Secular Investment Religions - Weekly Blog # 835

 

         

Mike Lipper’s Monday Morning Musings

 

Secular Investment Religions

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

   

       

Timing of Views

Apple announced its first calendar report this week, continuing a pattern of declining comparative quarters, albeit with a smaller percentage decline and slower sales of its latest iPhone model. Later in the week Berkshire Hathaway reported its first quarter results showing it sold 13% of Apple, its largest holding. During the Berkshire presentation I became increasingly concerned about the long-term outlook for US large-cap equities.

 

My worries were summarized in a column by Mohamed El-Erian for the Financial Times. He stated “tighter regulation, industrial policy, chronic fiscal looseness and internationally globalization has been giving way to fragmentation” as concerns.

 

Attending Berkshire’s annual shareholder meeting this weekend, I read a slide showing the major sources of the firm’s net operating income after taxes. One of the reasons to go to the meeting is that they report the results of the over 60 wholly owned and majority-owned companies in summary. In aggregate, their growth in earnings has slowed down or fallen. Most of these companies produce products and services used globally. Despite record domestic stock prices, it appears we are probably going to see an economic decline of measurable depth and magnitude. The questions that remain are timing and whether the decline is cyclical or structural. These questions forced me to examine the nature of these two remarkable companies presented this weekend.

 

Share Owners Create the Nature of Ownership

While management of the company largely dictates the nature of most companies, owners of the stock determine the nature of ownership of the stock. As both stocks are within ten percent of their all-time highs, there are very few losers in the stock. Both are multi product companies that provide services to both individuals and wholesale users. The companies have long outgrown their original set of products and services and their reputations allow premium positions within our society. While they have some competitors, they have no overall copycats. Their exact futures are not clear, although many users and owners have a great deal of faith in them, even though they don’t really know what their future will be. Without being sacrilegious, these two stocks have reached the point of being a religion in the secular world. Regardless of the existence of doubters and some heretics, it would take a major violation of the trust that has been established to destroy their faith in these two companies. (This has happened in the past, a couple of generations ago when the “Generals” were the secular religion, as in General Motors and General Electric, and many lesser Generals.)

 

Management Mistakes Admissions Help

Apple finally gave up on Project Titan (their car project). Elimination of their car project will allow Apple to conserve some needed talent. A complete car is a very different business and is not highly valued. Motorola lasted much longer, from its taxi and police car two-way radio in its early days to the semiconductor and early mobile phone years. On Saturday, Warren Buffet admitted he made the decision to sell Berkshire’s losing position in Paramount. While they were a supplier to Amazon, they didn’t buy the stock or another tech company until Apple.

 

Pulling the Thoughts Together Early

Revenue leverage in an inflationary period is unlikely to be maintained as a growth driver with small unit growth. Around the world, unit growth is decelerating. Productivity is also slowing because new hires are not as profitable as the seniors let go, even though juniors are initially paid less. However, lower pay expenses do not last long, as fringe benefits are more expensive, except for retirement. Retirees have not built-up enough savings to cover expenses in a non-work period. Productivity, where it exists, is driven by non-domestic born labor. Birth levels are below replacement needs and the education system is not producing ready, willing, and educated workers. AI gains, if delivered, will probably help the middle class but not the lower classes. The push for fewer working hours will create additional expenses and possibly social problems.

 

We need Berkshire Hathaway, Apple, and others to succeed for a healthy society around the world. Long-term it must be global, let’s hope it happens.       

 

 

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Value Investing: Yes, Book Value: No

Introduction

Two thoughts to begin this post:

1.  Value focused investing has produced good results for hundreds of years.

2.  The use of unadjusted book value found in the modern corporate accounting statements can mislead the value investor.

Investment See-Saw

With our need to label anything that moves, particularly in the stock market, during rising markets we often divide companies, stocks, and fund portfolios into either growth or value. With the power of computers to sort and mislead, many foolishly believe that there are some statistical divining rods that can separate growth from value. In truth almost every entity has alternating periods when it can be recognized as either growth or value.

The Perceived “Two Number” Screens

As a life long student of investing I have noted that growth investing is essentially time-focused arbitrage. The growth investor has reasons to believe that in a particular future the price of the shares of interest will be materially higher than today’s price. Growth investors are essentially forecasters. In a secular rising market (as experienced by US investors) the trend is their friend until it periodically disappoints.

