how can the spread in margins be maintained?  I think that by many accounts, the difference between Apple products and others are rapidly shrinking.

Anyway, I think the one big competitor is Samsung.  They do break out sales and operating profits for their mobile segment (IT & Mobile Communications).  This segment in 2012 had operating margins of 18%.

If Apple had operating margins of 18%, how cheap is Apple stock then? 

Analysts predict revenues for the current year to be $181 billion.  18% of that is $32.6 billion.  With a 25% tax rate, net earnings (excluding other income) would be $24.5 billion, or $26/share.  10x that is $260, and adding back the cash and securities from above of $110/share, that gives us a total value of $370/share.

Suddenly, Apple stock at $400/share doesn't look so cheap anymore!

Of course, there is no reason why Apple's operating margin has to go down to 18% right away if ever.  But I do think that the historical tendency in these fluid, fast moving industries is that excess margins get competed away.

So anyway, maybe we can't really compare Apple to Samsung.  They are different beasts, and Apple does in fact own the operating system and the eco-system whereas Samsung only provides the hardware.  This is the tricky part.  We know that software has much higher margins than hardware (look at Dell versus Microsoft, for example).  So maybe Apple will always earn a higher margin.

I figured that Apple always did both, so why not take a look at Apple historically?

Here is the gross and operating margin history for Apple since 1992 (I can only get data back to 1992):

Historical Apple Margins

So even though Apple did both the hardware and the software, their gross margins were never above 30% until the iPhone era.  Their operating margins were subpar too for most of the period since 1992. 

Yes, we know that Jobs left in the 80s and Apple was mismanged for years.  But Apple products were still loved by fans and were often said to be the best computers out there.  And yet this is their margin history. 

Things are different now for sure once Jobs came back and fixed the place up.  But there is no guarantee that Apple won't go back to what it was before Jobs came back.  It can still be making the best products, but the above shows that that doesn't guarantee fat margins.

The last time Apple had gross margins above 40% was in 1992 and it went down since then.  Here is what the 10-K said about the drop in gross margins in 1994:

"The downtrend in gross margin was primarily a result of pricing and promotional actions undertaken by the company in response to industrywide pricing pressure."
 

And for the 1992-1993 drop, they also said it was:

"primarily the result of industrywide competitive pressures and associated pricing and promotional actions"
 

And here's a chilling quote too:

"Although the company's gross margin was 27.2% for the fourth quarter (1994), resulting primarily from strong sales of Power MacIntosh computers and the PowerBook 500 series of notebook personal computers, it is anticipated that gross margins will remain under pressure and could fall below prior year's level worldwide due to a variety of factors, including continued industrywide pricing pressures, increased competition, and compressed product life cycles".

If operating margins go to 10%, which would be respectable for a manufacturing company and happens to be the long term average for Apple since 1992, let's see what Apple looks like.  With $180 billion in sales (never mind for now that if Apple takes pricing actions to reduce margins, sales would change too but there is no telling by how much).  That would give us an operating profit of $18 billion.  At a 25% tax rate, that's a $13.5 billion net profit and $14.40/share in EPS.  10x that would be $144/share and add to that the $110 in cash and you get $254/share total value for Apple.

Of course, I don't expect Apple to post a 10% operating margin any time soon.   I'm just fooling around with figures to get a sense of this thing.

I know that the universal view is that Apple will keep creating new products just as industry-changing as the iPod, iPhone and iPad.  But if they don't, Apple may, over time, start to look more like the long term Apple than the short term Apple (with hit after hit).

In that case, the stock would be worth much less than it is now because you will have years of good hits and years where nothing really interesting happens and industry competition eats away at margins (like it has before).

Again, this is not to say that this has to happen any time soon.

Increasing Pricing Pressure
I don't cover this industry so this is just a casual viewpoint, but I do think that there will be a lot more pricing pressure in the next couple of years.  I'm not just talking about Samsung and other gadget makers catching up. 

I think the mobile industry is getting more and more competitive and it seems like that maybe growing through acqusitions and subscriber growth may be coming to an end.  When they are adding new customers and growing through acquisitions, Apple did great because the iPhone was a great way to add subscribers.

