Friday, October 10, 2014

The Halo Effect

After posting about the Collins book, Good to Great, some people mentioned the book The Halo Effect: . . . and the Eight Other Business Delusions That Deceive Managers by Phil Rosenzweig as a counter to it.

So of course, I got it and read it right away.  And it's a really good book.  I agree with a lot of what Rosenzweig says and this is one of the reasons why I generally don't read management "how-to" books.  If I do read them, I read them quickly and don't think much of them either way because, frankly, I have never really been all that interested in management.  I have never wanted to be a manager or CEO or anything like that at all.  Mostly, I read it to get corporate histories especially if they include case studies.  Ironically, I actually read them precisely for the "stories".  How to improve a business or build a great corporation, to me, is secondary and not all that important.  It's the stories that I want to read.  And it's this "story-telling" that Rosenzweig criticizes.  He says that many of these management books (like the Collins books) are not scientific studies but are just a bunch of great stories.  That's actually totally fine with me.

In any case, I enjoyed reading Good to Great, and think it was useful.

Amazon/Bezos Book
I also just finished reading The Everything Store: Jeff Bezos and the Age of Amazon.  This is a really good read and I think everyone should read it, even people who don't invest in internet companies.  The way Amazon is changing the world goes way beyond internet businesses so I think it's an important piece of the puzzle for anyone who wants to understand business and what's going on in the world now.

This is a really well-researched book and one of the better business profile books.  There are a lot of books that seem to have been thrown together over a single weekend with sources/information seemingly acquired in a bar nearby a company headquarters.  When Apple got hot, a few books came out that were like this; very little new or interesting information and anonymous sources spewing gossip (as if the author hung out in a bar for a few nights and talked to some lower level employees), but no real, substantive information.  (The Walter Isaacson book on Steve Jobs was really good, though).

This one is not like that at all.

One thing that is scary is that it seems like Bezos doesn't even want to raise prices at all.  Some people expected Amazon to lower prices and put everyone out of business and then later raise prices to make a ton of money.  But that seems not to be the case.  At one point in Amazon's history, they were actually contemplating raising prices.  But Bezos' model for Amazon was Sam Walton.  He really dug into his book, Sam Walton: Made in America.  Around the time Amazon was thinking about raising prices, Bezos met with Jim Sinegal of Costco and heard that they won't raise prices to make more money.   Apparently, after this meeting, he resolved never to raise prices for the sake of making money.    I did scratch my head at this part in the book thinking that Costco actually makes money and has a decent return on capital; why won't Amazon raise prices enough to at least make a little bit of money?

Bezos / Good to Great
Anyway, I went off on this tangent for a reason.  As I was reading the Bezos book, I was surprised that Bezos was deeply into Jim Collins and even had him come to Amazon to show them how Amazon can become a great company.

Apparently, a light went on at Amazon due to Collins' presentation (which was based on the then yet-to-be-released book, Good to Great).   The part that clicked with them was finding out what they were really good at and then developing it and get the flywheel moving.

Back to the book.

So what is the Halo Effect?

The Halo Effect
There is a good summary of the book on Wikipedia: Wiki: Halo Effect.
  1. The Halo Effect of the book's title refers to the cognitive bias in which the perception of one quality is contaminated by a more readily available quality (for example good-looking people being rated as more intelligent).[6] In the context of business, observers think they are making judgements of a company's customer-focus, quality of leadership or other virtues, but their judgement is contaminated by indicators of company performance such as share price or profitability. Correlations of, for example, customer-focus with business success then become meaningless, because success was the basis for the measure of customer focus.
There are other delusions (nine in total) that are summarized on the Wiki page.

I agree for the most part with what the book says about these cognitive biases and delusions, but I wouldn't go as far as to say that these biases make Collin's book and many business press articles worthless.  Rosenzweig doesn't go that far, but comes pretty close.

Any time someone says they want to investigate why some companies succeed and why others fail, I am going to be interested.  The methodology may not be perfect and there may be flaws in the assumptions.  But that doesn't really matter so much as just reading about what people did over the years; what worked and what hasn't can be interesting on it's own and you can make your own adjustments about the respective biases.  Rosenzweig uses Cisco as an example of how everyone thought it was such a wonderful company during the internet bubble (great customer service) and then the very same reporters talked about how lousy Cisco is (with horrible customer service) after the bubble popped  (I think most of us, though, recognized Cisco as a huge beneficiary of the internet bubble in a virtuous circle and had no doubt it would eventually reverse).

If you had access to some of the top CEO's in the country and you were able to have lunch or dinner with them, wouldn't you do it?  Of course you would.  And of course you would learn something from doing that a lot.

And of course you would be subject to all of the same biases discussed in Rosenzweig's book. You would be talking to people you see as successful, and they will tell you what they have done, but there is no way to tell what the cause and effect was (were employees happy because the company was successful and the stock prices (and therefore their 401-k's and stock options) were up a lot, or did happy employees create the success?

But you would still do it.   And you would still ask the same sort of questions.  And then you would make adjustments to what you hear  (and even those adjustments would reflect your own biases).

I guess what Rosenzweig has a problem with is how Collins simplifies and distills all of the case studies into a simple formula, but I think most readers read these books to get ideas and inspiration more than any sure-fire, fool-proof method of eternal success.

Managements Don't Matter / Nothing is Forever 
Rosenzweig also presents a study that shows that CEO's don't really matter as much as we think.  This may be true, but taking that to the extreme is not so great either because I don't think anyone would agree that the CEO doesn't matter.  I do think there are good CEO's and bad ones.  But that is not to say that good CEO's can't have bad results and vice versa.   He also points out that it is impossible to build a great company to stay great forever.  You can't build something to last.  He shows that previous excellent companies, companies built to last and good to great companies have done worse than the S&P 500 index, and the less favorable comps did better.  All companies go through a life cycle.  I agree with that too.

I personally believe more in CEO's than corporate cultures.  I would rather invest in a CEO I truly believe in (Warren Buffett, Jamie Dimon etc.) than a company known to have a strong culture of success (even though Goldman Sachs is one that I believe in strongly).

As an investor, I am highly skeptical of corporate cultures in general, unless it has been proven over multiple generations (like Goldman Sachs).  The fact that firms like Starbucks, Uniqlo (Fast Retailing), Dell and others floundered after their founders left (and they had to come back) makes me wonder about the importance of cultures versus CEO's.

Efficient Markets
Anyway, all this talk of CEO's not mattering too much and nothing can be built to last reminds me of the efficient market theory.  In the pure form of efficient market theory, the markets are too efficient for anyone to outperform.

That would make books like Intelligent Investor and Securities Analysis meaningless.  And all those Superinvestors (of Graham and Doddsville), Money Masters, the New Money Masters and the managers/traders in the various Market Wizards books by Jack Schwager would all be monkeys that just happened to flip a few heads in a row.

I haven't checked, but I tend to think that most of the managers covered in these books have done well over time, even after being featured in them (OK, maybe I said that about Good to Great and Rosenzweig has proven otherwise).  Sure, Tiger, Steinhardt and others closed shop after a bad year or two, but they closed out their careers with incredible track records.  I think there might have been some blowups in the commodities trading world (Richard Dennis?), but most people in the above books have gone on with great records (although increased size have lowered returns for many of them; the more common lesson in outperforming managers is that size kills performance).

Markets are Efficient Because Mutual Funds Don't Outperform?
One thing people keep pointing out is that markets are efficient because most mutual funds don't outperform.  This is something that I've been thinking about on and off for years.  Why do some people outperform while others don't?

