DoubleLine Capital Valuation Hint

So here's another followup post, this time for my OAK/DoubleLine post (here).

Jeffrey Gundlach was on CNBC yesterday and talked about the markets and surprisingly talked about what he sees for the future of DoubleLine.    Gary Kaminsky conducted the interview and he asked a really good question that lead to Gundlach's discussion of DoubleLine's future which may have implications for DoubleLine's valuation (for OAK shareholders).

Anyway, firstly, here is what he said in general about the markets:

• The 10 year treasury yields bottomed out in July.  What more is there to gain here?  How much lower can rates go?   Even if rates go down a little more, there isn't much gains to be had.
• This feels like the mirror image of the mid 80's when treasury yields were very high and everybody hated it.
• 10 year rates can go up 100 bps from here even before year-end.  People ask him what the catalyst for rising rates would be and he says that they are already going up; the catalyst is simply the bad return the low rates provide.
• QE3 is not going to be effective.  Can't see any connection between QE3 and increasing employment.
• Quotes Jim Grant; the markets now is a "hall of mirrors" due to the extensive market manipulation by central banks around the world.
• Wouldnt' buy equities now as risk assets are at a high level.  So short term not positive on stocks, but over the long term due to the central bank actions there will be inflation so real businesses and assets would be good.   Gundlach doesn't think there will be another lost decade in equities.
• He liked Spanish stocks in May because they were bombed out.  Liked it not because he thought Europe would solve problems, but just because it was bombed out.  Now the market that is bombed out to a scary extent is the Shanghai composite.  World markets at their highs and yet Shanghai and some other emerging markets are at multi-year lows.
• Apple obsession / fixation means it is over-bought and over-believed.
• Would (or said in the past) short Apple and the S&P and be long things like natural gas and commodities.  Apple is up 14% since he said that but natural gas is up 40%, so please don't look at only one leg of the long/short, pair trade idea.
• Where to invest?  Get away from traditional ideas and indexation.  He likes bank debt for the first time in a long, long time.  International bonds are interesting as U.S. treasuries are no good.  Some mortgages around the edges.  Also, really, really safe dividend paying stocks.  Not tech stocks, but really safe ones (he later mentioned Campbell Soup).
• Returns going forward, 5%.  Buy-and-hold is out the door.  Investors have to be more active, or have to find someone to do it for them.
• Bank stocks not short but wouldn't own them for dividends.  They are not safe.  If something happens in Europe they are still vulnerable to significant shocks.

So that's the sort of things he said.

DoubleLine's Future
But what really got my attention was when Kaminsky asked Gundlach what level of assets is too much for a bond fund.  What AUM level would his investors have to start to worry as it might be getting too big.

At first Gundlach went off on this tangent about counterparty risk but Kaminsky got him back on track and asked the question again.  And then Gundlach said:

• Maximum AUM is $100 billion, probably south of that.
• For the Total Return fund (their flagship fund), they probably won't be open after $50-60 billion in assets.
• Not interested in having offices in Singapore and Mumbai, travelling around the world.
• Sees DoubleLine as a company with "mid-size staff and a mid-size culture".
• Wants a manageable business, know what they're doing with people working together.
• Maybe 100 employees, they now have 80.
• Current AUM north of $45 billion.
• Will probably close fixed income strategies at $60 billion.

So there you have it.  For those hoping for DoubleLine to become the next Pimco, this may not be very encouraging (Pimco AUM is over $1 trillion).

DoubleLine's Valuation
So going back to my other post and looking at the table there, if $100 billion AUM is going to be the maximum, DoubleLine would be worth $1.47/OAK share or $2.93/OAK share (at 1% of AUM or 2% of AUM respectively).

Of course, this doesn't mean that AUM can't keep going up with performance; just because they close funds doesn't mean AUM won't grow, so over time they can still get much bigger than Gundlach envisions at this point.  But it is one (and pretty significant) input we can use to value DoubleLine.

Leucadia FMG Note Resolution

This is just a quick follow-up to my LUK posts; today Fortescue and Leucadia came to an agreement on the 4% notes.  People who follow LUK know that FMG insisted that they had a right to issue more royalty notes and dilute LUK and they have been in court fighting this out.

Today LUK announced that they have come to an agreement.  FMG will redeem the notes for $715 million and LUK will book a pretax gain of $526 million.   With 245 million shares outstanding, that comes to $2.15/share gain for LUK.

Is this a good thing?  Well, of course, settling this thing is good. You never know where these things can go.  As for the price, I have no idea if it's a good price or not but knowing the folks at LUK, I don't think they would take a bad price to walk away.  Plus, with China in a state of slow-motion implosion and iron ore prices tumbling, it's probably not a bad thing for LUK to be out of this.

LUK Note Valuation
They already told us they will book a $526 million pretax gain, so we know that this note was on the balance sheet at $189 million.  The aggregate book value of the FMG notes (including prepaid mining interest, zero coupon note and interest accrued and receivable) was $295 million at June 2012.  The difference is accrued interest (for first half 2012) and whatever interest was paid and accrued since then until now.

On FMG's balance sheet according to their June 2012-end financial report, the notes were booked at $897 million; this included $770 million non-current and $127 million current (which is basically the interest accrued and payable).

So if we assume the $770 million non-current portion is a little lower (by say, $60 million for interest accrued in July, August and September), and all else unchanged, the notes would be worth $710 million (according to FMG's June 2012 model assumptions).

If this is correct, then LUK will have sold out the notes at a pretty decent valuation given that iron ore prices have declined substantially since then. 

I am not sure if this is correct as the $715 million may include accrued interest (but only for amounts accrued after June-end 2012 as interest accrued until then would have been paid out by now), in which case LUK would have sold the notes at a lower valuation.  But still, given the collapsing China and iron ore prices and the legal uncertainty, it still wouldn't be a bad deal.   I guess we will find out more in the next filing, and I'm sure LUK will summarize their FMG experience in the annual report.

FMG Overall
So how good are these guys?  Iron ore prices are falling, China may be imploding, and LUK is completely out of FMG including the notes (which would have exposed LUK to iron ore prices and other risks).

Just a quick look at this whole FMG experience shows how good these guys are.  According to the 2011 annual report:

• In August 2006, they paid $400 million for 264 million shares and the $100 million 4% notes
• In 2007, they paid $44.2 million for more shares
• Their total investment in FMG, therefore, was $444.2 million

Further, in the report, they said that including the sale of FMG shares (sold most in 2011 and some in 1Q2012), dividends and the interest income on the notes, they took out $1.8 billion from their FMG investment, and they still had 31 million shares outstanding and the notes.  This is all as of the writing of the letter to shareholders.

Since then, in the 2Q2012, LUK sold the rest of the their FMG stock for $153 million (they will book a gain in the income statement but it won't affect book value much as this position is marked to market, unlike the notes which are not).

So adding that, that makes it $1.95 billion they took out of FMG.

Now with this note redemption, this comes to $2.67 billion.  Also, in the first six months of 2012, LUK received $117 million in interest income on the notes.   I don't think that's included in the $2.67 billion so far (as we only included what was in the 2011 letter to shareholders, the 2Q FMG stock sale and the note redemption).

So we now have $2.8 billion. 

If the $715 million redemption price doesn't include accrued interest from the end of June 2012 through now, then there would be $60 million more (first half was $117 million so I just took half of that for the three months from July 2012 -> September 2012).

So in total, that would be $2.86 billion.  Almost $3 billion from a $444 million investment.  Wow.  And that includes the not-so-great timing of buying not too long before the biggest financial crisis in history and exiting at a point where China is imploding (or seems to be). 

Perspective
So let's put this in perspective for a second.  In June 2006, right before they made this investment, the shareholders equity of LUK was $3.8 billion.  They invested $444.2 million, so that's almost 12% of the net worth of LUK that they put into this deal.  That's concentration.