As this starts to peak out, you then get more and more price competition. When that starts to happen, then mobile operators start to look to cutting costs to provide cheaper service.

John Malone was on CNBC the other day (I may post about that later too as it was a fascinating interview on why he bought Charter Communications) and he said that he wants to consolidate the cable industry as an offset to the content providers.  He says that cable bills (due to content prices rising) has gone up so much over the years that people can barely afford it anymore.  The business model, he says, is unsustainable (mostly due to the expensive sports content that 80% of the people would not willingly pay for at wholesale).  He thinks cable will be unbundled and the old cable model will be gone in a couple of years.

This is not the perfect analogy, but I do sort of feel like the same thing is happening in the mobile market. Phones get better and more expensive to the point that people can barely pay their phone bills.  And like ESPN in the cable world, a lot of dollars seem to be going to the phone makers (Apple).

When phone companies start to see their subscriber growth stall, growth through acquisitions plays itself out and margins get pressured due to competition, it's only a matter of time before they start looking at where those dollars are going and demanding better deals.

But again, I don't follow the industry so this is just a casual observation and not expert insight at all.  We don't have to be experts in an industry to know which direction things tend to go (increasing competition = lower margins.  When customers (mobile operators) face margin pressure, they pressure their providers (phone manufacturers) etc...).   Only the timing is difficult to get right.

Conclusion
This is just a quick look at Apple.  My view hasn't really changed, but with the stock down so much it's not as interesting a short as it was last year.  But there could still be a lot more downside if these margins can't be maintained.

For these companies that depend on 'hit' products, I think it's really dangerous to normalize, or capitalize super-high margins far into the future (which is what you're doing when you put a 10x multiple on it).

I understand the bull argument too.  Apple has the eco-system, it's not just a gadget marker.  It has the great stores.  But to a large extent, I think these things are tied to and depend on Apple making cool gadgets.  Who the heck would go to an Apple store if they didn't have cool products?  Who would download anything from the app store if they didn't have the latest cool gadget? 

Lollapaloozas (Munger's definition), like leverage, can work both ways.

Although I am way less bearish than last year, I am still very skeptical of this stock.  And yes, I know, to the bulls this whole post must come across as totally ludicrous.  I have no idea what is going to happen.  This is just sort of a thinking out loud thing.

Oops, and the title of the post:  I was going to make some comments about Newton's laws of motion, the apple etc... but forgot to do so.  But never mind. You can imagine for yourself all the bad jokes I might have come up with...

 

Wells Fargo History Website

OK, so maybe I'm the last person on the planet to notice this, but I just found this website by accident (trying to find the WFC 2012 annual report). 

It looks like it was put up recently (?). 

So Loews puts up a comic book, JPM puts up a nice promotional video, but WFC tops it all with an entire website with videos and whole bunch of history.  This is great for people (like me) who love business history, seeing historic photos and film clips etc.

Here's the website:

http://www.wellsfargohistory.com/

My computer / internet connection is acting flakey now so I can't watch the videos (keeps stopping etc...) but I can't wait to see them all.

And of course, the best thing there are the annual reports going back to 1967 (why not further back?  They are 160 years old, aren't they?). 

http://www.wellsfargohistory.com/archives/archives.html  (click on annual reports, but not on the picture below because it's just a picture)




This should really be the standard for corporate websites.  I don't know why most companies only put annual reports on the website going back four or five years.  Do they have something to hide?  For that matter, I wish they would put up detailed, downloadable spreadsheets (like Sony does on their website) going back decades.  The world is moving in that direction with downloadable spreadsheets in SEC filings.

The problem with things like Value Line and Morningstar is that the corporate income statement / balance sheet data only goes back ten years or so, and the data is often wrong.  So if corporations put that sort of thing up themselves, it would be great.   We can't assemble that stuff ourselves as SEC filings only go back to 1994 or whenever, and annual reports on websites don't go far back at all.

OK, so this is more like a tweet than my typical post, but I really like what WFC did here so...

Anyway, here's some stuff from the website I cut and pasted without permission.

 

 

 

This is why people hate banks these days.  No banks give out stuff like this anymore...

 

 



 

 

 

And check out the beginning of high tech banking from home (?)... 