Most mutual fund companies are asset gatherers.  Their primary goal is to increase earnings of the management company.   And we all know that increasing asset size makes it harder to outperform the market.

So at the asset management company level, they are incentivized to increase AUM.   They are paid a percentage of AUM so this makes sense.  If you want to increase earnings, you have to increase AUM.  It doesn't matter if it gets harder to manage as they don't get paid on performance.

At the fund manager level, managers don't want to diverge too much from the index.   If they stay more or less within a reasonable range of the index, they will be fine and won't get fired.  The risk/return is asymmetric in this case if you want to take big risk to outperform (OK to fail conventionally etc.).

So the asset management industry is often not even trying to outperform.  They are trying to maximize earnings to the management company.

Missing the Trees for the Forest
Anyway, I brought up this efficient market argument because the "CEO's don't matter" argument sort of reminds me of it.  When you look at the data overall, you might find that CEO's actually don't matter, just as if you looked at the performance of mutual fund managers (or research analyst buy/sell recommendations), you would think the market is efficient and fund managers don't matter.

Oftentimes, the big figure can obscure the little facts.

For example, back in 2000 when the stock market was trading at 30x p/e (or whatever it was), people concluded that stocks were not good investments.  That's sort of missing the trees for the forest because BRK and many other value stocks were trading at attractive levels.

CALPERs recently decided not to invest in hedge funds.   This may be the right choice for them; it seems like they couldn't allocate a meaningful amount to hedge funds and the cost of maintaining such a small percentage of the portfolio just didn't make sense.  That's totally reasonable.

On the other hand, I always hear figures about some hedge fund index and how that hasn't done too well.  There are a lot of hedge funds out there and most of them are probably no good.  But there are really good ones.  The problem with hedge funds, usually, is that the good ones are closed.  So again, I wouldn't look at the hedge fund index to decide whether hedge funds are good or not.  I would just look at funds individually and if there is a good one, invest in that and otherwise don't.    A lot of information is lost when you look at the various indices.

Likewise, if a study shows that the CEO doesn't really matter too much, that doesn't mean that much to me.  If you look at a big enough group, then bad industries or bad cycles can easily offset good CEO's and the sum of everything might make it look like CEO's don't matter.

Well, I don't know that there is a conclusion to this post.  I think the Halo book is a good one and very interesting.  The arguments make sense. But on the other hand, there is a bit of an "efficient market" sort of thing going on there too.

I like "stories" and I don't think there is anything particularly wrong with reading them as long as we understand the context and limitations of those stories.  I know I will keep reading articles in the business press, business books (not "how-to" books, but books about businesses and biographies of business people).

Wednesday, September 10, 2014

Buffett on Market Valuation

I don't really spend too much time on market valuation, but I do think about it and post about it every now and then.  Of course, debate about market valuation is pretty heated these days due to the super-high looking Shiller p/e ratio, high profit margins etc.

I was reading through some old Buffett annual reports and found a great primer on how Buffett thinks about stock market valuation so I thought I'd post it here.  This is similar to what used to be called the Fed model (earnings yield = 10 year treasury yield).  The Fed model has been criticized because it only worked for a very brief period (back in the 1980's) and hasn't worked most of the time.  (Earlier this year I skimmed through all of Buffett's partnership and BRK annual letters to find comments related to the stock market, but I am now rereading all the annual letters from 1965-2012 again slowly, word-for-word).

But we can see that Buffett does in fact think about stocks using a similar approach.  And this makes sense because there is a rational reason why earnings yield can be fairly compared to treasury bond rates.  This is not to say that the stock market will always trade at parity with bond yields (history shows that it doesn't).

This may be relevant now to understand why some people like Buffett keep saying the market is trading in a "zone of reasonableness" while some charts show the market to be way out in terms of historical valuation.

And yes, we do understand that Buffett's comments make sense when you think about where interest rates are today (he does keep saying that stocks are better than bonds).

Anyway, this is a long clip but well worth reading almost as a primer on stock valuation, inflation etc.

From the 1981 Berkshire Hathaway letter to shareholders:

Equity Value-Added

     An additional factor should further subdue any residual enthusiasm you may retain regarding our long-term rate of return. The economic case justifying equity investment is that, in aggregate, additional earnings above passive investment returns - interest on fixed-income securities - will be derived through the employment of managerial and entrepreneurial skills in conjunction with that equity capital. Furthermore, the case says that since the equity capital position is associated with greater risk than passive forms of investment, it is "entitled" to higher returns. A "value-added" bonus from equity capital seems natural and certain.
     But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a "good" business - i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than one hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.

     Investment markets recognized this truth. During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were "good" businesses because they earned far more than their keep (the return on long-term passive money). The value-added produced by equity investment, in aggregate, was substantial.

     That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.

     During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.

     Thus, with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals. (If the business is owned by pension funds or other tax-exempt investors, the arithmetic, although still unenticing, changes substantially for the better.) Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist - if all earnings are paid out and return on equity stays at 14% - the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond. Such a perpetual 7% tax-exempt bond might be worth fifty cents on the dollar as this is written.

     If, on the other hand, all earnings of our typical American business are retained and return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio remains constant, the price of our typical stock will also grow at 14% per year. But that 14% is not yet in the pocket of the shareholder. Putting it there will require the payment of a capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course, works out to a poorer rate of return than the currently available passive after-tax rate.

     Unless passive rates fall, companies achieving 14% per year gains in earnings per share while paying no cash dividend are an economic failure for their individual shareholders. The returns from passive capital outstrip the returns from active capital. This is an unpleasant fact for both investors and corporate managers and, therefore, one they may wish to ignore. But facts do not cease to exist, either because they are unpleasant or because they are ignored.
     Most American businesses pay out a significant portion of their earnings and thus fall between the two examples. And most American businesses are currently "bad" businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.

     It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.

     Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that now must be classified as economically "bad" would be restored to the "good" category under such circumstances.
     A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the "bad" business. To continue operating in its present mode, such a low-return business usually must retain much of its earnings - no matter what penalty such a policy produces for shareholders.

     Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity, does not take the coupons from that bond and pay one hundred cents on the dollar for more 5% bonds while similar bonds are available at, say, forty cents on the dollar. Instead, he takes those coupons from his low-return bond and - if inclined to reinvest - looks for the highest return with safety currently available. Good money is not thrown after bad.

     What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas. (The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised - "wicked and slothful" - but also is required to redirect all of his capital to the top performer. Matthew 25: 14-30)

     But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the "bad" business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.

     For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

     Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or "real" dividends. The tapeworm of inflation simply cleans the plate. (The low-return company's inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of "dividends" that can be paid out only if someone promises to replace the capital distributed.)

     Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after-tax passive return - but barely. Our historic 21% return - not at all assured for the future - still provides, after the current capital gain tax rate (which we expect to rise considerably in future years), a modest margin over current after-tax rates on passive money. It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone's control or from poor relative adaptation on our part.

What Would He Say Now? 
So here are current interest rates:

                  U.S. Treasuries                 Munis
10 year           2.5%                              2.2%
30 year           3.3%                              3.1%

Buffett said that stocks should have higher returns than passive, fixed investments.  Actually, he said that that is the economic justification for investing in stocks.  He didn't say that stock returns should equal fixed income investment returns; just that it should be higher.  So we can see the earning yield - bond yield parity model as the upper limit of stock market valuation.