And they ended up taking out $2.86 billion.  Ten years ago, the year-end shareholders's equity was $1.5 billion (December 2002), and in 2001 it was $1.2 billion.

Who'da thunk LUK would make more than their entire net worth (or almost twice their net worth) in a single deal within ten years?

Did I already say wow?

Special Opportunities Fund (SPE)

So someone posted a recommendation for SPE in a comment on this blog so I decided to take a look.  As I posted before, I am not a big fan of closed-end funds, and it turns out this is a closed-end fund that invests in other closed-end funds (and other things).  So my initial reaction, of course, is that the total expenses/fees would be too much for this to make any money (double layer of fees!).  This is why I'm not a big fan of fund of funds either.

But of course, this one is different.  It is run by none other than Phillip Goldstein of Bulldog Investors.  Goldstein is known as an activist investor that pressures closed-end funds to do something to close the discount.

Obviously, this means that this is not going to be a vehicle where someone just keeps it going without much effort just to retain the fee income.  Goldstein will be very motivated to make this perform well and if this trades at a discount too long, there will obviously be some action taken to close the gap.

(The manager is Brooklyn Capital Management (no relation to this blog), which is basically Phil Goldstein, Andrew Dakos and Steven Samuels. BCM was set up to become the advisor to SPE).

There is a lot of stuff on Goldstein on the internet so I won't go too much into his past.  He is most known for his activism with closed-end funds and his lawsuit against the SEC.

He is an interesting character; he doesn't come from a Wall Street background, but was a NYC employee for years until his late 40s when he started to manage money full time.  It's a great story.  (Here's a link to one article:  2008 Fortune magazine article.)  There's also a video interview on Opalesque TV on Youtube:  video interview.    (By the way, I don't know what Opalesque TV is but it has some great video interviews with hedge fund managers including Izzy Englander; I've never seen this very secretive, publicity shy person on screen before).

One story that is great (I think from the above article) is how Goldstein, when meeting with an early investor, wasn't allowed into a restaurant because he was wearing shorts.  He went next door and bought a pair of sweatpants, then went back to the restaurant, had dinner, and then afterward returned the sweatpants at the store (next time I buy a pair of sweatpants I'll try not to remember this story).  Cheap is good.

This reminds me of someone making Buffett wait; he was busy driving around looking for a free parking spot (my reaction, though, was how the heck can you make Buffett wait to save a few bucks?!).  Buffett knew immediately that he was dealing with the right person.

Goldstein has that quality, obviously.  He stays in $70/night hotel rooms in Vegas instead of the more expensive, fancy places.  So you can check mark that box.

So How Has He Done?
As is often the case with people who run hedge funds, sometimes it's not easy to find out how they have done over time.  The big ones are usually known as people talk about them all the time and letters to investors float around and their returns are published in magazines etc. 

So I have to just scrape up some information from the internet to see what I can put together (I don't have access to expensive hedge fund return databases, but that's OK).

According to the Fortune magazine article of June 2008, Bulldog Investors had $500 million in AUM and the main fund had an annualized return of 15%/year in the 16 years since 1992 (when the first fund was formed in December 1992), and never had a down year.  $1 million invested in the S&P 500 index was worth $4.5 million versus $8.9 million for the main fund during this period (using 16 years which may not be exact, that's 14.6%/year versus 9.9%/year for the S&P 500 index).

That's actually pretty impressive.  The outperformance, of course, is nice but the fact that they didn't have any losing years between 1992 and 2008 is pretty good.  Of course, this is before the financial crisis really gets going, but it does include one of the worst bear markets in history between 2000-2002.  It is a validation of Bulldog's approach emphasizing capital preservation. 

According to the video interview dated January 2011, the Full Value Partners fund (flagship fund formed in 2001) returned 10%/year between 2001 and presumably the end of 2010.  The cumulative return over that time period is 125.29% versus 32.45% for the S&P 500 index.

In the interview, Goldstein says that over 18 years, the Opportunity Partners fund has done 5-6% better than the S&P 500 index with only one down year.

In the November 2009 letter to investors of SPE, Goldstein said that over 17 years, the Opportunity Partners L.P. earned +12.8%/year (net of fees) versus +7.4%/year for the S&P 500 index with a loss in only one year during that period.

In the 2010 interim report to SPE shareholders, he said that the hedge fund he managed earned +17.5%/year in the period 1995-1999 while the S&P 500 index gained +28.6%/year.  In the period 2000 - 2002, the S&P 500 index fell -37.6% while the hedge fund gained +24.2%.  He wrote that to illustrate the conservative nature of his approach:  he will underperform in strong markets but will do well in choppy, flat or down markets.

So these are some of the data points for Goldstein.  They all look pretty good to me.

What About SPE?
OK, so what is SPE?  SPE, in short, is a fund that Goldstein took over after a proxy fight.  To save some time from typing and also to display my excellent "snip"-ing skills, here's a cut-and-paste from one of SPE's annual reports:

From the first letter to shareholders (interim report 2009), this is how they introduced themselves to shareholders:

And the last paragraph of that letter was (after taking about the various types of investment funds including closed-end funds):

And to show that he means it, he has put his money where his mouth is (even though I don't know who owns how much at this point):

In the June 2011 letter, Goldstein after showing return data, wrote:

And then he listed some of the horrible things that happened in 2011 and pointed out that the market was UP.  Sounds like a Brooklyn Investor blog post!

Anyway, the letters to shareholders for the SPE fund are all great reads and Goldstein explains why he is investing the assets in SPAC (special purpose acquisition corporations), auction rate preferred shares, closed-end funds and other special situations.  The latest interim report of June 2012 (not on the SPE website but is available at sec.gov) is a fascinating read with updates on current holdings (including such hairy special situations like MYRX, IFT and GYRO, progress on some closed-end fund liquidation (potential), SPAC deal closings etc.).

Here's the website for SPE:  SPE Reports
Here's the SEC page for SPE's filings:  SPE's SEC page

I think it's a great place for special situations investors to look for ideas (particularly small cap ideas; these ideas won't work for big funds).

Current Asset Allocation
SPE is not top down; I don't think they choose asset allocation, but the allocation is just a result of the opportunties available (they don't target portfolio allocations etc.).

Here is their current breakdown of assets (as of June 2012):

Closed-end funds:                      53.30%
Auction Rate Preferred Shares:   5.34%
Business Development Co:         2.32%
Common Stocks:                       31.65%
 (of which SPAC:                      25.71%)
Promissory Notes:                       0.39%
Standard Life Settlement Notes: 0.46%
Warrants (SPAC):                       0.56%
Money Market Funds:                 6.41%

So it's easy to see why this portfolio is conversative.  26% of the assets are invested in SPACs, many of which are just cash.  If a deal can't get done, the cash is returned to investors with no downside risk.  Closed-end funds too have downside protection as they only buy funds at deep discounts to NAV and where they feel they can initiate some action to close the gap (I think Goldstein said in the interview that if they buy at 15% discount to NAV and can get some sort of action (like tender offers) within two years, that can explain 5-6%/year in alpha (versus the market).  They are usually agnostic to market direction of the underlying portfolios.

If you look at their other common stocks and other holdings, you will see that they are not market correlated but are very specific special situations where the value is realized (or destroyed) by company specific events.


SPE Performance
So how has SPE done since they took over?  SPE dates the beginning of their new strategy at January 25, 2010.  Up to then was basically the liquidation of the old portfolio etc.  So that's the date SPE sees as the start date for the new strategy.

According to the June 2012 interim report, SPE returned an annualized +9.00%  versus +11.65% for the S&P 500 index from January 25, 2010 to the end of June 2012.  So it's lagging a little bit, but then the time period is a little too short.  This is not one of those "I guarantee you 1%/month in any market no matter what (or until I blow up)" funds, so this short term result isn't indicative of anything.