 

And ads...



And I just put this picture in here because it looks cool...

Check out the site!   (and no, this sounds like a sponsored post but it's not!)

JPM 2012 Annual Report

So the JPM annual report was put up yesterday.  There is not much new here but as usual I'll just make some simple comments and highlight things that struck me.

One thing, though, is that at the front of the annual report (and at the end of Dimon's letter to shareholders), they mentioned that they put up a video about JPM.  You can see it here.

So, Loews puts up a comic book and here JPM puts up a promotional video.  What's going on? 

Actually, I do think it's a good thing that JPM (and others) get their stories out there.  The general press and even the financial press is so biased and tends only to talk about the bad stuff (if it bleeds, it leads works in financial journalism too, I guess).  And there's nothing wrong with having a video like that out there.  I'm kind of surprised that there are 200+ likes and only 6 dislikes.  Maybe JPM has control of this 'channel' (YouTube).  On a typical YouTube post, you would have all sorts of nasty comments, even for good videos.

But anyway, it's a sign of the times.

As usual, I won't summarize the whole report, but just point out some things.

The Usual Figures
Here's the usual stuff that JPM shows.  Tangible book value has grown from $16.45 to $38.75 from 2005-2012.   That's +13%/year.  As I always say, this is great given what happened between 2005 and 2012.

Long Term Performance
And here's some long term stuff that they showed on investor day.  Dimon shows that shareholders would have done well investing with him since his Bank One days.  Since the Bank One days, Bank One/JPM since March 2000 has gained 8.6%/year versus +1.4%/year for the S&P 500 index and -1.0%/year for the S&P Financials index.

Since the merger with JPM, JPM has underperformed the S&P 500 index a little, but outperformed the S&P Financials index.

Long Term Tangible Book Value per Share Growth
And this table was in the annual report and I don't think it was in the investor day presentation.   It is basically the same as the above but compares growth in tangible book value per share over time with the S&P 500 index.  Share price performance is important, as that's what determines total return to shareholders, but CEOs can't control valuations.  If valuations are high at the starting point and very cheap at the end point, it may not show how well the CEO has actually done.

From this table we see that since 2000, Dimon has compounded tangible book value per share at a 13.4%/year pace compared to 2.6%/year return in the stock market; that's a 10.8%/year outperformance.

Since the merger in 2004, tangible BPS has grown +15.4%/year versus +4.8%/year for the S&P 500 index.  Pretty impressive.

Capital
And this was all done while improving capital ratios.  Not only has JPM grown tangible BPS at a respectable clip over the years despite the financial crisis and even the whale loss, it has done it while increasing capital ratios.

Dimon says, JPM has "been able to grow its business, increase dividends, buy back stock AND materially increase capital ratios".

Dimon said that dividends will go back up to $0.38 per quarter (pre-crisis level) in the second quarter of 2013, but share buybacks would be half the level of last year because they want to get to the Basel III target capital ratio by the end of 2013 (they will buy back an additional $6 billion this year).

Whale Loss
Obviously, the first issue covered is the whale loss.   He takes full responsibility for it and apologizes to everybody and then covers some key points to prevent something like this from happening again.   You can imagine what he means for each point:

• Fight complacency
• Overcome conflict avoidance 
• Risk management 101:  Controls must match risk
• Trust and verify
• Problems don't age well
• Continue to share what you know when you know it
• Mistakes have consequences
• Never lose sight of the main mission: serving clients

Senate Report
I'm reading the Senate report on the whale loss (and embarassed to say not quite done with it), but I have something to say about that.  This wasn't mentioned in the annual report but I am just tossing my thoughts in here.  

Does it make me uncomfortable?   Yes, of course.  There are a lot of disturbing things in there, particularly the mismarking of the position and some of the discussions between the trader and his supervisor (level below Ina Drew). 

But on the other hand, the way the report is written, it seems to show this incident in the worst possible light and forces the facts into a story that the committee wants to tell.

For example, the report says that the CIO was supposed to use the SCP (synthetic credit portfolio) to hedge the overall risk that JPM is exposed to.  But contrary to JPM's claims, the SCP was in fact not a risk hedge but actually added risk and was in fact just a huge speculative, proprietary trade.  Or something like that.