Value investors see the future as a range of outcomes, only some of which are identifiable. Charlie Munger is the epitome of rational investing. He and his partner Warren Buffett have three baskets, In, Out, and Too Tough. Jason Zweig quotes Charlie invoking Confucius, who said that real knowledge is knowing the extent of one’s ignorance.”

Dangers of “Latest Published Book Value”

Far too many professional investors start their search with a screen of current prices compared with the latest published book value. I would suggest they are taking an easy and faulty crutch to find value. One of the many things drummed into me by Professor David Dodd of Graham and Dodd fame was never to accept the validity of a balance sheet as presented. Balance sheets then and now are important initial file instruments for the credit world. The initial bottom line for credit work is book value. This is a calculation derived from taking all the liabilities on the balance sheet from the total of all assets also shown. For investors in stocks and bonds priced way below par or maturity value, Dodd would term book value, unadjusted as “rubbish.” The good professor was not just a learned academic at Columbia University, he was also an investor and partner with Ben Graham* in a very successful investment partnership.

The Lessons Not Learned

On my recent trip to visit investment managers in London I came across at least two instances where they could have profited from Professor Dodd’s classes. In the first case a sizeable, successful group invested in closed-end discounts from the fund’s current net asset value (equivalent to book value for funds), large family dominated non-US financial entities, and other conglomerates. I have been an analyst of bear raids on US closed-end funds selling at significant discounts. These “operations” rarely work out in practice compared to what they should do in theory.

All published net asset values for funds are based on the closing price of the individual holdings on statement date. Market operators are well-conscious of important stated dates and may adjust their closing prices accordingly. If the fund has particular positions in somewhat illiquid stocks the price to liquidate the positions will likely be anything other than the last price in the NAV. Also the unwinding of the raided investment advisor’s management company can prove to be expensive in terms of settling leases and termination payments. Further, to force a liquidation of a closed-end fund an initial investment needs to be taken and it is at risk for the difference between the purchase price and the liquidation proceeds in the future when the market could move materially. At times, hedging this risk can be expensive. As faulty as raiding a closed-end is, the rest of this portfolio is at risk for using book value as an important measure.

I was one of the very few analysts who in the 1960s spent a great deal of time following multi-industry companies. These were soon called conglomerates, somewhat forgetting that General Electric and other industrial companies were producing products for a wide range of business customers. One of the reasons I was attracted to these companies is that there were many fewer analysts following them and thus they were not highly valued.

One of the sales pitches to convince institutional investors to buy these stocks was to show that there was a substantial discount from the value of each of the major parts of the conglomerates. It was a good sales approach, but I can not remember a single conglomerate that liquidated itself by selling off all of its parts. Yet this is the very same approach that was being used by this London manager. Further, as I knew a little bit about some of the financial operating holdings, I questioned whether book value was reflective of a liquidating value.

In one case, the financial operation was one of a handful of major players in a somewhat restricted market. I raised the question as to whether the local government would permit its sale to a foreign entity. Having recently visited this particular headquarters, I asked whether a very extensive art collection was in the book value calculation. (There is at least one important US group with a similar art collection.)  The conversation then pivoted to their treasures, we did not even get into the expected size of retention packages for key personnel or any guess as to the proportion of revenues that could be lost if the founding family was no longer involved.

On a second London visit, to one of the great names in the global financial world, we were going over its balance sheet and other financials. It was pointed out to me that the monetary value of the firm’s great name was not included. I raised the question whether or not they could get an external appraisal as to the value to the name, which my hosts never considered. As someone who has a globally recognized name in various financial communities, I am aware that a well-known name helps in getting the first introduction. But from that point on it is what one is presenting that will determine what is bought. Thus, the value of a name is a bit ephemeral, but I believe it still can be measured.

The interesting thing coming out of this type of exercise is that for internal purposes the value of the brand would have been added to its assets and perhaps materially. If that was the case, the return on assets and return on investment could well show that the present management was not really earning its keep.

What to do Now?

As we do not know which type of investing will do the best for any particular period, in our portfolio practice we own both growth and value focused mutual funds for our accounts. Over long periods of time the survivors of these two schools of investing produced similar results, but quite different in shorter periods. On a year-to-date basis in each market capitalization size category, value funds have underperformed growth funds. In a somewhat extreme example, through the 24th of September, the average Large-Cap Growth fund is barely down -0.36% as compared with the average Large-Cap Value fund falling -8.57% as measured by my old firm. As a long-term contrarian investor I note that the spread is unusually large and could prove to be attractive in the next cycle. 