For the  first six months of 2012, SPE returned (on a NAV basis) +5.87% versus +9.5% for the S&P 500 index.

As Goldstein explained and illustrated above, SPE will lag strong up markets but will do well in choppy, flat or down markets.

Fees and Expenses
Despite the great track record, the management fee charged to SPE is only 1.00% and there is no incentive fee.  Can you imagine that?  A manager that beats the market by 500-600 bps/year charging only 1.00% with no incentive fee.  That's like getting a big suite at the Bellagio for $70/night, isn't it?

The expense ratio is around 1.5% (this includes the management fee), so that's reasonable given that you pay 2%/20% to hedge funds.  You often pay similar or more to equity funds that can't even outperform the market, ever.

Value
As Goldstein says, the great thing about closed-end funds is that it's easy to value.  In this case too, the NAV of SPE is published weekly.  As of the end of last week, the NAV was $17.48/share.  The stock is currently trading at $15.37/share, so that's a 12% discount.

A 12% discount for a fund that only charges 1%/year management fee, no incentive fee and that has a long track record (assuming SPE invests similarly to Bulldog Investor's hedge funds) of outperforming the S&P 500 index by 5-6%/year?

It seems like a no-brainer to me.

Conclusion
So this is a really interesting situation.  Goldstein is 66 years old so not so young.  There isn't a 30 or 40 year runway here.  But 66 is a lot younger than say, Buffett.  He probably has a good 10, 15 years or more.  If Dakos is good, he is in his mid forties; plenty of runway there.

Other points are:

• The size of the fund is very reasonable, at a little over $100 million these guys don't have the size issues that a lot of the other alternative asset managers I look at have.  Maybe they now have to manage $500-600 million including the other hedge funds that they manage.   A lot of the private equity/hedge fund guys I really respect had their best years managing $500 million - $2 billion, maybe.  And now they are trying to swing $10-20 billion around or more.  That is a very difficult thing to do.
• Of course the fee structure and discount stated above is a big positive.  1% management fee, no incentive fee for 5-6%/year in outperformance?  What's not to like?  
• The market insensitive nature of this strategy (focus on special situations and take positions only where they feel they have a true edge) is also good and may be reassuring to people who don't want a whole lot of long equity exposure.  Of course, the closed-end funds have market exposure, but as I mentioned above, the alpha generated from the discount purchase price and potential catalyst to close the discount should make up for that market risk over time (may lead to continued attractive risk-adjusted returns).
• Their historical returns seem pretty consistent.  Goldstein's funds seems to have done really well over their entire history, but also pretty good since 2001 which is reassuring as the market has been flattish since then.  The fact that they can earn 10%/year in a flattish market (2001-2010 for Full Value Partners) shows the consistency of their alpha-generating ability.  (I can't believe I just typed that sentence; I sound like some financial magazine writer! Not that there's anything wrong with that).
• The fact that they made money in 2000-2002 is good too, particularly for people worried about a prolonged bear or flat market.  It seems that SPE is not a bull market dependent strategy.  I wouldn't say SPE is bear market-proof as all bear markets are different.  But it seems to be bear market resistant.  The strategy has been stress-tested through a few cycles.
• Great letters to shareholders.  When was the last time you read a letter to closed-end fund investors?  Of course, why would anyone.  They are horrible.   Goldstein's letters for SPE are really good.  They offer clear thoughts on what they are trying to do and specific ideas with some details on them.  This is exactly what you want from a manager of your money.  Most fund letters seem to be so focused on blaming and excuses; "The Euro crisis worsened during the period and our exposure to cyclicals caused our severe underperformance versus our benchmarks but it's not really our fault so don't blame us! It's Bernanke's fault!  It's Merkel's fault!"

So given all of the above, I think SPE is a really interesting opportunity and I wouldn't be surprised if it did very well over time.

I think this is the first time (in a very, very long time) that I would ever recommend a closed-end fund.

What was that Tom Cruise movie?  "You had me at 'hello'".  Well, maybe Goldstein had me at "sweatpants".

But then again, do your own work.  This is just my opinion and I could be wrong.  Anyone who buys something after reading about it on the internet deserves to go broke!

Quick Comment on Fundamental Analysis

So the conversation I overheard this weekend that I mentioned in the previous post reminded me of something.  Back when I used to talk a lot more to 'trader' types many of them used technical analysis, macro-forecasting, astrology and all sorts of other things because they claimed that fundamental analysis of stocks just doesn't work.

Part of it is that they are believers in the efficient market theory (never mind the irony that they think markets are efficient but they believe you can make money buying and selling stocks based on moving average cross-overs or some other such thing...).

As evidence that fundamental analysis doesn't work, they point to:

Wall Street Analysts are Always Wrong
Yes, analysts in aggregate are no better than random when it comes to forecasting EPS.   But there is a problem with this.  It's true that analysts spend all of their time analyzing the companies they follow so they should be able to be 'right' in their analysis.  But they often are not.  Their buy/sell recommendations are awful too, according to many studies.

But there are a few problems with concluding that fundamental analysis doesn't work based on that.  Here are some off the top of my head:

•   Wall Street analysts always have to have an opinion.  If you cover an industry, you have to have an opinion.  You can't say, "I have no idea what this company will earn this year; it all depends on factors I can't predict".  This is just not acceptable on Wall Street.  Guys like Buffett and Klarman can be right often because they don't have to have an opinion on all 500 S&P stocks every single day of the year, every year.  Most of the time, they look at something and go, "I don't know".  And then only act on something they have conviction on.  This is very different from Wall Street analysts and even strategists that always have to have an opinion no matter what.  No wonder the results are random.   (Using Buffett's batting analogy, analysts and strategists have to swing on every pitch!  No wonder they strike out so often!!).  If Buffett had to fill out a form and say buy or sell for each of the S&P 500 companies, I bet he would be no better than Wall Street.
• Wall Street Analysts Aren't Unbiased.  Wall Street exists to facilitate financing of businesses so they are long/buy biased.  Of course they are.  People complain that Wall Street issues 99% buy recommendations or whatever.   Part of that is because they want business and they just won't bother covering bad, trashy companies.  Why bother?  You can't have clients buy it, and you wouldn't want investment banking business with them.  How about investment banking clients?  Well, we all know the street is very unwilling to issue a "sell" recommendation. On the street, we know that if you are bearish and you are wrong, you will be fired quickly but if you are bullish and wrong, the guillotine doesn't fall as fast.
• Wall Street Analysts Have to Focus on Short Term Results.  Contrary to popular belief, Wall Street is forced to accommodate client needs, and that is often short term profit estimating.  Clients demand accurate EPS estimates on a quarterly basis, even if it is actually impossible to provide.  So a lot of the resources are used up in that, and analysts are evaluated by it.  I don't think Buffett would be able to come up with more accurate EPS figures for his large holdings than any other analyst.  But that's not what Buffett's strength is, and that is not what matters.  But that's what the Street focuses on due to the structure of the industry.  Analysts are also evaluated on the performance of their buy and sell recommendations over short time periods.  Even Buffett can't do that well.

There's a bunch of other reasons why analysts are so often wrong (and some better than the above), but these are just some off the top of my head.   The point is, I don't think analysts' accuracy has anything to do with whether fundamental analysis works or not.  I tend to think it's an indication of how the industry works and nothing to do with the relevance or value of fundamental analysis.


Most Mutual Funds Underperform the Index
The other argument you always hear is that most mutual funds can't even outperform the S&P 500 index.  Every mutual fund manager seems to have a copy of Securities Analysis in their bookshelf,  and yet those very same managers underperform their index, year after year.

So therefore, fundamental analysis simply doesn't work.  There's too much evidence to show that it doesn't.  The number of mutual funds is high enough for it to be statistically significant.

