With Value Fully Priced, Expectations are Needed

Introduction

In many periods value focused mutual funds and similar managers perform better than growth oriented managers. When growth managers perform well they can perform very well and in some cases produce doubles without leverage. Value oriented managers in good times don’t do as well. However the secret to their better performance in many periods is that they do not fall as much as the portfolios of growth managers. The smaller declines are not only due to the fact that their stocks don’t rise as much as the growth stocks, but often because of the value managers’ price valuation discipline, they cannot find qualifying securities to buy. Thus, they somewhat involuntarily start to build up their cash positions, particularly if some of their holdings are subject to cash acquisitions. In reviewing a number of fund portfolios as part of my investment practice, I am beginning to notice a rise in the cash and short-term holdings of respected value managers. As these managers do not claim any market timing expertise, in the past the buildup of cash could have been premature to a top of the general market. Now I believe we are seeing early stages of this phenomenon. If this is not a top, market participants will have to see rising expectations.

Fair to full value

From my prior posts one can see that I believe that the large value positions in my financial services portfolio have recovered substantially from their 2008 low points, and perhaps are selling over their fair value levels. A portion of my portfolio is invested for the long-term in good companies. My unwillingness to currently buy more of these good companies would suggest that I have backed into a portion of my portfolio that is currently fully priced. I believe other value focused managers have reached similar views in their broader portfolios. In my case I have not been using current earnings, but my subjective belief in the earnings power of these companies contingent upon a “normal” business and financial expansion. My valuations have been inordinately helped by the currently manipulated interest rates in the marketplace. The math behind the valuation process is to determine a reasonable estimate of future earnings power from existing businesses and then to discount the resultant future stock prices using a somewhat cyclical price/earnings ratio. I use the current level of interest rates to discount this future valuation back to a present price comparison. For high quality companies, historically I have used the yield on 10-Year US Treasuries, now below 2%. For lesser quality investments I have used the yield on similar maturity High Yield (“junk bonds”) currently below 7%. The lower the yield the smaller the discounts applied. In the past these yields have been 5 percentage points higher, 7 and 12% respectively. Therefore my valuations are susceptible to market forces.

Expectations

The value investor uses the current price as representative of perceived value by the market and compares that to his/her perceptions of value, particularly to a what a strategic buyer or a liquidator would pay. The growth buyer perceives what a security would be worth in the future. The future price is based on a series of interrelated expectations. These expectations include broad factors encompassing demographic and psychographic trends, political realities, economics, relative military powers and the willingness to use them. Also included in the list of expectations by smart analysts and smarter investors in dealing with a specific company are its revenues, operating margins, net free cash flow, debt service, market share, new product development and likely competitive responses.

Professional portfolio managers’ expectations should include expected changes in the current shareholder population and their motivations.

Whether we recognize it or not, the play of expectations is at work in the marketplace every trading day. During the “risk on/risk off” phase for the last couple of years, a narrowing fraternity of traders dominated the marketplace. While traders are still important, a renewed group is coming off the sidelines. These are institutional and individual investors who are being forced to remedy the shortfall in the purchasing power of their capital to meet their long-term needs; i.e., retirement and building/rebuilding long-term facilities. For the most part these investors did not leave the investment arena. They either let their cash build up, chased yields into fixed income securities, and/or invested in alternatives in private equity, real estate and some commodity plays including a little bit in gold or gold mining shares. I believe we are in the process of seeing a change of comrades in arms as to the investor army that is taking the lead for market leadership. Recently stock markets around the world have been rising. Many of the trading fraternity, (including aggressively managed hedge funds) have long positions in gold or related securities and their short book has been growing. Some believe the rapid rise in the VIX Index over the last week was somewhat due to panic buying by hedge funds to cover their short positions in response to this supposed indicator of bearish sentiment. The rise in the stock markets coming during a period of extreme negative views toward many elected politicians is being led, I believe, by longer-term investors. If I am correct, the impetus to commit money now into common stocks is based on growing changes in expectations.

New/different expectations

In general, I believe that buyers of stocks these days believe some of the following:

1.    The private sectors of the economy are showing gradual signs of global expansion. Materially higher stock prices are dependent of revenue growth.