The reality the way I understand it is that the SCP morphed into something completely different due to their attempts to wind down the position.  Someone had the horrible idea to put on offsetting positions to reduce the book instead of just unwinding it.  And this turned out to be a big mistake.  But it's hardly a situation where someone was secretly making huge directional bets on market direction and things like that.

Also, the report says that the SCP was never really a hedging transaction as nobody within JPM can tell the committee exactly which positions / loans the SCP was supposed to hedge.   In GAAP accounting, you have to have an exact match to use hedge accounting.  But in these so-called 'macro-hedges', that is often not the case.  For example, in the old days, some equity trading desks would routinely buy put options or short index futures as a 'hedge'.  This may have been partly to hedge the inventory of stock that they held for market-making purposes, but it was also a business hedge; if the markets tanked and business dried up, they can at least hope for some payoff from the puts or short futures position.  It works sort of like business self-insurance; you spend x% of your monthly net revenues on insurance. 

In the case of JPM, they have all sorts of built in risk, particularly credit and interest rate risk and exposure to 'tail' events (sudden worsening of credit markets).  When these tail hedges are put on, you can't really point to any single loan or position that you say you are directly hedging.  It's much broader than that.  But the report states that since JPM / CIO people couldn't point to specific positions it was trying to hedge, that the SCP was in fact just speculation and not hedging.

The report also makes it seem like these derivatives are too complex and dangerous, but upon reading JPM's report and the Senate report, I find that that wasn't really the issue.  The investment bank had no problem pricing and managing similar positions.  The big problem was that the CIO didn't mark their books accurately and kept adding to losing positions.  This is not too different than Nick Leeson blowing up Barings; there is nothing too complex and difficult with simple, straight index futures contracts.  But there is a big problem if you don't mark your positions correctly and you keep adding to positions hoping things will turn around.

The problem seems to me what I initially suspected; Ina Drew was sort of like a teacher's pet and operated outside of the class rules.  If Ina is OK with it, Jamie is OK with it.  And noone messes with her or challenges her business.  THIS was the big problem.   The same trades would not have happened if it was in the JPM investment bank (or if it was, it would have been managed very differently).

And I don't think this will ever happen again. I don't think JPM set up all of these checks and balances just so that some people wouldn't have to operate within them.  It's very clear to me that that was the biggest flaw in this case; JPM had all the tools, expertise and understanding to prevent something like this, but it wasn't applied at all due to the above "teacher's pet" syndrome.

The Senate report wants to use this incident to prove that derivatives are too dangerous, that trading is too dangerous, that risk management models don't work (Dimon has always said for many years that he doesn't like VAR models) etc...    But my view is much simpler than that.

Having said all that, I am not saying there can't be more losses elsewhere in the bank.  There probably will be other derivatives losses, just as there will be losses on municipal bond holdings, sovereign credit holdings, credit card loans and mortgages.

On the contrary, I think Dimon and JPM handled this situation very well.  It did take the press to call management's attention to the problem position, but once they realized what was going on, they disclosed it, put a team on it and resolved the problem within the year.  And it's amazing to look at the above performance figures (earnings, tangible book growth etc.) and think that people are calling for Dimon's head (while many CEO's will make stupid mistakes that will cause their firms to book losses constantly without anyone calling for their heads!).   Dimon 'only' made 15% return on tangible book because of the dumb whale loss; off with his head!

I know many people will disagree with this view and that's OK.  I am just saying what I think and how I look at all of this.

Anyway, back to the annual report:


Port of Safety
Dimon said, "We want the public, our regulators and our shareholders to have confidence that we are the safest and soundest bank on the planet".

State of the World
And Dimon does spend some time talking about the state of the world.  I guess this is to illustrate how much potential business there is for JPM in the future (contrary to calls that investment banking is dead).