But I have a different take on this.  Here are some quick points off the top of my head.  I'm sure I am missing better arguments, but here goes:

• The industry in aggregate cannot possibly outperform.  Some will outperform and others will underperform.  In aggregate they will underperform by the amount of fees and expenses charged.
• The industry is not incented to outperform.   This may sound strange as I think most mutual fund company CEOs want their funds to outperform.  I don't doubt that individual fund managers really want to outperform too.  But the industry is structured as an asset accumulation business.  Funds are incented to avoid large mistakes.  That's why there are so many closet indexers.  They don't want to stray too far from the index because if they underperform by a wide margin, they fear losing their jobs (or fear fund outflows).  This is why funds seem to be overdiversified, even when the fund is not so big.
• Many funds are just too big to perform.  Many funds are just so huge now that they really can't veer too far from the index.  I would bet that even Berkshire Hathaway's equity portfolio has increased correlation to the S&P 500 index over the years as their holdings become much larger cap.  Fidelity Magellan is a great example.  What can you do with so much AUM?  Your universe of stocks to choose from is tiny.

When you really sit down to think about how the industry works, it is not really designed to perform well.  It is designed to retain and grow assets under management.  It's much more profitable to run a $100 billion mutual fund that lags that market (but keeps accumulating assets due to intensive marketing) than to run a $2 billion fund that outperforms the S&P 500 index.    So just as Buffett is stuck managing a huge portfolio for so-so returns when we know he can put up spectacular returns with $100 million, mutual fund firms tend to take their better managers and have them run the bigger funds (and give the smaller funds to young, next generation managers).

Superinvestors
But the folks that can avoid these 'traps' tend to do well over time.  The superinvestors are proof that fundamental analysis matters.  Of course, Buffett is also proof of that.

There is a lot of data that supports the effectiveness of sound, fundamental analysis.  This is the village of Graham and Doddsville.

Technical Analysis
When I first started in the business,  I was huge into technical analysis.   It was very appealing to me as I didn't have to bother too much with research; reading reports, doing spreadsheets etc.  All I needed were some charts, a ruler and a pencil.  Or a computer for moving averages and other things like that. (Plus, technical analysis books were a lot thinner than Securities Analysis!).  There really is nothing more thrilling than drawing a trendline, watching a stock break below it and watch it continue to fall.

There are some people who have done well with charts; we know that even people like George Soros and Stanley Druckenmiller look at charts (even though I don't think it's their primary tool in most of their trades).

But at the end of the day, there really was no village of Edwards and McGee-ville (Technical Analysis of Stock Trends by these authors is considered the bible of technical analysis).  Yes there are some here and there that have made money from technical analysis.

But from my experience, it seems like most of the people who made money in this field made their money publishing newsletters and books.  

Are Wall Streeters Irrational?
Which leads to the next question; are Wall Streeters really all that irrational?  (OK, maybe this is an unrelated tangent).  They blow up with subprime.  They blow up their mortgage book.  Mutual funds constantly underperform the index and do irrational, stupid things like buy Yahoo stock at $250.

Is all of this stuff irrational? There have been books published that love to talk about how stupid and irrational Wall Street is.  I tend to agree at the big picture level.  But is it really so at the micro, individual level?

I don't think so.

When a mutual fund manager buys Yahoo even though he knows it is overvalued, is he acting rationally or irrationally?  He may be totally rational:  He wants to keep his job.  The odds are higher for him to be fired for not owning Yahoo than for buying Yahoo and losing money with everybody else.

Doing something because others are doing it is irrational at one level.  But doing it to keep a job is rational at another.

How about those 'dumb' Wall Street traders that always blow up?  Are they rational or irrational?

I remember a fixed income desk blowing up because they increased their balance sheet proportionately to the decrease in interest rate spreads.  I asked someone what the spread on their business was when they started.  They said 1000 bps (10%).  And then I asked what it was now.  They said 140 bps.

So over the years, to grow earnings (which the desk promised they would do to senior management), they had to increase their balance sheet to make more and more money as the risk increased (proportionately to the decrease in spread).

So they had the maximum balance sheet at the moment of highest risk, highest price and lowest spread.  And a minor speed bump in their business blew them out.

This merits the question; were these people irrational?  The casual observer would think so.  But more thought would make it clear that these people acted perfectly rationally. 

If the market didn't turn around, they would have gone home with huge bonuses.  If the market turned sour and they blew up, they would simply walk away (which is what happened).  In other words, they had a bonus pool every year so the only thing at risk for the desk was the bonus for that single year.  

Back then there were no clawbacks.  Of course employees (that are not shareholders or partners) are going to bet the ranch.  That is the totally rational thing to do at the individual level.

By the way, this is not an argument for banning risky behavior or increasing regulations.  This is about wrong incentives.  In the above case, I would blame senior management; not regulation or even the desk that blew up.

Buffett believes that regulations can't fix stuff like this; you have to give the right incentives for people.  Munger is huge on the incentive question too.  He thinks much of the wrong on the Street is not a regulation issue, but an incentive issue.  Buffett says that if CEO's and their wives had to go broke if their firm failed, they would act differently.  Same with traders; if they had clawbacks for previous year bonuses, this sort of betting the ranch bigger and bigger every year wouldn't happen (because they would have more to lose). 

So anyway, I meandered again...  Oh well.  It's my blog so I get to do what I want!

DF Spinoff, Mr. Market, When to Sell etc.

So it's been a while since I posted.  Some late summer, beginning of the school-year business, some laziness and some dead-ends is my excuse. 

Dean Foods / WhiteWave Foods Spinoff
I spent some time digging into the Dean Foods (DF) WhiteWave spinoff but couldn't get over the fact that it just looks like a really crappy business.  Sure, sales have been growing at WhiteWave in double-digits which is rare in the food industry, but their operating margins is in the high single digits; much lower than other branded goods.  It was hard for me to give it a high multiple which would be needed to make this an interesting sum-of-the-parts/spinoff play.

Maybe WhiteWave after the spin improves operations and gets their margins up, but they didn't really indicate that on their recent conference call.  I think they have said in the past that high single digits is the normalized operating margin they expect over time at WhiteWave and when an analyst asked if that is still the case in a post-spin-announcement conference call, they said they don't want to comment on that now.  So my take is, why would it change after the spin?

Looking around in stores, I wonder what the moat is in the WhiteWave business.  Most of the brands are relatively new, and I think that it's the concept of non-dairy milk that is the attraction, not so much the brand name itself.  For example, if I was going to buy soy milk, does it have to be "Silk"?  I wonder about that.

Not to mention all the debt that these guys have to deal with.  In any case, having looked at this for a while, I didn't come up with anything interesting enough to merit a whole post.  If things change, I may post something on it later.

Mr. Market
When I was looking at asset managers to come up with comps in a recent post (the OAK post), I came across GAMCO Investors (GBL).  Of course, we all know Mario Gabelli, a bubblevision regular and long time Barron's roundtable member.  GBL has been listed for a while too and has been talked about over the years.  I've always paid attention to what Gabelli has to say but never really looked that closely at GBL.  It still seems like an OK stock, nothing really exciting.

But what was interesting is that in the last few years, Gabelli has this excerpt from the Intelligent Investor at the beginning of his annual reports.

Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise?  Only in case you agree with him, or in case you want to trade with him.  You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

- Benjamin Graham, The Intelligent Investor

This is nothing new.  We all talk about Mr. Market all the time, but I do think that sometimes people forget about that.  For example, all the complaining about high-frequency traders, market distortions due to leveraged ETFs, hedge funds making markets more volatile, the frustration with the "risk on/ risk off" modes of the market (which reminds me of the "inflation day / deflation day" markets not too long ago) makes me wonder if we forgot that Mr. Market is irrational.  It doesn't matter what form it takes; in one era they were daytraders and SOES bandits, in another it was the index arbitrage and portfolio insuring delta hedgers using futures.  How about the days (before my time) when markets moved based on money supply figures published on Thursday nights?    Now the players are different, but still irrational.