2.    The public sector is shrinking its employment base and to some extent its overall compensation load on taxpayers. In an ironic way, this could be good for both the surviving government workers and the public they serve. One of the reasons the private sector is in better shape than the public sector is that business has raised operating margins to high, if not record levels, by significantly improving labor and capital productivity. (Doing things better with fewer people.) Until very recently many federal and some state and municipal governments have not faced these challenges. Traditionally the way governments in control have addressed problems, the same way the North did early in the American Civil War, was to throw enormous amounts of people and money at the perceived crisis of the moment. Over time this technique is self-defeating; as those with more limited resources come up with productive solutions.

To comprehend the growth in the US federal government’s direct and contracting payroll, drive as we did this weekend through Northern Virginia and Maryland on the run up to Baltimore and observe the enormous real estate developments that are full of employees and their families dependent on US taxpayers. Smarter and further automation is likely to improve the delivery system of necessary government services.  In field after field society has found that externalizing various government services has produced better results, particularly when there is no union involvement. The non-profit world is going through similar problems. As they become more market disciplined their audiences will benefit from more efficient delivery of their vital services

3.    The unstoppable march of demographics is producing several cohorts of capable people who want to work. At the one end is a better schooled, (notice I did not say educated) population. These individuals are eager to earn and for the most part eager to learn commercially viable skills. I believe the expectation is that these willing workers will be absorbed into the work force both here within the US as well as in many other countries. High-speed computer communications have made locations less sensitive to success than specific expertise, including customer service. At the other end of the age spectrum, we and many other “developed” countries have a growing segment of seniors who want to work for income or socialization. They have useful skills and in many cases seniors are the fastest growing learners of new computer techniques. These two leagues, the young and the seniors, represent to me and my Marine Corps training, a large reserve element than can support and supplement those who are more advanced, but at lower net wages.

4.    Technology and particularly medical/health technology is producing a potential population that can be productive in every sense of the word. Many of these improvements will actually lower the cost to society which can have dramatic impact on the growing gap of retirement funding that is a global phenomenon. All of this represents investment opportunities.

5.     Because of European colonization efforts we currently live in a world where the Northern Hemisphere is economically and financially more advanced, with a number of exceptions. Identifying three of the exceptions demonstrates what can happen in the Southern Hemisphere; Australia*, Chile*, and South Africa. I expect over time that money and talent from the North will leverage the local talent and other resources in the South to create a long-term investment boom.

*I have investments in these markets through single country funds.

Changes in levels of expectations are normal in the attitudes towards the stock market. One can gauge where we are in terms of the distance from a speculative top by looking at the period that the bulls are using in their purchase recommendations. While quarterly numbers are taken as verification of longer-term trends, they are having less impact now. Currently the focus is more on the second half of this year which leads to the full year results which for the most part are used for valuations. We are entering the time of the year when professional analysts will start to publish their next year’s estimates. Recent visits to sound buy-side shops focused on the detail in their five year estimates. As part of my responsibilities for a non-profit I was asked to come up with a ten year estimate of endowment performance to test the ability to meet spending needs. I am also in the process of working with my accountant to come up with the ranges of expected performance to be contemplated for a dynasty trust. Thus I am already dealing with different time period expectations, but so is the market. The price of Apple at over $700 in September, 2012 was largely based on a long-term projection of the continued growth of their recently introduced iPhone 5, with particular focus on the perceived potential in China. For lots of reasons that I will be happy to discuss privately, these expectations were wrong or at least way too premature. The current price of 430.17 displays the risk in rising expectations. As the stock with the largest market capitalization, it is note-worthy that the fall in the price did not lead to a general market sell off (which has happened previously when the leader’s price balloon was popped) and may signify that market participants do not currently expect a market decline. 

Please share with me, perhaps privately, what are your expectations for your money in the period you are most focused?

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Do Something Now to Make Money Later

Introduction

Unfortunately, some people have the habit of remembering what I say even if I don’t. In order to protect me, I am trying to write down what I think I say in various conversations. This week I had four discussions that separately focused on what investors and managers should be doing. In thinking about these communications, my point of view was they should be doing something now, to make money in the future.