According to this idea the stock market would have to get up to 30-40x p/e (using the pretax U.S. treasury yield for 10 and 30 years) before it starts to look like stocks aren't worth it.

Using Buffett's tax-equivalent model, assuming 20% long term capital gains and qualified dividend tax rates and 3.1% muni yield, the equivalent earnings hurdle for stocks would be 3.9%; this implies a p/e ratio of 26x.   Using the 10 year muni rate you'd get 36x p/e.  Again, this would be the upper end of a valuation range, not the fair value.

(It's kind of stunning to think that Buffett, in 1981, seemed to be saying stocks aren't worth 7x p/e but says they are reasonably valued now (or at least he said so relatively recently)).

That's silly.  I've seen charts showing the differential between earnings yield and interest rates to show how relatively attractive stocks are.   Those charts do imply that stocks can get to 30-40x p/e and I certainly hope stocks don't get up there.   It probably shows more how expensive bonds are.

Buffett has said that bonds are in a big bubble and is unsustainable (even though I still suspect, because of my having watched Japan post-bubble, that rates will stay a lot lower for a lot longer than most people think).

So if bond rates are unnaturally low due to central bank activity, what is a more natural level of interest rates?

Tangent on No-brainers
What's a post on this blog without an off-topic tangent?  Speaking of interest rates, one of the big no-brainers for 2014 was that interest rates would go up due to "tapering".  The Fed has been buying truckloads of treasuries every month for so long, if they reduced their purchases interest rates will go up.  Simple supply and demand.  It's the easiest trade in the world.  You would have to be stupid not to understand that.  Oops.

I remember a very similar trade when people thought treasuries would crash at the end of QE1 (or QE2, I can't keep track).  The no-brainer trade then was the same; everyone knew that the Fed would stop buying bonds (to the exact date), and everyone knew that this would disrupt supply and demand, and it was obvious that bonds had to decline dramatically.  Oops.  (Bonds rallied dramatically on a collapsing Europe)

One of my early posts on this blog was about gold (Ungold), and gold was a no-brainer too back in 2011.  If the economy recovers, inflation would soar and so would gold.  If the economy didn't recover, then central banks will have to print even more money and QE-infinity would take gold to $5,000.  Heads I win, tails you lose.  No-brainer!   Oops.

Where Should Interest Rates Be?
So then, let's see where interest rates would be on a normalized basis.  First, I thought that the range for the 'real' fed funds rate was around 2.00% - 2.50%.  But a quick googling tells me that it averaged 2.7% between 1984 and 2005 (real rates have been deeply negative in recent years, so no need to update).

If inflation is 2.0%, then the Fed Funds rate should be around 4.7%. What about the yield curve?   The spread between the 10-year treasury rate and Fed Funds rate since 1954 was 1% or so.  That would give us long term rates of around 5.7%.   In that case, this would imply a p/e ratio of 17.5x (as the high end).

However, the 20 year and 30 year average spread between the 10-year treasury rate and Fed Funds rate is 1.5% and 1.6% respectively.   Using 1.6%, we get a normalized 10 year rate of 6.3%, or an implied p/e ratio of 15.9x.

The S&P 500 index, on a trailing twelve month basis, is trading at a 19x p/e ratio now, and 16.7x forward earnings estimate.

Nominal GDP Growth Rate
OK, so the above normalized interest rate guesses might be a little "noisy".  I used real Fed Funds rate and then assumed a yield spread. That's too many indirect assumptions.  Don't assume because...
Another more simpler model for normalized long term interest rates is simply the nominal growth in GDP.

I just googled this and cut and paste it from an old BlackRock report.  The data is from 1963, so it shouldn't matter too much that it's not up to date.

Using this idea, I think the expectation for real GDP growth is between 2% and 3%, and inflation is expected to be around 2%.   The 10-year breakeven inflation rate (on TIPs) is currently around 2.1%.  It looks like it gets above 2.5% every now and then so we can use that too to be conservative.

So putting the above together, if you assume 3% real GDP growth and 2% inflation, that's a 5% 10-year treasury rate and implied 20x p/e ratio.

I think at the annual meeting, Charlie said that it would be insane to expect more than 1% growth over the long term.  If that is the case, and inflation is 2%, we'll be looking at bond yields of 3% (and 33x p/e ratio).

But more realistic might be 2.5% real GDP growth and 2% inflation for a bond yield of around 4.5% (22x p/e).  Oh, and that would be 5% and 20x p/e if you used 2.5% inflation.

You can use whatever assumptions you want and get your own 'normalized' long term interest rate.  And yes, I know.  Nobody can really forecast economic growth or inflation with any accuracy; I'm just thinking out loud and trying to get my arms around this stuff.

Low Inflation? Really?!
And yes, of course many of you would laugh at the notion of 2% or even 2.5% inflation.  With what all the central banks are doing around the world, it's not possible for inflation to remain low for long.  Even Buffett said that there will be consequences to all of this and it won't be pretty.  He may be wrong this time too, though; he was wrong in 1981 when he said:
In past reports we have explained how inflation has caused
our apparently satisfactory long-term corporate performance to be
illusory as a measure of true investment results for our owners.
We applaud the efforts of Federal Reserve Chairman Volcker and
note the currently more moderate increases in various price
indices. Nevertheless, our views regarding long-term
inflationary trends are as negative as ever. Like virginity, a
stable price level seems capable of maintenance, but not of
I have followed Japan over the years so I suspect we are in a similar situation (but much better, of course).  The old rules of monetary policy and inflation may not apply.  I know this sounds like "this time it's different".  But it sort of is in many ways when you think about it.

High Inflation in the 1970's and 1980's
Many people seem to think that we will have another 1970's-like inflationary situation.  It might happen, but what bothers me about that is that I strongly believe that the 1970's inflation wasn't really a function of bad policy in the 1960's and 1970's (well, the overspending in that period by the government was a catalyst for sure) but more of a huge adjustment of an unsustainable global monetary structure that was in place for decades.

I think the view is that the U.S. leaving the gold standard was one of the reasons why inflation went out of control, and our abandoning of the Bretton-Woods fixed currency system contributed to the chaos.  Books have been written that say things were fine with the gold standard and Bretton-Woods and only after we ditched them did things blow up (so therefore we should go back to them; which makes no sense given the history of price controls!).

Well, my view is exactly the opposite.  I just think the 1970's was a huge adjustment to the huge imbalances that were built up over the decades after World War II.  As we have seen over and over in the past twenty years with the Asian currency crisis, Latin American crises, Euro etc., fixed currency systems just don't work.  And neither did Bretton-Woods.  The 1970's was the global version of the above currency crises that we have seen over and over again since then.  And they were mostly due to fixing exchange rates, not floating them.  Fixing them allowed unsustainable imbalances to build up.

Gold prices were fixed for a long time too (even longer than the currencies in the Bretton-Woods system) so that had an even bigger imbalance built up.  It was quite a coiled spring by the time the price control was lifted.

So when I look at it that way, I don't see what that imbalance is, necessarily, that would cause high inflation now.  As Dimon said, a lot of the QE money is sitting as reserves in the banking system.  When QE is withdrawn, the money will leave bank reserves.  This has no real economic impact.

Where is the coiled spring today?  (Yes, QE is artificially keeping interest rates low.  That is one coiled spring to be sure.)

But anyway, despite all of that, I am not forecasting low inflation forever.  It's more of an expression of my doubts about high inflation on the horizon that so many people expect.  As I've said for a long time, my suspicion is that we go along the road that Japan has, but in a much better situation.