We need these people as value investors.  We need people to be trading stocks based on things other than fundamental values.  Value investors love people who sell a stock because it breaks below support and think it will go lower and buy stock as it gets more expensive.

Without these people, who will we sell to and buy from?  The crazier and more insane Mr. Market is, the better it is for the value investor, as long as they are not leveraged and have their fate dependent on the generosity of a prime broker.

Interesting Conversation
I was at Barnes and Noble the other day (I am such a boring person that nothing to me is as exciting as browsing a bookstore.  Oh, getting a fresh-off-the-press annual report in the mailbox is actually a little more exciting) and was wandering around in the business/finance section.  This particular bookstore was near some major financial firms so had a larger than normal finance section.

Anyway, I overheard an interesting conversation.  I almost jumped in but thought better of it and quickly walked away.

The conversation was between some young, pimple-faced kid (maybe early to mid 20s) and a young middle-eastern looking kid of around the same age. 

I heard the young kid tell the middle-eastern kid that he runs a macro hedge fund  (this reminds me of another time when young kids seemed to jump into something!).  He said why bother with stocks?  If you buy a stock you like, like a consumer staple, the stock can go down because of what happens in Europe even if it has nothing to do with the company you own.  Why bother with stocks then?  It makes no sense to own something where the stock price is impacted by factors that have nothing to do with the business.  So therefore, he explained, he primarily buys and sells corporate bonds, government bonds and foreign currencies.

Well, OK.  I was tempted to jump in with my thoughts, but I know how these conversations tend to go so I just thought better of it.

This reminds me of the Lind Waldock TV commercials not too far back.  The commercial was similar to the above conversation.  Some lady was talking to some guy and she says, why bother with stocks?  With stocks you have problems like p/e ratios and corporate scandals. Why bother with that?  Just stick to what you know, like coffee and crude oil.

As much as I am a fan of free speech and free market capitalism, I thought that was awful; to try to convince people in TV commercials that speculating in commodity futures is safer than investing in stocks.

Anyway, this conversation reminded me of the above Mr. Market story. We should love that markets go up and down for the wrong reasons.

When to Sell
So someone asked me when it's a good time to sell after buying a stock.  That's a really good question.  In the investing world, sometimes it's harder to figure out when to sell rather than when to buy.

For someone like Buffett or other super-long term investors, this is not an issue as his favorite holding period is "forever".  In that case, when to sell is not an issue (even though he regrets not selling Coke in the late 90s).

There are many reasons to sell.  An investment can be a mistake, an error in analysis etc.  Things can change at the company for the worse and it can turn into something that is different than what you initially imagined.  But I would advocate never selling due to short term concerns about the economy or next quarter's earnings.

Otherwise, if you buy something thinking it's worth $100 at $60, you typically would want to sell it at $90 or $100.

But is it always that simple?  What if the company is growing at 10%/year and you think this is sustainable.  Wouldn't it be OK to hold it even at fair value if that fair value is growing at 10%/year?  I would say yes, assuming the intrinsic value calculation is conservative.

If what you own is an excellent company with great management with a great track record, I would be inclined to own it even at fair value or above.  How many people would have sold out of Berkshire Hathaway years ago after making money on it?  Maybe someone bought it at $50 in the 1970s and sold it at $100 or even a whopping $200 (now trading, as we know, at $130,000/share).  Surely some people bought at $50 and sold at $500 for the best trade in their investment lives.

A recent example is AAPL; I remember a good friend kicking himself for patting himself on the back with Apple.  I think he bought it at $10 and sold out at $20.  Homerun!  He was complaining about this trade when it was at around $70.

Apple is not a great example because I too didn't see this coming either; after every hit product I wondered what the next thing will be.  I was late into the game and did well on it, but I don't know that AAPL is a company that will sustain their edge for the next ten or twenty years.

So back to the question; if I bought a stock because I thought it was cheap, then I would sell it when it is no longer cheap unless it is one of those 'great' companies that I want to own over the very long term.

Comparing to alternatives is also a good idea.  If you buy a stock for 60% of intrinsic value and then sell it at 90% of intrinsic value, where do you put that money?  Is there another stock trading at 60% of intrinsic value?  Is intrinsic value growing at a pace that makes owning the stock close to intrinsic value attractive?

Sometimes owning a company that is growing intrinsic value at 10%/year at intrinsic value is better than owning a non-growing company at 60% of intrinsic value, unless there is reason to believe that the discount to intrinsic value will close relatively soon.   This really all depends.

Greenblatt's book (The Little Book That Beats the Market) has shown that stock prices do routinely get undervalued, and really cheap stocks tend to get back to higher values in a year, so focusing on what something is worth should still be the primary goal (again, except for when structuring permanent, long term portfolios).

This is interesting because in his other book, I think he said that some of his best investments took two or three years before it really took off (I think he was talking about spinoffs).

When to Buy
And this leads to the other question; when to buy?  People are so concerned about all sorts of things that they don't want to own stocks.  So if you don't buy a stock you like now because of worries about a European implosion, the fiscal cliff or the elections, then when do you buy?   If these uncertainties clear, wouldn't stock prices actually be higher?  Yes, if the nightmare(s) are realized, stock prices can also be materially lower.

So if you get out of stocks now to buy back in later when it feels better, then the math that has to be done is:  What are the odds that the negative scenarios unfold?  What are the odds that stock prices go down because of that?  And then what are the odds that you will have the courage to be able to buy stocks when it goes down?

I was going to pull out some old spreadsheets and actually calculate the economic value of owning cash right now in front of all of these uncertainties.  You can use exotic option pricing models to see what the value of holding cash now is and waiting for a market decline.  This can be compared to just owning stocks now and what the long term expected return is based on the current price  (down-and-in knock-in call options, lookback call option (where call buyer gets to choose lowest price in certain period etc...) pricing models can be used to calculate the theoretical value of this optionality).

But it's a hassle, so maybe I'll do it one of these days but not today.

The point is, if you can buy a stock now with an expected return of, say, 10%, that's great.  It's probably better to forget about what can happen between now and the medium to long term.  Who cares?

If you know that the business will grow 10% per year and the stock price will move up with that, who cares if there is a crash in October that would allow you to buy it 20% cheaper then.  In fact, if you plan on holding the stock for a long time, then the 20% discount isn't even that important;  if you plan to hold something for 10 years, a 20% discount will bump up your annualized return from 10% to 12.5%.  Over 20 years, a 20% discount will bump up your return from 10% to 11.2%.

Of course, 2.5% is not trivial.  Over time, that compounds meaningfully.  But the point here is that the other side of the equation is that the 20% discount may not come and the stock can run away. 

As I keep saying again and again, if you go back to the beginning of the year and gave someone just the headlines throughout the year 2012, nobody would guess the market would be where it is now...

This is not to say that we should all be 100% fully invested.  As Greenblatt said in a column at his website (that I can't find there anymore), one should own as much stocks as one can stand to watch it go down 50% because the stock market *will* go down 50% every now and then.   The mistake people made in 2008/2009 wasn't that they didn't get out in time.  It was that they owned too much for their own comfort so they sold out in fear at the lows to make their losses permanent.

Also, Buffett has said many times that he has never not invested in something because of his or someone else's outlook on the economy, macro risks or anything like that.

OK, anyway, this was another meandering post but at least I put something up. 

I hope to be more active going forward with some interesting things to look at.





Oaktree's Grand Slam

I don't plan on updating things every quarter on companies I mention here; figures will go up and down over the short term due to markets and AUM changes due new fund launches and returning of capital to investors (due to realizations) etc.