Not that I get macro advice from bank CEO's, here is what he sees:

• World GDP is projected to grow +5%/year through 2017
• Keeping pace with global GDP growth will require $57 trillion in infrastructure investment between now and 2030.  This is 60% more than $36 trillion spent in the past 18 years.
• Emerging economies will likely be 40-50% of this infrastructure spending
• The value of the world's exports grew an average +11%/year between 2001 and 2011.  This may continue "if not accelerate"
• Global cross-border capital flows grew by 4x in the last two decades and that will likely continue
• Foreign direct investment grew as a share of total global capital flows in the last five years from 22% in 2007 to 38% in 2012.  This trend will likely continue
• In 1990, 19 of the top 500 multinationals were from developing economies.  In 2012, 125 were. In 2012, 32% of global capital flows went to developing countries versus 5% in 2000.  China and India will account for the greatest number of new multinationals in the next 15 years
• Majority of world's population live in urban areas.  This will grow to 70% by 2050.  This will fuel demand for infrastructure, clean water, schooling, healthcare etc...
• Total global financial assets of consumers and business were $219 trillion in 2011; this is projected to grow 6%/year through 2020 to $370 trillion.

U.S. in Great Shape But...
He points out the usual strengths of the U.S. (similar to Buffett's view) but points out problems too:

• Needs good immigration policy:  it's a problem when 40% of foreignors who get advanced degrees in science, technology, engineering and math can't stay in this country even if they choose to.
• Infrastructure:  we need a good 20-year infrastructure plan
• Citizens need better opportunities:  problem when 50% of inner city high school students don't graduate
• Need rational long term fiscal policy

Risk
Dimon also points out there are risks to the current global fiscal and monetary policies.  He says, "We don't know the outcome of these efforts".

He points out that in 1994 and 2004, short term and long term interest rates went up 300 basis points within one year and a lot of people got hurt.

He is not predicting a similar rise in interest rates but he says the bank is prepared for one.  The bank is positioned such that if rates went up 300 basis points in one year (and all else equal which they are not!), JPM's pretax income would be $5 billion higher.

He says, "You should know that it costs us a signicicant amount of current income to be positioned this way.  But we believe it is better to be safe than sorry".


Demand/Opportunities
Dimon doesn't seem like a guy that listens to management consultants, but he does quote McKinsey estimates to show the opportunities for the bank:

• Corporate equity and debt issue demand could grow 25-30% over the next five years
• Global investor client demand could grow 20-25% by 2017
• Loans outstanding for small to mid-sized enterprises projected to grow 6%/year through 2020.  JPM grew middle market loans 14%/year from 2009-2012.
• Investable assets of high net-worth individuals globally rose almost 9%/year from $33 trillion to $42 trillion between 2008 and 2011.  This is projected to grow 6%/year through 2020.
• U.S. consumer financial assets grew 6%/year in the last decade. McKinsey thinks this will continue through 2020.

Conclusion
So JPM is looking pretty good to me.   At $49.40, it's trading at around 1.3x tangible book so it's not such a table-pounding buy anymore, but it's still a pretty solid hold if not buy.   If it can grow tangible BPS at 10%/year and trade at 1.5x tangible BPS in two years, that's a $70 stock and a 20%/year return (before dividends) without heroic assumptions.   (Tangible BPS has grown at 13%/year in the recent past, but dividends may go up in the future so I used a lower BPS growth rate.  But some of that dividend payout will be offset by improving ROE if the environment continues to improve).

As Dimon said, JPM has been "able to grow it's business, increase dividends, buy back stock AND materially increase capital ratios" in recent years.  But you can also add, "and absorbed the whale loss with barely a blip on the income statement and balance sheets".

Loews 2012 Annual Report

So the 2012 annual report is up on the website.  They revamped it and Loews even has a new logo.

Here is the new logo:

I'm not an art major or anything like that so I don't know anything about it but my first impression was that this looks a little retro, even Art Deco-ish.  Loews is going for a more contemporary look with this, apparently, but it looks more retro than modern.  But then again, what do I know.  I'm sure they paid good money to a well-schooled designer to create it so it must be good.

For reference, here is the old logo:



Not to complain too much, but many of the materials on the website including the ones updated in 2013 still has the old logo.  That sort of spoiled the 'freshness' of the new website.  

Anyway, what the heck am I talking about?  Who cares.   Let's look at some stuff in the annual report.   This is not a summary by any means, but just random comments that came to mind as I read through the report.

