Mike Lipper’s Monday Morning Musings
Investors Can Learn from History, If Diligent
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Most memories are summaries of what people think happened and these memories over an extended period become enshrined as facts that are used for future investment decision making. Current investors are under the impression that “history” favors “value” and “Goodbye Globalization”, without being fully conscious of the history that created these impressions. Upon further study, one would realize that the underlying history is more nuanced and complex.
Value vs. Growth
We like to use short labels to cover complex situations. For example, we use the same label for both a company and its stock price, which often go in different directions. A company’s growth is essentially dependent on increasing sales and possibly its earnings, whereas stock prices are the result of buyers and sellers, often evaluating the stock in relation to other investments. Daily stock prices make them easy to rank from best to worst performance for each time period, which probably has little predictive power for long-term investing. Nevertheless, some investors search through the poorer performers looking for turnarounds, fitting with a part of the American psyche that likes to cheer for the underdog. Many investors who have missed being heavily invested in different forms of growth are now cheering the long-awaited trend of “value” beating “growth”, at least for a period.
I believe the first textbook publishing of Security Analysis by Ben Graham and David Dodd was written during the Depression in the 1930s. (The first was an adjunct professor and the second a full professor at Columbia University, which twenty years later suffered having me in his class.) Their approach, both in class and to some extent in their practice at a successful closed-end fund, was to find a security selling at a substantial discount to their analysis of value. What worked for them and others like Ruth Axe and Max Heine, was looking at distressed bonds and preferred shares using this approach.
The first thing the good professor taught us was to reconstruct the balance sheet by discounting finished inventory by 50%, work in progress by 100%, and raw materials by 75%. In the same fashion we reduced the value of physical assets to our estimate of quick resale prices. We wrote off all intangible assets and what was left of the underlying equity (more on this later). Comparing our new estimate against the depressed price of the senior securities became our initial estimate of value. During the 1930s and into the war years, this led to some very successful investments in railroad bonds and preferred shares. In effect, what we were taught was the rapid liquidating value.
Today, Merger & Acquisition activity has become the main determiner of value. Instead of determining the liquidating value, the acquirer is interested in what accountants call the going concern value. However, the acquirer often writes off some of the assets, adds the cost of expected layoffs, and determines an estimated increase in earnings based on “better” management and new opportunities from existing assets. I suspect that in the acquirers view of the future there is no estimate for a down period or the reactions from competitors.
M&A driven prices create an accounting problem, because after accepting the remaining costs of fixed assets transferred to the new balance sheet, an amount must still go to the consolidated balance sheet. Some of this gap can be labeled as the value of intangibles, such as customer lists and patents. However, even with these additions there is typically still a gap labeled “goodwill”. (I was the beneficiary of this math when I sold the operating assets of my data business, a service business who’s price was substantially above the value of the physical assets sold.) This is where the fictional portrayal of balance sheets and book value come into the picture.
For publicly traded companies, “goodwill” and other assets cannot be written up but can be written down if there is clear evidence of loss of value (a non-cash charge which lowers reported earnings). The CFA Institute notes that private companies can write off goodwill over ten years and there is a movement to allow publicly traded companies the same privilege. In an article they pointed out that there are 25 corporations that have between $28-$146 billion of goodwill on their balance sheets, including Berkshire Hathaway, CVS Health, and JP Morgan Chase. In my case it would be difficult to write off the goodwill from the transaction, as they continue to use the name and basic calculations for the statistics. As the acquirer continues to have many of the same clients after a sale 22 years ago.
I believe too many investors lump “value” stocks with cyclical stocks, which is why they have been greeted by poor performance for over ten years. Most of the world’s economies have grown during this period due to increasing services revenue growth. Over the same period there have been relatively few goods and materials shortages. Prices of goods, particularly manufactured or natural resources, have not kept up with inflation.
In our fund selection process we like to find true value stocks that show substantial discounts from their intrinsic value. These tend not be economically sensitive and are found infrequently. Most of what others call value, are cyclical stocks selling at the low point in their cycle. Typically, their stock prices rise when shortages appear, often when large competitors drop out or the demand level shifts in their favor.
There is a difference in when to sell a true “value” stock versus a cyclical stock. One completes a trade when the discount disappears in the value stock price. Cyclical stocks should be sold when the investor believes the demand for a company’s product or service is peaking. My own way of timing this is to watch commodity prices and commodity fund performance. We could be entering a more favorable period for cyclicals as 66 of the 72 weekly prices tracked by the WSJ were up, but most commodity funds did not rise, except for those invested in energy.