I really have no idea what is going to happen; where GDP or inflation will go etc.  I have no clue.

But playing with these various factors that might impact p/e ratios, I can see why many see the market as reasonably valued despite the really scary looking Shiller p/e charts etc.

Sunday, August 24, 2014

Good to Great: The Stockdale Paradox

After watching a video of Carlos Brito pounding the table on the book, Good to Great by Jim Collins, I had to reread it.  I read it years ago when it came out and thought it was a great book, but rereading it now, I enjoyed it even more.  That's because I've spent more time since then reading about businesses, annual reports, and watching companies succeed and fail over the years.  So I have many more reference points to relate all of this stuff to.

It is fun to read about Wells Fargo and how together they are, and it's nice to see that they have maintained their "greatness".  Unfortunately, Circuit City and Fannie Mae no longer exist, but most of the others have been doing well since then.  Collins did say that if these 'great' companies change, or don't continue their great ways, they will quickly fall back to mediocrity or worse.

By the way, here are the great companies in the book:
Circuit City
Fannie Mae
Philip Morris
Pitney Bowes
Wells Fargo
An interesting point is the contrast between this book and the Outsiders book.  Jim Collins even points out Teledyne and Henry Singleton as an example of a "genius with a thousand helpers"; a company that did well under a genius and then stumbled when the genius departed.

As an investor, either one is fine with me.  I don't mind investing with "geniuses" (that's what we do when we invest in Berkshire Hathaway and other companies not to mention some funds/hedge funds).  And I would love to invest in great companies too even if they are not dependent on a single genius.

Anyway, both are great books so there is no need to compare.  Each book looks at businesses from a different angle (one looks at great companies (and how they became so) and the other looks at great CEOs).

Stockdale Paradox
But the thing that really got me (again) is what Collins calls the Stockdale Paradox.  It is a well-known concept now; it is mentioned in survival books (like Mt. Everest survival stories) etc.

And the idea is really similar to what I wrote about in my recent post, Catmull's Mental Models.  

For those who don't know, Admiral James Stockdale was a POW during the Vietnam war; the highest ranked 'guest' in the Hanoi Hilton.   He was there for eight years and was tortured more than twenty times.

Many POWs didn't make it but Stockdale and some others did.

Collins asked Stockdale, "Who didn't make it out?"
"Oh, that's easy," he said.  "The Optimists."
Collins was confused as he thought Stockdale was an optimist as he had no doubt he would get out of his situation.

Stockdale clarified:
"The optimists.  Oh, they were the ones who said, 'We're going to be out by Christmas.'  And Christmas would come, and Christmas would go.  Then they'd say, 'We're going to be out by Easter.'  And Easter would come, and Easter would go.  And then Thanksgiving, and then it would be Christmas again.  And they died of a broken heart."
"This is a very important lesson.  You must never confuse faith that you will prevail in the end - which you can never afford to lose - with the discipline to confront the most brutal facts of your current reality, whatever they might be."
Collins defines the Stockdale Paradox as:
Retain faith that you will prevail in the end, reglardless of the difficulties.
                                                       AND at the same time
Confront the most brutal facts of your current reality, whatever they might be. 

Stockdale Paradox and Value Investing
And of course, I have to tie all of this to value investing.  This concept is very similar to the stuff that the Pixar people shared with Catmull in his book.  They all had mental models to help them get through the inevitable tough times in making movies.  And those models were really good models that would apply to value investing as value investing is not at all easy and have some rough periods.  Bear markets are inevitable, and even the best stocks will go down 50% every now and then (as we know, even Berkshire Hathaway stock does that too!).

And the Stockdale Paradox is a perfect model to deal with this.

Optimists and Perma-bulls
It's interesting how Stockdale puts it when he says that the "optimists" didn't make it.  This sort of reminds me of a perma-bull.

But first, we must define a perma-bull.  Is Warren Buffett a perma-bull?  He is always talking up the future of America, and he is always almost fully invested (he may build up cash every now and then).

Buffett is not a perma-bull in the sense that he is always bullish the stock market (because he is not).  He is more of a market agnostic.  Bull markets will happen, bear markets will happen, but nobody will really know when, so don't try to figure it out.  That's his stance, so it's not really perma-bullish at all.

Perma-bulls are people who always think the markets will go up.  You see this in wire-house investment strategists etc.

So I distinguish perma-bulls from market agnostics.

Optimistic Investors That Fail
So Buffett is a long term optimist, confident that the U.S. will do well over the longer term, just like Stockdale was confident he will get out of his situation.  But like Stockdale, Buffett just doesn't know when things will happen, just that things will work out over time.

Like Stockdale's colleagues that didn't make it, though, there are a lot of optimistic investors that don't make it.  For example, people who were excited about stocks in the late 1990's were optimistic that stocks will continue to earn 15-20%/year just as it had in the recent past.  This was sort of the "we'll be home by Christmas" optimism in Stockdale's story.  Maybe it doesn't seem so bad as the market hasn't done much since then, but most likely, these people piled in at the top and then puked out their positions in the following bear market (and most likely didn't get back in).

If you buy stocks and expect them to go up 10% every single year, you will be disappointed when it doesn't and will probably end up dumping stocks at the wrong time. If you don't think a bear market will come any time soon, then you will be disappointed when one does come and you will probably sell out at the worst possible moment.

Some became value investors after seeing the 1999/2000 internet bubble/crash.  And then they got hit in the financial crisis and swore off stocks altogether.  They were optimistic that they wouldn't lose money as they would stay away from bubble stocks.  When value stocks got hit hard in the crisis, they were disappointed and left.  This too, is sort of like the "we'll be home for Christmas" optimism.

Or how about optimists that believe that their stock will keep beating earnings estimates; once the streak of 'beats' ends, they get disappointed and dump their stock (regardless of whether it is a good long term investment).

Or optimists that believe their stock or fund will beat the market every single year, year in and year out.  A recent study showed that very few people can do that but I found it interesting because it is sort of irrelevant; you don't need to beat the market every single year in every single time period to beat the market.  Most good funds have periods of outperformance and periods of underperformance.  Insisting on outperformance at all times is what leads to trouble.

I can go on and on (and so can most of you).

Most of us who have been in the business have seen this sort of thing happen over and over.  And it's amazing because it perfectly fits the Stockdale Paradox model.

So let's take a look, again, at the Stockdale Paradox as defined in Collin's book:
Retain faith that you will prevail in the end, reglardless of the difficulties.
                                                       AND at the same time
Confront the most brutal facts of your current reality, whatever they might be. 

For retaining faith, we have to believe that whatever happens (recessions, near depressions) that we in this country (including the government) will (eventually) do the right thing.  In severe recessions, they will step in.  Corporations will cut costs and do what needs to be done to survive.   Just as we figured out how to make more food (after Malthus' prediction), whatever problem we face, we will figure it out.

We also have to retain faith that value investing does work over time.  As Joel Greenblatt says, no investment strategy or approach works all the time.  There will be times when value investing doesn't seem to work (and many value investors will abandon the idea).  If you buy something for less than it is actually worth, then over time you will make money.  We value investors can't lose that faith. 

The brutal facts that we have to confront are usually bear markets (in the whole market or just the stock or stocks we own).  The stock market will fluctuate.  No matter how much due diligence we do and how well we know a company, the stock price of that company will go down 50% or more at some point if you own it for the long haul.   That's just a fact that we have to face, and one that many people can't (and that's why they dump stocks at the wrong time!).  If that is not acceptable to us, then we simply shouldn't be investing in stocks.  