But anyway, one of the interesting things about OAK is the off-balance sheet items.  One of the large ones is the accrued incentive fees that is not booked as income at OAK (other managers book these even if not realized which causes higher p/l volatility).  The accrued incentive fee is held at the fund level and not paid out so doesn't show up in earnings or on the balance sheet.  It is itemized in the filings, though, so we always know how much is there.

At the end of the 2nd quarter, there was around $1.1 billion of that held at funds that actually belong to OAK (if realized and paid out). This comes to a little more than $7/share so is not trivial.  It's a nice chunk of the value at OAK.

Doubleline Capital
The other piece that is not reflected on the balance sheet is Doubleline Capital, a fund management company started with the help of OAK by Jeffrey Gundlach.  If you google him, you will find an interesting past to this person; trying to become a rock star in California, seeing an episode of the Lifestyles of the Rich and Famous and wanting to get rich, becoming (or trying to) an investment banker etc.  How can you not love America?

So as of the end of the last quarter, Doubleline already has $40 billion in assets under management (AUM), and has earned OAK $4.8 million in the second quarter alone (this includes their 22% stake in Doubleline Capital LP and an affiliated entity).  Earnings in Doubleline Opportunistic Income LP is stated separately.

This stake in Doubleline Capital LP is on the books at a cost basis of $18 million (the original investment was $20 million, I think, so they must have gotten dividends paid out or some other thing to reduce the cost basis).

Since the equity income passes through the income statement, this is not a completely off-balance sheet item; it is reflected in distributable income, economic net income etc.   It's just on the balance sheet at a really low price that doesn't reflect reality, so any valuation using distributable income or ENI is not affected by this.

The question becomes, how much is Doubleline Capital worth?  

Someone commented on my previous OAK post that it may be worth 2% of AUM.  Using 2% of $40 billion, that makes Doubleline Capital LP worth $800 million.  OAK owns 22% of that so that would be worth $176 million.  That's a nine-bagger ($176 mn / $20 mn)!  Nice trade.

Since there is 150 million total A and B shares outstanding, that comes to $1.17/share.  So currently, it's not a huge part of the total valuation of OAK (trading now just under $40/share).  But Doubleline is growing rapidly.  I think they had $30 billion earlier this year and it is now up to $40 billion.

Valuation Comps:  PIMCO
So I don't really know who the comps are for Doubleline other than TCW itself and PIMCO.  Blackrock used to be a fixed income manager until they bought Merrill's asset management business (which was mostly equities) in 2006.  So before that, they were a fixed income manager.  But those guys were a little different than TCW / PIMCO.

Anyway, thanks to the internet we have some data on PIMCO.   PIMCO was bought by Allianz back in March 2000.  They bought 70% of it for $3.3 billion, valuing the whole company at $4.7 billion.  At the time, PIMCO had AUM of $256 billion (they now have a whopping $1.8 trillion).

From the Allianz / PIMCO purchase presentation, the valuation of PIMCO was 1.8% of AUM and 14.5x EBITDA.  However, at the time back in 2000, 36% of PIMCO's AUM was in equities.

TCW / METwest
SocGen paid $880 million for a 51% stake in 2001 valuing TCW back then at $1.7 billion. They had AUM of $80 billion then, so that's 2.1% of AUM.

In 2009, Gundlach tried to buy TCW (51% stake) for $350 million, valuing TCW at the time at $700 million.  With TCW AUM at around $100 billion at the time, that comes to 0.7% of AUM.

The Carlyle purchase of TCW is said to be worth $700-800 million. With a current AUM of $131 billion, that comes to 0.53% - 0.61% of AUM. 

In 2009, Citibank bankers (hired by TCW to seek strategic options) valued TCW at between $700 - 900 million; AUM in 2009 was $100 billion, so that comes to 0.7% - 0.9% of AUM.

TCW, after Gundlach left, bought Metropolitan West Asset Management to fill the void for $300 million, and the AUM for MetWest at the time was $30 billion, so that's 1.0% of AUM.

So these are the data points from various articles written recently about the Carlyle / TCW deal.

By the way, here is the TCW AUM trend:

$bn
2006  $145
2007  $147
2008  $103
2009  $100
2010  $116
2011  $118
2012  $131 (current)

Doubleline Worth 2% of AUM?
Two key data points support a 2% AUM valuation; the PIMCO purchase by Allianz (1.8% of AUM), and the SocGen purchase of TCW (2.1% of AUM).    I think the underlying companies may be close comparables, but the problem is that these purchases were by large European financial institutions (not the most price sensitive?) and the deals were done in 2000 and 2001.  This was at the peak of the bubble so valuations may be peak-ish too.  More importantly, this was before the financial crisis and all financial valuations are far lower now than pre-crisis (if we want to use pre-crisis valuations, we might as well value GS at 3x book and just stay at the beach).

More recent data points suggest something closer to 1% of AUM.  Of course, TCW may be 'troubled' so it may not be such a great comp as far as the Carlyle deal is concerned.

But the Citibank valuation in 2009 of 0.7% - 0.9% of AUM is post-crisis and I assume TCW was still doing well at the time (Gundlach still there?).   Also, Gundlach himself bid 0.7% of AUM for TCW.  Of course, this may have just been a low-ball bid, but if he really wanted TCW he wouldn't bid such a small fraction of what it is worth.   Since it comes in at the low end of Citibank's evaluation, this 0.7% - 0.9% of AUM range is probably not too far off.

Also, TCW paid 1.0% of AUM for MetWest, which was presumably not a troubled firm.  This supports the notion that Doubleline may be worth closer to 1.0% of AUM rather than 2.0% of AUM.

By the way, you can't compare Doubleline with OAK; the big difference is that OAK is a hedge fund manager with higher fees and incentive fees which account for a large part of the value of OAK.

Blackrock (BLK)
Just as a sanity check, I took a quick look at BLK pre-2006 (when they bought Merrill's asset management business) as they were primarily a bond manager at the time. Since this is pre-crisis, it may not be too useful.

But anyway, a quick look shows that at year end 2005 and 2006, enterprise value to AUM was around 1.5% and 1.7% (10k's don't go back that far), and the p/e ratio ranged from 25-29x in 2001-2006 (on a year-end basis).

They are a totally different beast now, with a lot of equity assets and a big ETF business.  I think we will be laughed out of the room if we mentioned a 25x p/e ratio for someone in the financial industry.

P/E Ratio
Just as a cross check, since we know that Doubleline earned for OAK $4.8 million in the second quarter, let's look at some earnings ratios of some asset managers.  This measure will be more stable across different types of asset managers (percent-of-AUM valuation differs drastically according to what type of fund it is; equity, fixed income, hedge fund, mutual fund etc...).  P/E ratios are indifferent to asset type and only look at earnings. 

Since Doubleline is an LP, I assume the equity income that OAK books is a pretax figure.  So we will have to look at pretax P/E ratios (market cap divided by pretax earnings).  These are some listed asset managers in no particular order and their pretax p/e (based on FY 2011) and their trailing twelve month p/e (ttm) which I just pulled from Yahoo Finance.

Asset Manager Valuation

From this, we see that a pretax earnings multiple is pretty consistent across asset managers regardless of type of assets, and they average around 10x pretax earnings.  I put the ttm p/e ratio in there just for reference (note that the time period is different; ttm versus FY 2011).

OAK booked equity income of $4.8 million on their Doubleline stake in the second quarter.  Since Doubleline is growing so quickly, let's annualize this rather than double the six month figure (which happens to be $8.9 million). 

That gives us pretax earnings of $19.2 million.  Assuming little debt at Doubleline and minimal D&A, this may be close to EBITDA.  In that case, we can compare this figure to the PIMCO purchase by Allianz which was at 14.5x EBITDA.   This would give a value for Doubleline (OAK's share of it) of $278 million, or $1.86/share.

Using the above 10x pretax figure, OAK's stake in Doubleline would be worth $192 million or $1.28/share.   This is just a cross check; I can't really get too comfortable with an earnings valuation without a little more data and some more detail.  But if we keep an eye on it, it can be a good sanity check.