There is really nothing new here, just stuff we already know.  In this year's annual report, they put in the stock price performance versus the S&P 500 index for 10, 20, 30, 40 and 50 years:

...and the usual shares outstanding comparison.   They are very good allocators of capital and they do buy back a lot of stock.  Share count is down by 2/3 since 1971 which is very reassuring; these guys aren't going to go on a buying binge just to get bigger or use up excess capital.




They explain their approach to investing.  I think investors are antsy that L is sitting on so much cash; they wonder when they will do a big deal that might get the market excited about L.  So this is their response to that, I suppose.

Substantial Investments
Tisch did say that although they haven't done any large acquisitions, they have been investing actively at the subsidiary level.  L has spent or committed $6.5 billion since 2010 through their subs. 


Sum of the Parts Valuation

And as usual, here is the sum of the parts valuation of L they include in their annual reports and presentations (stock price data as of Feb 1, 2013).   I haven't talked about the numbers in this post at all since I already did some work on the 10-k in my previous posts:  Loews Adjusted Book Value Update and More Adjustment to Loews Book Value.

Hedge Funds
L mentioned hedge funds in the annual report, that they invest 5% of CNA's investments in limited partnerships.  People are always asking who they allocate capital to, or what the performance is like.  In the annual, they said that in the past 15 years the partnerships have earned 11%/year.  In a recent interview, Tisch said that the hedge funds over time have earned 5-10% more than the 3 month treasury rate.

Also, at the website on the annual report page is a presentation called "Company Overview" which is worth reading.

From there is a little more about L.  I won't summarize everything that's in there but here are some interesting things I'll cut and paste here.

First is how well Diamond Offshore and Boardwalk has done for L.  People criticize Diamond Offshore as having an old fleet, but Tisch explains in the annual report that the age of the fleet might be old, but they have spent a lot of money building new rigs and rebuilding old ones and these rigs do get contracted out at good rates so that's what counts.  Diamond's returns over time is shown in a table below.  Also, L has taken a lot of cash out of Diamond over the years.  Boardwalk has also done well and even though they just invested in 2003, they have already gotten back their total investment (invested a total of $3.2 billion and got it all back already and they still own a bunch). 

That's pretty good.

The company overview presentation shows some promising trends in their subsidiaries.  Here's one that Tisch has been talking about; the firming of pricing in P&C insurance:

If this continues, obviously it would be good for CNA, which accounts for a large part of L's value. 

 



Contrary to what you would imagine, ultra-deepwater day rates are trending nicely, getting back up to the 2007-2008 highs.  This is good for DO, of course, since they have some new rigs coming online soon.

 DO has performed well over time:

And they think that natural gas demand will rise over time:

Lotta Value: Investment Hunter
And I don't know if this is desperation, but they put up on the website a comic book, oops, sorry, I meant graphic novel (this makes it OK for adults to read, I suppose) to tell the Loews value story.  I know they have been frustrated for years that L doesn't trade at or above the sum of the parts.  Tisch believes that L is worth more than the sum of the parts, and it has been frustrating for him for many years.

So this is where they go.  They turn to a comic book!  Oops, I mean graphic novel.  I suppose it's OK.  There's nothing wrong with having some fun.  But I would be shocked (and scared) if Lotta Value helped narrow the discount between stock price and intrinsic value. 

I know Warren Buffett has been frustrated too with the stock price of Berkshire Hathaway, pounding the table recently in his annual reports insisting that BRK is worth far more than book value. 

If Buffett did a comic book, maybe he would borrow some talent from Iger (Disney) and do a better one.   Who knows.

This one certainly won't appeal to the younger crowd... but then again, the younger crowd is not the ones with the money, I suppose.

 

 

This is just the first page.  You can download the whole thing at the L website.
For people who are too lazy to even read a comic book, they did a video so you can watch that instead.

Lotta Value book and video

I suppose it's good that they are trying new things to get the word out and try to narrow the discount.

Conclusion
The new website is nice.  Simple and fresh, with some new stuff on there.  It would be really great if they put more meat in the history section.  I'm sure there is a lot of interesting stuff they can put there.  The new logo to me is nice even though it doesn't seem contemporary to me.  But what do I know, and why am I even talking about it?  What difference does it make to an investor?