This is not fair to Admiral Stockdale, but think of bear markets as sort of the market torturing investors (losing money can't fairly be compared to physical torture).  This is what markets do.  If we hope that there won't be any more bear markets, or that we will be smart enough to get out before the next one, that is sort of like "home by Christmas" optimism and we would inevitably die of heartbreak.

Friday, August 22, 2014

WL Ross Holding Corp (WLRH)

As I was looking through the new lows list in the newspaper, I stumbled upon WL Ross Holdings Corp (WLRH).  Wilbur Ross is a very successful distressed investor so I was surprised to see a listed entity with his name on it.

This is a blank check investment company (or Special-Purpose Acquisition Company (SPAC)), and who cares about those these days?  I am not a big fan of these things, usually, as they tend to just do nothing for a long time and then they either make a good deal or a bad deal and the stock price responds accordingly.   I don't follow these systematically so don't know what the historical record is (even though a quick googling shows that they have generally performed poorly), but off the top of my head, the disasters were things like American Apparel and Crumbs.  Even RLJ Entertainment (RLJE) run by the legendary Robert Johnson (founder of BET) looks like a disaster.   Recent success stories are Burger King and Platform Specialty. 

Over the years I've read a bunch of S-1's for these things and for me it really boils down to the people.  Who is running it and making the investment decisions?  We've had SPACs run by ex-CEOs, private equity guys and even celebrities.   But for many of them, there were no verifiable, independent track records.  So how do you evaluate someone who is going to make one big acquisition without something to look at?

Free Option
The reason why SPACs can be interesting (and the Special Opportunities Fund (SPE) has almost 10% of assets in SPACs) is that they often have a term of two years and if they can't make an acquisition by then the cash is returned to shareholders.  If they make an interesting acquisition, the stock price will pop up and you make a quick profit on the difference between private market value and public market value.   They are usually offered with warrants too, so you can buy warrants in anticipation of making money on the 'pop'.

Hedge funds like them (or used to like them) as they can buy them at a discount to the cash redemption value and vote down acquisitions or redeem their shares for a decent return, especially with leverage (plus the optionality). 

Flat Stock Price Can Be Good
And then it occurred to me that these investment vehicles that remain flat for the most part until some event occurs, with the option of getting your cash back instead of holding onto the shares through an acquisition might be interesting to some in this market where people seem worried about an imminent crash or bear market. 

From the prospectus (dated June 5, 2014):
We will provide our public stockholders with the opportunity to redeem all or a portion of their shares of our common stock upon the completion of our initial business combination at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account described below as of two business days prior to the consummation of our initial business combination, including interest (which interest shall be net of taxes payable) divided by the number of then outstanding shares of common stock that were sold as part of the units in this offering, which we refer to collectively as our public shares, subject to the limitations described herein. If we are unable to complete our business combination within 24 months from the closing of this offering, we will redeem 100% of the public shares at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest (less up to $50,000 of interest to pay dissolution expenses and which interest shall be net of taxes payable) divided by the number of then outstanding public shares, subject to applicable law and as further described herein. 
If the stock market crashed tomorrow, these SPACs will not move in price at all.  OK, maybe there would be some selling pressure in a severe crash, but since the asset is mostly cash, the value wouldn't change at all. 

In fact, SPACs might actually benefit in a crash as it may lead to more investment opportunities. 

So let's just take a quick look at WLRH.  What I like about WLRH is that Wilbur Ross himself is listed as the Chairman and CEO.  Of course, this does not guarantee that he will spend a lot of time on WLRH.  But if he is going to hold those titles, I don't think he is going to just let anything happen.  He will make sure whatever deal happens is a good one. 

There is obviously some conflict here as Ross runs other funds and dealings between WLRH and his other funds are not forbidden.   Will he save the best ideas for his other funds?  Will he dump a bad asset / lemon in his private funds into this entity?  Of course, that is possible.  

But as usual when looking at these things, we have to look at the people.   There are some names that come to mind that I wouldn't trust at all in this sense.  But Ross, as far as I know, has a very good reputation and I wouldn't worry about funky self-dealing here. 

For those who don't know much about him, from the prospectus: 
We believe that our management team is well positioned to identify a value-oriented investment opportunity in the marketplace and that our contacts and transaction sources, ranging from owners and directors of private and public companies, private equity funds, investment bankers, attorneys, accountants and business brokers across various sectors will allow us to generate attractive acquisition opportunities. Our management team is led by Wilbur L. Ross, Jr., our Chairman and Chief Executive Officer, who has 17 years of experience in the private equity industry and 24 years of prior experience in the restructuring financial advisory industry. Over the course of his career, Mr. Ross and his team have invested in approximately 135 portfolio companies across four continents, deploying approximately $10 billion of invested capital. Mr. Ross is the only individual who has been elected to both the Private Equity Hall of Fame and the Turnaround Management Association Hall of Fame.
Mr. Ross is the Founder, Chairman and Chief Strategy Officer of WL Ross & Co. LLC, which we refer to throughout this prospectus as WL Ross, an affiliate of our sponsor. Mr. Ross was also formerly the Chief Executive Officer of WL Ross prior to stepping down from this role on April 30, 2014 to become its Chief Strategy Officer. Founded in 2000, WL Ross is a global distressed private equity firm with approximately $8 billion of assets under management as of December 31, 2013, across private equity, credit, infrastructure and mortgage funds. Mr. Ross and our management team will leverage the relationships of the investment professionals of WL Ross to identify and complete an initial business combination. Acknowledged as one of the world’s leading turnaround groups, WL Ross invests in and restructures financially distressed companies in industries in which the investment professionals of WL Ross have knowledge. WL Ross seeks niche opportunities in markets where it believes its knowledge, insight and experience offer an advantage in assessing and cultivating new investment opportunities. WL Ross has offices in the United States, China and Japan, and WL Ross’ current network of approximately 40 portfolio companies, which operate in over 10 industries and 12 countries across the globe, provide a broad network of relationships and market insights that we believe will help our management team source attractive value-oriented investment opportunities.
Prior to founding WL Ross in 2000, Mr. Ross was the Executive Managing Director of the Restructuring Advisory Group of Rothschild, Inc., where he and his team advised various constituencies through bankruptcies and workouts around the world, assisting in restructuring in excess of $200 billion of liabilities. In 1997, Mr. Ross and his investment team organized their first private equity fund, Rothschild Recovery Fund L.P. In April 2000, Mr. Ross founded WL Ross and acquired from Rothschild Inc. its general and limited partner interests in Rothschild Recovery Fund L.P., which was renamed WLR Recovery Fund, L.P. Our executive officers, Stephen J. Toy and Wendy L. Teramoto have worked at WL Ross since its founding and Michael J. Gibbons has been with WL Ross for 12 years. 
Some of the spectacular failures in SPACs have occured when they bought crappy companies (American Apparel), or companies that were simply not ready to be public (Crumbs?).  This is why I would avoid venture-type SPACs.