Conclusion
So judging from this quick look, it seems that a 2% of AUM valuation for Doubleline might be a little aggressive in this post-crisis market (and what if bonds actually do enter a bear market?).  A 1% of AUM figure sounds totally reasonable given recent transaction trends.

At 1% of AUM, Doubleline today would be worth around $400 million.  OAK owns 22%, so that's $88 million or about $0.60/share  (That means if we double the valuation, it's worth $1.20/share (at 2% of AUM)).

So even though this investment already is a home run for OAK, it's still not a big part of OAK's total intrinsic value.

We looked at the EBITDA valuation, but we can probably throw that out as it's based on a pre-crisis transaction at the peak of another bubble.  Using 10x pretax earnings which many listed asset managers seem to be consistently valued at, and a 2Q2012 run rate earnings, OAK's stake in Doubleline is worth $1.28/share  ($4.8 million x 4 / 150 mn SOS). 

This curiously gets us back to 2% AUM valuation, so maybe Doubleline is worth 2% of AUM after all.  But since Doubleline is still starting up, we have yet to see what their normalized earnings is going to be; we don't know what Doubleline will earn over time.

In any case, either way, Doubleline now is worth anywhere from $0.60-$1.28/share (1% or 2% of AUM or 10x pretax earnings).

But we have to remember that Doubleline is growing dramatically now.  Earlier this year they had less than $30 billion in AUM and now it's $40 billion.

So let's project out what they can possibly do.

Let's say that Doubleline can basically recreate TCW.  From the above table, we see that TCW had AUM in the $100 billion - 150 billion over the years.

Using the 1% and 2% AUM figures (we won't know what the pretax earnings are going to be), here is what Doubleline might be worth to OAK on a per share basis:

The first column is simply the AUM Doubleline will have.  The Total value figures are just 1% and 2% of that.  The value per OAK share is simply the total value times 0.22 (22% ownership) divided by 150 million shares of OAK shares outstanding.

From this, we see that OAK's stake in Doubleline is currently worth $0.59 - $1.17 / OAK share.  If Doubleline can recreate TCW and get AUM up to where they are, then the value to OAK of their stake would be $2.05/share (at 1% AUM valuation) or $4.11/share (at 2% AUM valuation).

Of course, they can keep growing.  If they get AUM up to $200 billion, then Doubleline would be worth $2.93 - $5.87 / OAK share.

If you want to up the AUM assumptions, just double the $400 billion AUM, or just use $1.50 per share per $100 billion etc.   I'm sure some bulls will want to argue that  Doubleline can become more like the $1.8 trillion PIMCO.   Now that would be something.

Doubleline is already a home run for OAK, but if they get AUM up to $140 billion, OAK's share at 2% could be worth $616 million.  Think about that.  A $20 million investment going to $616 million.  That would be a 30-bagger.

But as much a home run Doubleline is for OAK, it would still account for only $4.11/share in value to OAK shareholders.  Doesn't seem like much on a $40 stock (but we'll take it!).

World War III and the Stock Market (and other random thoughts)

I've read the 1934, 1940 and 1988 editions of Securities Analysis but haven't read the 1951 and 1962 editions.  For whatever reason, they slipped through the cracks.  I really love the 1934 edition because it is the first edition and really digs into what went wrong in the 1920s and early 1930s (sounds exactly like the 1990s bubble), and the 1940 edition.

I think Buffett has said that the 1940 edition is his favorite.  He said he has read it at least four times over the years.  A sixth edition was published recently with comments by some of the current great investors and those 'essays' alone are worth the price of the book.   The sixth edition is just a reissue of the 1940 edition (updated) with these essays added. 

The commentators are:

•   Seth Klarman
•   James Grant
•   Roger Lowenstein
•   Howard Marks
•   J. Ezra Merkin (?!)
•   Bruce Berkowitz
•   Glenn Greenberg
•   Bruce Greenwald
•   David Abrams
•   Thomas Russo

Anyway, here are the links to the various editions (of course, from the Brooklyn investor store; I just set up this bookstore for fun.  I wanted to understand how this stuff works (after following Amazon for so many years) and did it out of curiosity, plus I find myself recommending the same books over and over to people so figured I would put it all up somewhere.  I haven't really finished stocking it up and organizing it, though).

1934 Edition
Sixth Edition (1940 reissue)
1951 Edition
1962 Edition

If you haven't read any of them and only had to read one, I would say start with the Sixth Edition  (The 1988 edition was not written by Graham).

1951 Edition
Anyway, so I started reading the 1951 edition and in the preface dated October 1951, there was a paragraph that struck me as relevant to today (well, everything he says is still relevant today):

This preface is being written when the possibility of a third world war weighs heavily in all our minds.  We need to say only a word about this unhappy subject in relation to our present work.  The effect of such a war upon ourselves and our institutions is incalculable.  But in the field of securities analysis we need consider only its bearing on the choice between various securities and between securities and (paper) money.  It seems sufficient to observe that since war and inflation are inseparable, paper money and securities payable in specific amounts of paper money would seem to offer less financial or basic protection than soundly chosen common stocks, representing ownership of tangible, productive property.

And in the footnote, there was an excerpt from an essay Graham wrote for the Analysts Journal in the first quarter of 1951 titled The War and Stock Values.

Here is a quote from there:

Stock prices as a whole may be expected to rise, sooner or later, to reflect this cheapening of the dollar.  The course of the stock market from 1900 to date (1951) shows a fairly close over-all correspondence between the rise in stocks and the general prices, although there have been significant divergences for fairly long periods.

This is relevant today because most people seem to fear now high inflation due to all the pump-priming around the world.  This is not news to stock investors; many believe that stocks are better than cash and bonds, but others are worried that high inflation will cause stock prices to go down; they think they should wait by holding cash (despite inflation risk), gold or look into investing in 'hard' assets like real estate.

Hard Assets or Stocks?
I wrote a lot about what I think of gold here so I'll talk about other assets.  There is somewhat of a boom in farm land around the world with purely financial buyers bidding up prices.   The story makes a lot of sense; there will be inflation in the future so own hard assets.  Food demand will continue to grow on increasing population so farmland prices will go up.

But it's important to remember (and nobody really talks about anymore) that the housing bubble in the U.S. was driven largely by people wanting to own a 'hard' asset.  They got killed in stocks in the 2000 internet bubble.  They vowed, no more stocks!  And they rushed into real estate.  It's a hard asset, right?  It will hold it's value.  The Fed will always print more money at every economic downtick.  The government will keep spending money.  Inflation is inevitable.  So why not own houses and real estate?  Land bank stocks boomed too back then.  They don't make more land, right?  But they do keep printing more money. 

So it made perfect sense.  Buy houses, land, land bank stocks etc.  And what's more, you can borrow to do so.  Borrowing money is shorting the U.S. dollar.  And sometimes you can do it with positive carry or zero carry (cash savings or rental income pays interest and other expenses so you get the rise in prices for free).

This was a major factor in people rushing into real estate, I think. 

And there are people driven to certain investments today for the same reason and I am a bit skeptical of them.

Stocks are Real Assets Too
People tend to brush off stocks as a piece of paper and forget that it's a partial ownership of real assets, or "tangible, productive property" as Graham called it.  Of course, this is not true for all stocks.  As I mentioned in a post a while back, Coca-Cola has done really well over time despite the inflation that has occured in the past century.  As Graham says, stock prices eventually catch up to the rise in general price levels.  (I wrote about KO and inflation here)

If a business has a good product, good management, good business etc., then inflation won't be much of a problem.  The only problem is that if inflation ticks up, stock prices may go down in the short term (Earnings may go down too, but if it's a good business, they will be able to reprice and do well over time).