Flipping through the annual report and company overview, I get the sense that L is really on top of things and are working hard to create value.  There does seem to be a lot of potential in their various areas of investment.  If the CNA turnaround really works and they get their combined ratios down, premiums go up and rates keep firming, there can be some real upside in the stock as CNA is still trading cheap.  Interest rates might have to go higher, though.  

Diamond Offshore looks good too in the longer term as it does look harder and harder to find cheap oil and oil companies will need to keep drilling. 

I'm actually surprised at how well Boardwalk is doing despite low natural gas prices and L sees a lot more growth ahead which is good. 

Loews Hotels too seems to be more active.  For a long time, it seemed to me that it was just there.  They owned some nice hotels but it just didn't really do anything.  Now it seems like there is some activity going on, so we'll see how that goes.

Anyway, other parts look interesting too.  Have a look for yourself.

 

Markel 2012 Annual Report

The Markel (MKL) results have been out, but I just noticed that the annual report is out too (I don't check so it may have been out for a while).  The MKL annual report is a very good read of you have the time to check it out.

We know this from the earnings release, but MKL grew book value a nice +14.7% in 2012 (despite Sandy) and had a 97% combined ratio.   They had a $399 million reserve release last year, but that's because they tend to be conservative in their reserving (they explain it in the annual report).  Some may complain that the combined ratio in recent years is phoney due to these releases, but that's like saying AIG isn't really as bad as it looks because they are just taking hits on past policies they wrote that were bad.  If we can penalize some for under-reserving, why should we penalize others for being conservative?

Anyway, the investment portfolio at Markel did quite well too with the equity portfolio rising +20% and fixed income portfolio earning 5%.

There was a nice explanation in the report about their approach to equity investing.  Their equity portfolio has returned +9%/year in the past ten years (versus +7%/year for the S&P 500 index) and +10%/year in the past twenty years (versus +8%/year for the S&P 500 index).  I wonder if there are any mutual funds or even hedge funds out there with 20 year returns like this?   Probably not too many.

The book value per share (BPS) at MKL also increased nicely over the long term rising +13%/year over  ten years (versus +7%/year for the S&P 500 index) and +16%/year over twenty years (versus +8%/year for the S&P 500 index).

This is how they explained what they do in their equity portfolio (this should be boringly familiar to regular readers here):

MKL's underwriting continues to do well (MKL combined ratio):

And here is an updated table on their investment portfolio:

There's a lot more in the annual report so check it out.  

Anyway, all of these five, ten and twenty year figures got me curious.  I do follow a lot of these "Berkshire-like" entities and have been updating their performance so I figured, why not put all of this stuff into a table?   The annual reports of these entities are starting to dribble out (Y and FRFHF are out too).  How are these guys doing compared to the S&P 500 index and Berkshire Hathaway over time?  

                          2012           5 year          10 year        20 year
MKL                +14.7%        +8.8%         +13.1%      +16.1%   
Y                     +10.8%          +6.1%           +8.8%            na
FRFHF              +6.5%       +10.6%          +11.6%      +16.2%
L                        +5.1%         +9.6%         +10.0%        +11.2%        
LUK                  +9.6%          +2.0%        +12.4%        +10.6%
GLRE                +1.9%          +5.8%

BRK                 +14.4%        +7.9%         +10.6%       +14.4%
S&P 500          +16.0%        +1.6%           +7.1%         +8.2%

(All of the above include dividends except LUK and FRFHF.  FRFHF 2012 return includes dividends, but historical BPS growth does not)

What's pretty amazing is that not only did MKL beat the S&P 500 index in most time periods, it also beat BRK in all of the above time periods.  Of course, it's not in the nature of the MKL folks to mention that in their annual report, but there it is.

MKL is trading now at $504/share versus 2012 year-end BPS of $403.85/share, around 1.3x book.  MKL is certainly not dirt cheap but with performance figures like the above it may well be worth the premium.    