Here is what WLRH is going to look for:

Investment Criteria

Consistent with this strategy, we have identified the following general criteria and guidelines that we believe are important in evaluating prospective target businesses, including value-oriented investment opportunities. We will use these criteria and guidelines in evaluating acquisition opportunities, but we may decide to enter into our initial business combination with a target business that does not meet these criteria and guidelines. We intend to seek to acquire companies that we believe: 
Are Well Positioned within Industries Undergoing a Period of Dislocation.  Whole industries or sub-segments within industries routinely undergo periods of dislocation, often due to non-recurring macro-economic forces or disturbances, and our management team has a track record of contrarian investing in such industries and sectors, including banking institutions, basic building materials, financial services, metals and mining and transportation. We believe that the perceived risks inherent in these investment opportunities are often greater than the actual risks, and we believe that we are able to analyze and estimate the size of the actual risks through our diligence process. Within dislocated industries, we intend to target companies that have leading market shares, low-cost operations relative to peers or the ability to attain low-cost operations, defensible competitive characteristics or high barriers to entry, entrenched positions with customers and high potential returns on net assets where our capital and sponsorship can assist companies during periods of dislocation.
Offer Opportunities to Create Investment Platforms for Consolidation or Growth.  Our management team has an aggregate of over 70 years of experience creating platform investments and often consolidating meaningful portions of large industries. Mr. Ross and our management team have previously applied this investment strategy, creating horizontally and vertically integrated platforms, in industries such as steel, coal, automotive component parts and marine transportation. We intend to capitalize on their history of analyzing global macro-economic trends and industry-wide investment themes in the context of potentially creating investment platforms for consolidation or growth.
Have Significant Situational or Structural Complexity.  We believe that our management team has expertise undertaking complex transactions and providing flexible, long-term capital solutions, which often enable us to distinguish ourselves from other financial buyers. We believe that situational or structural complexity often hides compelling value that competitors may lack the time, inclination or ability to uncover. Our management team has historically capitalized on such investment situations, which have often taken the form of business, regulatory or legal complexity. We believe that successful private equity investing in complex special situations requires investment structuring expertise, which Mr. Ross and our management team have developed through their experience investing in approximately 135 portfolio companies. We intend to leverage the operational experience and financial acumen of our management team and the investment team of WL Ross to identify structurally complex opportunities where we believe we have the ability to unlock value for the benefit of our stockholders.
Are Underperforming Their Potential Peak Operational and/or Financial Performance Capabilities.  Companies underperform operationally and financially for various reasons, including due to cost mismanagement, weak relationships with organized labor groups, poorly strategized market positioning, capital investment misallocation, capital structure inefficiencies and ineffective management teams. We believe that given our management team’s experience with value-oriented investing, we are well-positioned to identify investment situations where additional capital investment, effective sponsorship, board of directors supervision and, often, a new management team, will result in improvements in operational and/or financial performance.
Offer a Value Proposition that is Not Recognized by the Market.  Our management team and the investment professionals of WL Ross typically conduct substantial due diligence with respect to potential acquisition targets, with a goal to uncover value that is unrecognized by the market and would allow us to invest in companies and buy assets at prices that we believe to be below intrinsic value. Our due diligence process typically involves an in-depth analysis of the target’s industry, including competitive positioning and barriers to entry; a strategic, operational and technical review; an analysis of downside protection and alternative channels through which we can realize value; a detailed historical and projected financial review focusing on revenue potential and earnings margins, which is done in concert with a stress test of projected financials and, often, a quality of earnings review; capital structure analysis; and an evaluation of a company’s management team and their financial incentives. 

This is a pretty big SPAC, I think, with $500,250,000 in cash held in the trust account.  Common stock outstanding subject to redemption is 47,789,319 shares.  That's a bit more than $10.00/share redemption value ($10.00/share is an estimate and not a guaranteed or fixed redemption amount).  Included in the trust account is deferred underwriting commission of $18,309,150 which is to be paid upon the closing of a deal.  Excluding that, you have $10.08/share in cash in the trust account.

Here's an interesting twist on the deferred underwriting commission:
The underwriters have agreed to waive their rights to their deferred underwriting commission held in the trust account in the event we do not complete our initial business combination within 24 months from the closing of this offering and, in such event, such amounts will be included with the funds held in the trust account that will be available to fund the redemption of our public shares.
So if a deal is not closed within two years, this underwriting commission doesn't have to be paid and will instead go to the public shareholders (shares offered in the IPO).  That would be an extra $0.38/share.  If none of the trust account cash is touched, the redemption value would be $10.46/share if a deal is not done.   With the stock currently at $9.85/share, that implies a 6.2% return over two years (actually, 1.8 years through June 11, 2016); that's 3.4% annualized return.  With interest rates so low, you can see how this might not be such a bad idea.

If a hedge fund can get 7x leverage with funding at Libor+50 bps (which might amount to 70 bps funding cost today), then a hedge fund can earn 18.9%/year ((3.4% - 0.70%) x 7).  

[ Correction after the fact:  The above analysis is not correct, please see comments section; redemption value should be based on 50 mn shares, not 47.8 mn shares ]

Not bad at all in this environment.  7x leverage is usually for long / short positions, but since this position is basically against cash held in a trust, it may be doable.  But I don't know.  Liquidity and other factors might make the economics not applicable here.

Think about that.  They can earn 18.9%/year with optionality; if a nice deal happens, they get a nice pop.

Others would have to settle for 3.4%/year with possible upside.  You can see why the Special Opportunities Fund folks like it; as a basket, it's a reasonable proxy for cash with some upside potential.

This sort of basket approach has never been that interesting to me as you would need a lot of them to 'pop' for your returns to get interesting without leverage.

In this case, you only get that nice return if a deal doesn't get done and the underwriting commission doesn't get paid (and instead goes to the public, non-founder shares).

If a deal goes through and you redeem your shares for cash, then you wouldn't get that extra $0.38/share; at this point you would get only $10.00 (or $10.08 according to my math, but I'm not sure what else is in the trust that I may not have accounted for).  In that case, it's only a 1.5%-2.3% return over 1.8 years.  I'm assuming the cash will generate no interest income.

So of course, someone will just buy up a ton of shares and then make sure a deal doesn't get done.   To prevent that, they have this provision:
Limitation on redemption rights of stockholders holding more than 15% of the shares sold in this offering if we hold stockholder vote
Notwithstanding the foregoing redemption rights, if we seek stockholder approval of our initial business combination and we do not conduct redemptions in connection with our business combination pursuant to the tender offer rules, our amended and restated certificate of incorporation provides that a public stockholder, together with any affiliate of such stockholder or any other person with whom such stockholder is acting in concert or as a “group” (as defined under Section 13 of the Exchange Act), will be restricted from redeeming its shares with respect to more than an aggregate of 15% of the shares sold in this offering. We believe the restriction described above will discourage stockholders from accumulating large blocks of shares, and subsequent attempts by such holders to use their ability to redeem their shares as a means to force us or our management to purchase their shares at a significant premium to the then-current market price or on other undesirable terms. Absent this provision, a public stockholder holding more than an aggregate of 15% of the shares sold in this offering could threaten to exercise its redemption rights against a business combination if such holder’s shares are not purchased by us or our management at a premium to the then-current market price or on other undesirable terms. By limiting our stockholders’ ability to redeem to no more than 15% of the shares sold in this offering, we believe we will limit the ability of a small group of stockholders to unreasonably attempt to block our ability to complete our business combination, particularly in connection with a business combination with a target that requires as a closing condition that we have a minimum 

Also, there are some more complicated issues that you have to think about, but the above is basically the gist of it.