I think this is what most investors worry about.  They remember stocks at 7x p/e back in the late 1970s and think it can go back to that level when high inflation inevitably comes.

In the above mentioned The War and Stock Values essay, Graham wrote:

War conditions could be destructive to stock values but the mere possibility proves nothing of significance.  It is the weight of probabilities that is important.

This is another key point.  People worry about inflation, but it is important to weigh the probabilities.  Many smart people do think inflation is inevitable (as I do too), but we don't really know when and how much.  Some feel hyperinflation is inevitable and others have more moderate views.

But nothing is certain.  When a scenario is certain and absolute (and many agree), you should look elsewhere anyway as you can only make money on the divergence between perception and reality.   (There is a conundrum here as gold and other hard asset prices says inflation is inevitable but bond prices say deflation).

Stocks Outperform Inflation Over Time
OK, so I'm going to borrow this chart from Bill Gross' (PIMCO bond guru) recent, controversial letter that I will comment on later.

This shows that stocks over time have handily outperformed inflation, bonds and cash.  But the key words are "over time".  Of course, stocks were flat in the inflationary 1970s.  One might have averted that flat period by successfully timing the market, but I think it's been proven that nobody can time in and out of markets over time successfully (most individual investors lose money or underperform because they get in and out of stocks at the wrong time!).

(I have shown here that there is a class of investors (residents of a village) that can make good returns in a flat market period without resorting to getting in and out of the market.  This group has outperformed in all sorts of market environments over long periods of time.  I have yet to find similiar performance figures for tactical asset allocators and market timers).

Fear of 7x p/e Stock Market
So anyway, yes, if inflation spikes up like in the 1970s, stock prices will go down and may go down really hard. But we don't know when and how much things will go down. One big risk in avoing stocks until such event occurs is that it may not happen as planned. Back in 1987, people thought a 1930s-like depression was inevitable (so they stayed out of stocks). Others thought that the market won't bottom until the market p/e gets to 7x.  They looked at a long term chart of market p/e ratios and they saw that the market went down to that level in 1932 and 1972.  So they figured it must get there in 1987 or 1988 too.   In fact, many called for 7x market p/e's in 1990-1992 too during the Iraq crisis, real estate / Citibank crisis etc.  I heard people call for it in 1997/1998 too.

If there were two times it should have happened, it was after the 2000 bubble collapse and of course the financial crisis.  The market p/e didn't get low then either.    You can fairly argue that stocks haven't done much since 2000 so it doesn't matter; staying out of the market wouldn't have cost much.

But it's still not a certainly that we will get 7x p/e's in the near future. 

So what if it does?  Odds are that people who get out now and wait for a 7x p/e before jumping back in will do worse over time than people who ride it all the way through.

Cheap Can Be Good for Current Stockholders
There is a big difference between thinking that the bear market will bottom at 5x or 7x p/e and thinking that stocks will get to 7x p/e and stay at that valuation forever.  If you think the former, it doesn't matter.  If you think the latter, then maybe you are better off staying out of the stock market (even though you have to calculate the odds that you may be right etc.).

People want to keep cash on the sidelines so that they can buy stocks when they get cheaper, or so they can moderate the losses on the downside. 

This is something each person has to figure out on their own and do what is comfortable for them.  But it's important to remember that even if you are fully invested, that doesn't mean you can't take advantage of a cheap market.

Charlie Munger talked about this at a recent annual meeting.  He said low stock prices is good because it allows good companies to grow.  He said this is how Rockefeller, Carnegie and others got rich.  They were around in bad times to buy stuff on the cheap to get bigger.   Without the bad times, they wouldn't have grown as big and wouldn't have gotten as rich  (I assume Munger meant Rockefeller/Carnegie got big at the company level; strong balance sheet and good cash flow to reinvest in bad times to expand).

If you own a stock that generates good cash flows, then you are going to benefit in bad times as long as the people who run the business know how to allocate capital.  They will get better deals than most individuals and even most professional investors will get. 

This is why it's important to invest in companies with solid businesses with high moats, not too cyclical and strong balance sheets.

Most investors are afraid of the mark-to-market losses they will have to take on a decline in the stock market and they don't think about what happens on an upturn after that.

So even if you have no cash and are fully invested, that doesn't mean good companies you own can't take advantage; in one sense, you are not fully invested.  (Think about the companies that I write a lot about here; BRK, LUK, L etc.  A lot of these companies have good cash flows and excess capital they are waiting to deploy.  This is true for strong operating companies too).

Culture of Equity is Dead
So Bill Gross wrote a letter stating that stocks are basically dead and even said that the stock market is a sort of Ponzi scheme.  He points to the difference in real stock market returns over time of 6.6%/year versus a real GDP growth over time 3.5%/year and says it is unsustainable as the stock market is just skimming 3%/year off the top.  Many have already pointed out the error in Gross' thinking; that difference is basically dividends that get paid out. 

He confused growth in stock market capitalization and total return. 

In any case, there was something else I thought about while reading that letter.  Even if the stock market as a whole can't outdo GDP over time, I do think that great companies can (not that we can always identify great companies).

For example, Walmart has been taking market share from unlisted, small mom and pop shops for decades.   This would show up in an increase in stock market earnings over and above GDP growth.  The same could be said of some great restaurant companies. Roll up strategies might give the same effect.  Globalization can also contribute to this trend; McDonalds, YUM Brands, Coke all get a lot of growth outside the U.S. and yet book earnings here in the U.S.

As usual, regardless of what the macro, top down charts show, at the end of the day, it's all about the individual businesses and the price you pay for them.


P.S. Market Up More Than 11% YTD
Not that short term stock market movements matter much, but I just couldn't resist pointing out yet again the futility of macro-analysis for stock market investing.  All year, we have been worried about a real implosion in Europe and even China.  I too was convinced that a real crash may happen and things really might get out of hand.  Reading the newspapers every day was a scary thing to do; sometimes I just wanted to not read the paper at all.

And yet here we are with the S&P 500 index up over 11% on the year.  As I said many times before, if you took all that has happened this year, went into a time machine to the beginning of the year and told them what would happen, I don't think people would have guessed the stock market would be up at this point.  (On top of the Europe problem, slowing China and the fiscal cliff, we also had JPM's whale problem etc.)

Louis Bacon recently gave back some of his investor's capital saying the markets are too tough to trade with all of this macro noise (or more the government interference).  He is supposed to make money off of that.  He complained that political meddling / interfering in the markets has made it hard to make money.  I scratched my head because it seems that that has always been the case.  Remember the Greenspan put?  Remember the Plaza accord?  Central bank intervention in foreign currency markets?  Rubin's bailing out of Mexico?  LTCM bailout?

I think it has always been pretty hard.  I would guess that Bacon's problem is size, and possibly even information flow.  I think some hedge funds were privy to some good, advantageous information (not necessarily illegal inside information) in the past and due to the crackdown on banks, independent research firms, insider trading busts and overall heavier regulatory scrutiny, maybe that sort of information doesn't flow as much as it used to.   But that's just a shot in the dark guess.  (I noticed that a high performance hedge fund's return started to slow dramatically also around the time that independent equity research companies started to be investigated.  This may be a coincidence, but I always wondered about that. Still, size is probably the biggest hurdle to high performance).

For equity oriented hedge funds, Sarbox and Reg FD may be a factor too in flattening the information flow; previously analysts were able to get access to more information and pass that on to favored institutional investors including hedge funds.  These new regulations made it harder to get good information.

This is nothing new; I am not making any allegations.  Michael Steinhardt himself has said in one of the Money Masters books that one advantage he had was that he paid Wall Street so much in commissions that he was a valued client.  Therefore, he often got the first call on upgrades, downgrades etc.  And when he didn't get the first call, he would go ballistic.  

The world has changed quite a bit since then, and this may be a factor in the moderation of hedge fund returns lately.