(Update after the fact:  The above $403.85/share BPS doesn't take into account the Alterra merger which will be about 4% accretive to BPS.  Plus a strong stock market, up 10%, would push up pro-forma BPS by another 3% or so, so the BPS would be 7% higher (the equity portfolio would be 30% or so of pro-forma shareholders' equity))

More Adjustment to Loews Book Value

So I made a post about the adjusted book value per share of Loews (L) and someone kindly responded that there are publicly listed MLP general partnership (GP) interests that I can use to value L's GP interest and IDR (incentive distribution rights) in Boardwalk Pipeline (BWP).

The thing to do, of course, would be to calculate the implied valuation of the GP/IDR from these listed entities at current prices and I may actually do that at a later date.

But for now, I just wanted to get a sense of the valuation of these things so I did some googling first (to avoid too much work!).  Keep in mind I'm not the best googler in the world, but I did find something interesting. 

There are some presentations and reports out there that value these GP/IDR interests very highly.  One report analyzed the implied values of GP interests (as a ratio of total GP cash flow (including IDR) based on acquisitions between 2007 and 2010.  The low was around 12x and the high was almost 60x with a median of 24x and average of around 28x cash flow.

Even Kinder Morgan (KMI), when it IPO'ed, came out at 25x cash flow (IPO enterprise value / total GP cash flow).  This valuation would include income from their limited partnership interest too.

For some clean numbers, I looked at the merger proxy of the Kinder Morgan - El Paso merger.  Merger proxies are great because of the valuation work included in there (even though we spend time laughing at investment bankers, sometimes that stuff comes in handy).

Anyway,  according to the proxy filed in October 2011, the peer group valuation of the general partnership interest that KMI owns as a ratio enterprise value (EV) of only the GP portion / GP distribution (including IDR) was valued using this peer group:

Alliance Holdings, L.P.
Atlas Energy, L.P.
Crosstex Energy
Energy Transfer Equity
NuStar GP Holdings
Targa Resources Corp

The valuations (EV of GP only / GP distribution including IDR) were:

                 mean             median            high           low
2011e        20.9x             19.4x               29.5x        15.5x
2012e        17.7x             17.2x               21.7x        14.5x

Since we know the 2012 cash flows for BWP, let's just use the 2011 estimated valuation of 19.4x median or 20.9x mean.  We can just use 20x because it's a simple round number.

There was also a historical transaction analysis done by Barclays of GP transactions between 2003 and 2010.  The valuation ranged from:

           low         median            high
           12.7x      18.8x               26.1x

Barclays added to this EV valuation KMI's holdings in the LP's, so the above 18.8x figure is for the GP-IDR cash flows alone.   The deal universe was:

Sellers:
Penn Virginia GP Holdings, LP
Enterprise GP Holdings, LP
Inergy Holdings, LP
Buckeye GP Holdings, LP
Magellan Midsteam Holdings, LP
Markwest Hydrocarbon, Inc.
Kaneb Pipeline Partners, LP & Kaneb Services LLC
Plains Resources, Inc.


Again, this points to a valuation in the 19-20x range, far higher than the 10x multiple I put on the cash flow in my L valuation post.

Loews Adjusted BPS Updated
So, adjusting the prices of DO, CNA and BWP as I did in my last post to current prices, we get an adjusted BPS of $52.21/share for L now.  This figure does not include the 2% GP interest and the IDR.

Here is the cash flow from the 2% partnership interest and IDR paid to L in the past four quarters:

Amount Paid to GP (including IDR, millions)
February 2012:     $9.1
May 2012:            $9.6
August 2012:      $10.2
November 2012: $10.8
Total:                   $39.7

Using the above figure of 20x, that comes to  $794 million for the value of the BWP GP, and with 392 million shares outstanding, that comes to around $2.00/L share.  

Add this to the $52.21 above and we get a total adjusted book value of $54.21/share.   With L now trading at around $44/share, that's a 19% discount to adjusted book value.

This is just a quick look at this piece of L.  I don't think people spend too much time on it as it doesn't take up a large percentage of the value, but if BWP keeps growing, this can get big enough to really make a difference.

I don't follow MLP/GPs at all so there is probably a lot more that can be done here in terms of fine tuning the valuation (or more recent proxy/valuation tables), but for now, I think the above look is a little better than just randomly throwing a 10 multiple on the GP cash flows.  Good enough for me (for now).