The reason why I made this post is not because I am interested in SPACs or that this one has a particularly interesting structure; it's because it is run by Wilbur Ross, a well-regarded distressed investor.  I have known about him for a while and even doubled my money in International Coal a while back and have a very good impression of him.  Of course, I don't know him or understand him as well as, say, Buffett or Dimon.  But still, he seems like a decent, straight-shooting dealmaker.

This would also be interesting if this entity became a platform for further acquisitions and not just a one-off deal situation.  One of the bullet points in the investment criteria (Offer Opportunities to Create Investment Platforms for Consolidation or Growth) seems to suggest that this may be the case.

So anyway, this is not for everyone.  I thought I would just make a quick post as it was interesting to me that there is an entity to invest with Ross with this SPAC twist today.

And for those market scaredy-cats, this is a 100% cash investment, so what is there to fear?!  If you owned this you would wish for a crash, and as soon as possible too!

Tuesday, August 12, 2014

Value Stocks In Market Corrections

So with all of this talk of a market correction coming and people wondering what to do in this toppy market, Pzena put out an interesting newsletter back in June.  It looks at value stocks and how they performed in market corrections in the past.

They define value stocks as the lowest quintile of stocks based on price-to-book.   We can argue all day what a value stock is, but since many value studies seem to show similar results whether you use p/b, p/e or whatever, let's just say p/b is a decent proxy for value.

Another question is whether there is survivorship bias in the data.  Companies that go bust often get kicked out of a database so when you go back and do a p/b ratio study, it excludes all the cheap stocks that went to zero (and therefore improves the performance of the low p/b group).  I think Greenblatt, in his studies, used a Compustat database that showed actual data that was available at the time (so eliminates this bias), and since Greenblatt and Pzena both spent time together researching these things, I assume that he is using a similar database for this study.

Anyway, read the whole thing here:

Pzena Second Quarter Newsletter

Here's an excerpt:
Recessions alone or corrections driven by excessive valuations absent a financial crisis appear to favor value stocks, which outperformed in nine out of ten of these periods by an average of 6.8%. One of the most dramatic of these periods was the bursting of the internet bubble which started in March, 2000. During the subsequent thirty-five months, value stocks went on to outperform the S&P 500 index by 14.1%, as the massive overvaluation of “new economy” stocks unwound. Although the magnitude of value’s outperformance was smaller during the stock market crash of 1987, this sudden adjustment in valuations saw value stocks outperform by 7.9%. Four other periods associated with economic recessions but no financial crises also saw value stocks outperform.

Of the five periods of underperformance, four were associated with financial crises. This included the Global Financial Crisis of 2008/09, European “echo” crisis of 2011, the Asian currency crisis of 1998, and the U.S. Savings & Loan crisis of 1990/91. Although the 1968-70 correction, where value stocks underperformed, included the Penn Central bankruptcy (the largest such event in U.S. history to that date), we have not included it in the financial crisis category.

The history of value in periods following market corrections is one predominantly of outperformance, in many cases by a significant margin. During our study period, value outperformed in thirteen of fourteen periods post-correction (Figure 1), leading to value stocks adding almost 2.5% per annum of excess return over the S&P 500 for the entire fifty-four year period. 

Figure 1:  Value Stocks In Market Corrections

Source:  Sanford C. Bernstein & Co., Pzena Analysis

Pzena points out that we can't really know what is going to drive the next bear market (recession, financial crisis or just valuation correction without either).

But if you don't think a financial crisis in the near term is likely, then value stocks is the place to be.

Buffett has said that he thinks it is highly unlikely that the next crisis will come from the banks.  I tend to agree with that as there is some institutional memory and people tend not to make the same mistakes twice in a row.  Of course, there will be crises in banking/finance.  But I don't think the next one will be anything like the last one.

More Fear Now?
I don't really follow sentiment figures or anything like that, but it does feel like there is a lot more fear in the market than earlier this year.  A lot of that is due to the situation in Iraq, Israel, and of course Ukraine.   I think there have been more calls of a market crash or severe market correction.

So people seem to have a different vibe when asking about what to do in the stock market.  I still point people to Buffett's annual letter and the market hasn't moved all that much since he wrote it earlier this year.

This is what he wrote:

It's interesting to ponder what Buffett might have written if the S&P 500 index was trading at a p/e ratio of 150x, but he suggests a 90% S&P 500 index fund and 10% cash (to pay expenses/bills etc).

Buffett says the S&P 500 index is fine now, regardless of all the things the pundits worry about.  But let's take a look at some of the things that people worry about.

Profit Margins Unsustainable
I've sort of looked at this in the past in various posts.  This is an interesting topic.  There is an argument that some of the higher profit margins is due to increasing globalization of U.S. corporations (especially when looking at profit to GDP), that some of it is due to more value-added businesses in the stock market now compared to in the past (more Googles and Apples rather than Bethlehem Steels; low margin businesses moving out of the U.S. to low labor cost countries etc...).  Pzena made a case that return on capital was consistent and that is what matters.

All of these arguments are interesting.

But for me, I just look at what I own and see if they have unsustainably high profit margins. And for most of the businesses that I talk about here on this blog, that is not the case.  For a lot of the larger big caps, I don't see anything like that either; margins seem stable over time.  Look at BRK's businesses, for example.  Which businesses are over-earning?  Housing?  Nope. Insurance?  Nope. Retail?  Nope.

Unsustainably Low Interest Rates
This too is a concern as it impacts the stock market in various ways.  It affects the discount rate, of course, and also the cost of capital for corporations with debt.  It can also affect final demand (sales) as low debt encourages consumption/investment.

As for the discount rate aspect of it, I don't worry too much about it as earnings yields stopped going down long before interest rates kept declining.  If the market kept going up with the decline in interest rates, the stock market would be trading at 40x p/e (using the Greenspan model of earnings yield = 10 year treasury rate).   The S&P 500 didn't go up to 70x p/e when interest rates went down to 1.5%.  This is why the market hasn't collapsed as interest rates came back up to 2.5%.

And this is why I don't believe the market has to collapse if interest rates goes back up to 5.0%.

As for financing costs, higher interest rates would reduce earnings of companies with a lot of debt for sure.  But many firms actually have a lot of cash and would benefit from higher interest rates.  Banks and insurance companies come to mind (and we like financials).

Companies with a lot of debt also anticipate higher interest rates in the future so are locking in rates at  current low levels, and future capital allocation decisions can be made with higher interest rates built into the model.  If anyone is expecting low rates forever, we should just stay away from that business!

Market Crash is Coming!
And of course, one major argument is that the market is just overvalued, plain and simple.  For that too, I just take a look at my holdings and see what might be overvalued.  If I don't see anything overvalued, I don't worry.

As Pzena has shown above, when the market is overvalued and there is a valuation correction, the overvalued stocks tend to get hit and value stocks tend to do way better.  This is a major reason why I am usually not worried too much about crashes/corrections.

Anyway, nothing new here, but I just thought the Pzena study was interesting.  And I thought I'd recap my thoughts about the market and why I am so at peace despite people calling for a market crash.

Of course, I am not saying that the market won't crash or go into a bear market.  I just have no idea about that.  I do have no doubt that something like that will happen at some point.    But I don't worry too much about it (for the above reasons).

TETAA: Teton Advisors, Inc.

Speaking of nanoo, nanoo, how about a nano-cap?  

There is some interest in small cap stocks as they tend to outperform over time, but small caps are now looking really expensive.  So I was kind of surprised to take a look at this thing and notice that it's not that expensive.