“Goodbye Globalization”
Goodbye Globalization is the headline in a recent edition of The Economist. This magazine is in the running to replace Time and Fortune magazines as excellent negative indicators. They do not know their history, countries and companies that build fortresses by gathering all needed resources within their walls have proven to be builders of self-inflicted prisons, with high costs and lowered productivity. History suggests that even during wars, opponents trade with each other through third parties. In WWII, the relatively easily conquered Sweden and Switzerland were left unoccupied to serve that purpose. Even when the US was clamping down on an increase in Japanese car imports, they still came in through factories in Mexico and Canada.
But the real historical lesson happened in the 15th Century, within those one hundred years created the “new normal” that guided economic and political trends until the late 18th century. During the 1400s the new young Emperor of China decided to recall its very powerful ships from the Mediterranean, India, Africa, and possibly America, before destroying them. At the time, China was the most advanced country in terms of science, gun power, and business structures. China has still not recovered from that decision and this is one of the reasons for China’s leadership moves today.
By mid-century the Ottoman Turks captured Orthodox Constantinople, turning it into the Moslem dominated Istanbul, enabling them to challenge Eastern Europe. An event that has effects even up to today.
Finally, by the end of the century there was the discovery of the misnamed America. This led to the extraction of Latin American gold which turned the European economy positive and the investment opportunity that the US proved to be.
The lessons to be learned from the 15th century was:
Good News
In April we saw some individual mutual funds and mutual fund management companies having positive net inflows. The winners had particular selection skills rather than being focused on sector section. Much of the inflows came from institutional or retirement investors. In brief discussions we heard that the trends seen in April continued in May. Nevertheless, on an overall basis equity products had net outflows, but larger amounts went into fixed income investments. Being a contrarian suggests to me that once the risks of higher interest rates and inflation rates become more pronounced, we are likely to see substantial equity inflows that can absorb the actuarially driven outflows.
Any thoughts? Please Communicate.
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html
https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html
https://mikelipper.blogspot.com/2020/05/top-down-sells-bottom-up-pays-weekly.html
Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at
AML@Lipperadvising.com
Copyright © 2008 - 2018
A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.
Value vs. Growth
We like to use short labels to cover complex situations. For example, we use the same label for both a company and its stock price, which often go in different directions. A company’s growth is essentially dependent on increasing sales and possibly its earnings, whereas stock prices are the result of buyers and sellers, often evaluating the stock in relation to other investments. Daily stock prices make them easy to rank from best to worst performance for each time period, which probably has little predictive power for long-term investing. Nevertheless, some investors search through the poorer performers looking for turnarounds, fitting with a part of the American psyche that likes to cheer for the underdog. Many investors who have missed being heavily invested in different forms of growth are now cheering the long-awaited trend of “value” beating “growth”, at least for a period.
I believe the first textbook publishing of Security Analysis by Ben Graham and David Dodd was written during the Depression in the 1930s. (The first was an adjunct professor and the second a full professor at Columbia University, which twenty years later suffered having me in his class.) Their approach, both in class and to some extent in their practice at a successful closed-end fund, was to find a security selling at a substantial discount to their analysis of value. What worked for them and others like Ruth Axe and Max Heine, was looking at distressed bonds and preferred shares using this approach.
The first thing the good professor taught us was to reconstruct the balance sheet by discounting finished inventory by 50%, work in progress by 100%, and raw materials by 75%. In the same fashion we reduced the value of physical assets to our estimate of quick resale prices. We wrote off all intangible assets and what was left of the underlying equity (more on this later). Comparing our new estimate against the depressed price of the senior securities became our initial estimate of value. During the 1930s and into the war years, this led to some very successful investments in railroad bonds and preferred shares. In effect, what we were taught was the rapid liquidating value.
Today, Merger & Acquisition activity has become the main determiner of value. Instead of determining the liquidating value, the acquirer is interested in what accountants call the going concern value. However, the acquirer often writes off some of the assets, adds the cost of expected layoffs, and determines an estimated increase in earnings based on “better” management and new opportunities from existing assets. I suspect that in the acquirers view of the future there is no estimate for a down period or the reactions from competitors.