The two portfolio approach

In a discussion with an organized group of sophisticated investors who travel behind a cloak entitled OFIC, much of the conversation was about the various concerns that were preventing them from investing. In reaction, in part due to my reading about naval warfare, I suggested that they immediately do something. In a naval battle, a ship that is not moving is a much better target for the enemy than one that is in motion, particularly if the motion leads to rapid changes of direction and speed. For my National Football League-oriented friends, this is advocating the use of broken field plays to keep the defense off guard. My suggestion was that each investor create, at least in his or her mind, if not in fact, two portfolios. The first portfolio is to hold the investor’s maximum need for liquidity. The first would have not cash (yielding nothing) but mostly munis and other income producing paper. With the need for liquidity addressed, the second portfolio could be aggressively invested. The aggressive portfolio should be focused on the reasonable extremes of the myriad of opportunities that are available today. We should keep in mind that even during the Depression there were some fantastic up-market moves.

There are two keys to this strategy, the first is get out of the middle where everyone else is, and the second, like a broken field runner, be prepared to change courses rapidly.

Essential elements of information

I spend a lot of time with analysts and portfolio managers trying to understand how they make investment decisions. I get worried when they express their decisions based on the complete confidence that they have all the information on a company, stock, or market. This confidence belies what I learned in the US Marine Corps as well as my own analytical endeavors on individual stocks. In the military intelligence world (perhaps it’s an oxymoronic statement), one needs to identify what are the critical facts needed to make a decision. These facts are called the essential elements of information. Further, each element was graded on the likely accuracy and the quality of the source of the information. In the heat of battle, did the Marines, and I suspect other forces, have complete knowledge of the situation that faced them? As an analyst, I used to lay out what I wanted to know about a company and a stock. (They are very different for the long-term.) In both cases, in the military and on the analyst desk, did we ever have 100% of the essential information? Due to time pressure, we frequently had to make decisions having only 60% of the needed elements. Rarely did we get to 75%. When the battle is on (or when the stock is recommended or bought), some of the missing elements become known, plus new unanticipated factors surface. When properly processed and communicated, the additional information can cause changes in direction. With this as a background, I am less likely to buy a fund where the manager and/or responsible analyst feel that they know everything. A level of doubt is an important additional attribute that is a positive for me.

Precision vs. accuracy

Recently I was in communication with a very bright law school student who was entering his last semester with a very good record. I suggested that it is possible that at the end of his last term some professor could ask a question whose answer was not in his books but in his evolving understanding of the practice of law. I used as an example that, I believe 50% of my last Asset Accounting exam was to answer the question as to what was wrong with accounting. What the professor was asking was, in essence, what value was all this work? (The same question could and perhaps should be asked at the final term of all professional schools.)

There is a significant difference between accurate bookkeeping and accounting. Bookkeeping requires the capture of all the financial information and displaying it in an acceptable format. Good accounting takes the product of bookkeeping and colors it for other factors based on experience, regulation, and tax management. A bookkeeper can capture the cost of an asset and assign it to an expense or asset account. The bookkeeper can charge against the asset an agreed depreciation, so that the balance sheet reflects how much of the asset has been paid for through the income statement. The accountant needs to determine whether the asset is overstated or the property is materially not worth its carrying cost. While the bookkeeping is precise, the accounting is making a judgment as to the accuracy of the numbers. As a portfolio manager and investor in financial services securities, I am offended by the argument in the press and by some managers and analysts that many banks and other financial companies are holding large amounts of assets, particularly loans, that are selling at ridiculous low valuations. They scream that these stocks are selling at prices that approximate book value. These same stocks are not only not going up, they are going down. They have mathematical precision to buttress their argument. The market is not buying it. The imprecise market is looking for accuracy. Accuracy as to what the assets are really worth. One could take the attitude that instead of being cheaply valued, that these securities are in fact, expensively priced. The assets could, for example, be worth 50% of their carrying value and thus these stocks are selling at 2X their realistic book value. On this basis, I am suspicious of many so-called value managers who assert that their portfolios are statistically cheap based on published book values. There are, undoubtedly, a number of stocks that are selling at substantially below what a knowledgeable buyer would pay for the company. When we see a pickup in M&A deals for already public companies, there will be more verification of values in the market.

Hire a good pro

One of the observations that I make in interviewing CEOs of private investment management organizations is to see whether they hiring people. During most periods one of the constraints on future growth of a business is the lack of good people to hire at reasonable wages. I believe that eventually we will see high stock market levels and that there are an inordinate number of good investment people that are either out of work or for the first time in their careers, would be willing to jump to a better opportunity. Thus, I think this is a good time to hire. As a matter of fact, if any member of this blog community knows of an experienced analyst of US mutual funds who is looking for an investment employment opportunity, there is a good chance we should talk directly (not through any intermediary).

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