Teton Advisors (TETAA) is a 2009 spinoff from Gamco (and spinoffs outperform over time so check that box! You can also check the owner-operator box too and then maybe the tiny-cap/below-the- radar box too).  They have been doing really well since the spin, but that's because they were spun off at the bottom of the bear market.  I don't think what they did from 2009 through 2013 can be considered 'normal'.

Tiny Cap with No Float!
But first, let's get this out of the way.  This is a highly illiquid stock on the pink sheets so doesn't even have decent filings (well, OK, not so bad.  But the proxy is a little thin).  Plus you can forget about any shareholder rights as Gabelli basically controls this entity and it is still intertwined with Gamco.  How this gets untangled over time is something I have no clue about.  But I do like and respect Mario Gabelli and think he wouldn't do anything to hurt minority shareholders.  He is sometimes criticized for his 10% pretax profit bonus he gets at GBL but that sort of thing doesn't bother me at all either.

According to the last 10-K they filed in 2009, Gabelli owned 600,000 shares and the CEO Nicholas Galluccio owned 260,000.    Westwood Management owned 200,000 shares but TETAA has since repurchased those shares.  Assuming there has been no big change in ownership since then, Gabelli would currently own 55% and Galluccio owns 26%.    Between them they own 81% of TETAA.   So float would be less than $10 million.   So let's not all go out and buy some at once!

Historical Performance
So let's look at how TETAA has done in the recent past.  Below are some figures I pulled out of the financial reports.  Some of the 2013 AUM figures are rounded to the nearest $100 million because reference to the AUM in the earnings release and 10-Q only gave a figure like $1.8 billion instead of a more precise number.  It may be posted somewhere else, but I just grabbed what was convenient for me.  And besides, it shouldn't make much of a difference.

Quarterly Results for TETAA
(figures are in $thousands except EPS and AUM)

As you can see, AUM has been growing nicely and they are making decent money with pretax margins up into the 30's.  In the last twelve months, they earned $3.34/share and pretax earnings of $5,883 million or $5.35/share.    At the current $49/share, that's 14.7x p/e and 9.2x pretax earnings.  I remember money management companies being valued at 10x pretax earnings in a post a while back, and TETAA is trading at below that.  At the risk of annualizing and capitalizing peak earnings, if you annualized the $0.95 2Q2014 EPS, you get $3.80/share in run-rate EPS; TETAA is trading at 12.9x that (or 8.0x pretax earnings).

Given this growth (and potential), it does look cheap.

Of course, the counterargument is that we are at the top of the stock market so equity managers should trade cheap, just as old, industrial cyclicals trade at a low p/e at the top of the economic cycle.  This is true to some extent, but if you look through-the-cycle, I don't think that is necessarily the case for asset managers (unless their AUM is bloated and unsustainably high due to a bubble; AUM here at $2 billion doesn't seem like that).

But How Are Their Funds?!
The important thing for me, though, is the funds.  Do they perform?  If they don't outperform, they can still be great businesses (as mutual fund/retail assets tend to be sticky), but for me, I would get more excited about an asset manager if I think they have a reason to exist.  And the only reason they should exist is if they can outperform.

Unfortunately, most of their funds aren't that interesting at all.  They started a new mid-cap fund, but it is too new to evaluate.

But the one big fund is actually really good.

Teton Westwood Mighty Mites Fund
This fund name makes me itchy, but let's take a look at it.   I pasted the table from their annual report since it includes a benchmark (and their semi-annual report doesn't).

Average Annual Returns Through September 30, 2013 (a) (Unaudited)  1 Year  5 Year  10 Year  Since
Mighty Mites Fund Class AAA
  36.18%    14.57%    12.20%    12.48%  
Russell MicrocapTM Index
  32.12       11.12       7.55       N/A(b)  
Russell 2000 Index
  30.06       11.15       9.64       6.81      
Lipper Small Cap Value Fund Average
  28.19       11.17       9.90       8.26(c


*Past performance is not predictive of future results. The performance tables and graph do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.
**The Russell Microcap™ Index inception date is June 30, 2000 and the value of the Index prior to July 1, 2000 is that of the Mighty Mites Fund (Class AAA). 

It does look pretty impressive, no?

The Teton website lists Mario Gabelli as the lead portfolio manager for this fund.   Here's a cut and paste from the website:


Fund Characteristics

  • The TETON Westwood Mighty MitesSM Fund seeks long-term capital appreciation.
  • The Fund focuses on securities of companies which appear underpriced relative to their Private Market Value (PMV) with Catalysts to unlock that value. PMV is the price the Fund's Adviser believes a strategic buyer would be willing to pay for the entire company.
  • The Fund primarily invests in micro-cap equity securities that have market capitalizations of $500 million or less at time of investment.

Investment Strategy

  • Diversified portfolio of micro-capitalization equities
  • Invests in companies with above average revenue and earnings growth
  • Focus on underpriced companies relative to their private market value
  • Seeks to exploit market inefficiencies associated with micro cap companies

Portfolio Management

Mario J. Gabelli, CFA
Chief Executive Officer
GAMCO Investors, Inc
  • M.B.A. Columbia Graduate School of Business
  • B.S. Fordham University
  • Founded GAMCO Investors, Inc. in 1977
  • Fund manager since inception
  • Co-Portfolio Manager with Laura S. Linehan, CFA, Elizabeth M. Lilly, CFA and Paul Sonkin.

So that would sort of be a problem if Gabelli's contribution is not perpetual.  Gabelli and some other employees work for both TETAA and GBL, and this will not last forever.  I think there is an agreement for two more years of GBL employees working for both GBL and TETAA.  After that, who knows what will happen. 

The question obviously is how much does Gabelli do for the Mighty Mite fund?  There is a team of co-managers, but can they perform as well without Super Mario?  Or will he stick around long enough for others to be able to step in as lead manager?  Or is he not doing much these days anyway?  I have no idea. 

The other interesting thing about TETAA is that Paul Sonkin of Hummingbird value has joined the company.  Sonkin is the co-author of the highly regarded book, Value Investing: From Graham to Buffett and Beyond.  His presentation(s) from value investing conferences were very interesting.  

I wonder what happened to Hummingbird Value fund?  Why would he join another asset manager?  Maybe his business didn't scale well?  I don't know.  I do remember him digging deep and alone into below $15 million market caps.  Maybe that sort of business model was unsustainable? 

But whatever the reason, it looks like Sonkin will be looking at stubs, spin-offs and other special situations.  He is currently listed as a co-manager of the Itchy Bites fund  Mighty Mites fund, but there might be a special situations fund offering in the future.

Hmmm...  Interesting... 

This is a tiny idea with only $10 million (or less) in float so not an idea for most.   And there is a lot I don't know.  If you buy TETAA, you will be a super-minority so you will just be along for the ride.  And whatever deal happens between TETAA and GBL (and Gabelli personally), too bad.  There is nothing you can do about it.

But I do have faith in the character of Gabelli and his team.  I don't think they would do anything funky.

This is a tiny spinoff with $50 million in market cap, so just a few ideas can really create value here.  Compared to running an asset management conglomerate with $100 billion in assets, you don't need a whole lot of ideas to work to get the market cap up.  And the fact that the highly regarded (as far as I know) Paul Sonkin of Hummingbird has joined is a very interesting development.  It's almost like getting in on the ground floor of whatever they do going forward.

Some would argue for a liquidity discount, but sometimes maybe there should be an easy-to-move-the-needle premium.

Oh, and at the very least, looking at the fund holdings (Mighty Mites) might be a great place to find some ideas.