M&A driven prices create an accounting problem, because after accepting the remaining costs of fixed assets transferred to the new balance sheet, an amount must still go to the consolidated balance sheet. Some of this gap can be labeled as the value of intangibles, such as customer lists and patents. However, even with these additions there is typically still a gap labeled “goodwill”. (I was the beneficiary of this math when I sold the operating assets of my data business, a service business who’s price was substantially above the value of the physical assets sold.) This is where the fictional portrayal of balance sheets and book value come into the picture.
For publicly traded companies, “goodwill” and other assets cannot be written up but can be written down if there is clear evidence of loss of value (a non-cash charge which lowers reported earnings). The CFA Institute notes that private companies can write off goodwill over ten years and there is a movement to allow publicly traded companies the same privilege. In an article they pointed out that there are 25 corporations that have between $28-$146 billion of goodwill on their balance sheets, including Berkshire Hathaway, CVS Health, and JP Morgan Chase. In my case it would be difficult to write off the goodwill from the transaction, as they continue to use the name and basic calculations for the statistics. As the acquirer continues to have many of the same clients after a sale 22 years ago.
I believe too many investors lump “value” stocks with cyclical stocks, which is why they have been greeted by poor performance for over ten years. Most of the world’s economies have grown during this period due to increasing services revenue growth. Over the same period there have been relatively few goods and materials shortages. Prices of goods, particularly manufactured or natural resources, have not kept up with inflation.
In our fund selection process we like to find true value stocks that show substantial discounts from their intrinsic value. These tend not be economically sensitive and are found infrequently. Most of what others call value, are cyclical stocks selling at the low point in their cycle. Typically, their stock prices rise when shortages appear, often when large competitors drop out or the demand level shifts in their favor.
There is a difference in when to sell a true “value” stock versus a cyclical stock. One completes a trade when the discount disappears in the value stock price. Cyclical stocks should be sold when the investor believes the demand for a company’s product or service is peaking. My own way of timing this is to watch commodity prices and commodity fund performance. We could be entering a more favorable period for cyclicals as 66 of the 72 weekly prices tracked by the WSJ were up, but most commodity funds did not rise, except for those invested in energy.
“Goodbye Globalization”
Goodbye Globalization is the headline in a recent edition of The Economist. This magazine is in the running to replace Time and Fortune magazines as excellent negative indicators. They do not know their history, countries and companies that build fortresses by gathering all needed resources within their walls have proven to be builders of self-inflicted prisons, with high costs and lowered productivity. History suggests that even during wars, opponents trade with each other through third parties. In WWII, the relatively easily conquered Sweden and Switzerland were left unoccupied to serve that purpose. Even when the US was clamping down on an increase in Japanese car imports, they still came in through factories in Mexico and Canada.
But the real historical lesson happened in the 15th Century, within those one hundred years created the “new normal” that guided economic and political trends until the late 18th century. During the 1400s the new young Emperor of China decided to recall its very powerful ships from the Mediterranean, India, Africa, and possibly America, before destroying them. At the time, China was the most advanced country in terms of science, gun power, and business structures. China has still not recovered from that decision and this is one of the reasons for China’s leadership moves today.
By mid-century the Ottoman Turks captured Orthodox Constantinople, turning it into the Moslem dominated Istanbul, enabling them to challenge Eastern Europe. An event that has effects even up to today.
Finally, by the end of the century there was the discovery of the misnamed America. This led to the extraction of Latin American gold which turned the European economy positive and the investment opportunity that the US proved to be.
The lessons to be learned from the 15th century was:
- Adam Smith in his book titled "The Wealth of Nations" showed the benefit of countries/companies specializing to get economic advantage through world trade.
- Fortresses become prisons, eventually.
- Often, new critical stimulus come from outside the recognized ecosystem.
Good News
In April we saw some individual mutual funds and mutual fund management companies having positive net inflows. The winners had particular selection skills rather than being focused on sector section. Much of the inflows came from institutional or retirement investors. In brief discussions we heard that the trends seen in April continued in May. Nevertheless, on an overall basis equity products had net outflows, but larger amounts went into fixed income investments. Being a contrarian suggests to me that once the risks of higher interest rates and inflation rates become more pronounced, we are likely to see substantial equity inflows that can absorb the actuarially driven outflows.
Any thoughts? Please Communicate.
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html
https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html
https://mikelipper.blogspot.com/2020/05/top-down-sells-bottom-up-pays-weekly.html
Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at
AML@Lipperadvising.com
Copyright © 2008 - 2018
A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.
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