* I was very honored when the New York Society of Security Analysts awarded me the Benjamin Graham Award, my old Professor might not have believed it.

Question of the Week: What measures do you use to find value?
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LESSONS TO ALL INVESTORS FROM WARREN BUFFETT’S LETTER

Many investors, including me, spent Saturday and Sunday of this weekend reading Warren Buffett’s latest letter to the shareholders of Berkshire Hathaway. I was interested in his comments about the company and its quite poor 2008 investments. I have been a shareholder for many years and the stock is in the portfolio of the hedge fund that I help manage. However, my principal focus was on the implications I could draw from the 22 page letter to apply to our other investments and to share with you in this blog.

What follows are items that Mr. Buffett commented in the order of his comments and my reactions to the comments. As usual in most things that I write, my mission is to provoke tangential thinking on your part rather than the laying down dictum “according to Mike Lipper.”

Throughout the letter Buffett focuses on the financial and political abuses of our trust carried out on both the national and local levels. I agree with him that the after-inflation value in various governments’ paper is more questionable now than ever. In addition, Buffett also expects rising unemployment in 2009, and perhaps beyond. Despite those dour views, he intones that the best days for America lie ahead. Part of his optimism is probably based on his assumption that Americans are focused on saving money as never before. (With our oversized position in financial service securities that is good news in the long term.)

Turning to investing in securities, Buffett has a number of observations that may seem to be logically inconsistent, but actually recognize the complexities of investing. “When investing, pessimism is your friend, euphoria the enemy,” Buffett reminds us. Nevertheless, he points out that the S&P500 has gone up about 75% of the time in the last 44 years that he has been managing the company. The historic upward slant to the market has not prevented him from either buying securities or companies. However, his pricing decisions are different and insightful. He says, “We like buying underpriced securities, but we like buying fairly priced operating businesses even more.” I suspect this apparent dichotomy is based on the reality that good, privately-owned businesses managed by owner/operators instinctively know both their present and future values, and want their price.

It is my belief that in the public securities market, future prices are not primarily dictated by the operating results, but by the co-ventures in the security. When will they sell and what will prompt the sale? Thus, one needs to apply a discount from value for the irrational behavior of one’s co-ventures. Given the choice between the two; securities or operating businesses with management attached, Berkshire has a decided bias in favor of buying operating companies at fair prices over securities at a discount. A number of ultra high net worth investors have a similar bias.

Buffett issues some cautions regarding the future. He is suspicious of relying on past financial data, particularly price data in its many derivative forms. Two of his quotes are instructive. First, “Investors should be skeptical of history-based models. Beware of geeks bearing formulas.” Second: “If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.” Having really learned about security investing at the local race tracks, I have a more than skeptical view of those who have a “system” that can beat the odds repeatedly. Despite these cautions, I agree with Mr. Buffett in believing that after many years of under-pricing risk, we are now over-pricing risk. His major financial warning deals with derivatives, which he appropriately labels as dangerous, having spent $400 million to unwind the derivatives he bought at a very wrong price when he purchased General Re.

Despite these feelings, he has entered the market for credit default swaps (CDS). These securities are somewhat like the reinsurance policies that Berkshire manages brilliantly in most instances. On the other hand, in some cases these securities settle many years in the future, and it is the final price that matters, not any of the intervening prices. What makes this much more risky is that the counterparty can, and does change without the permission, or in some cases knowledge, of the other party to the trade. I believe Buffett is correct that until effective clearing houses and exchanges are established, the bulk of this business will rest with a concentrated group of dealers. In this case a handful or less of major banks will be dealers, which add to both risk and opportunity to those in and around the concentrated circle.

Finishing his securities insights, Buffett provides details of his sale of part of his positions in Johnson & Johnson, Procter & Gamble and Conoco, which I assume were largely at a profit. He did this to fund his high yield with equity kickers in Wrigley, Goldman Sachs and General Electric. I am much more confident in the return of all of his capital than I am of the value of the GE kicker. What is significant about these trades is that while Berkshire still had significant cash and debt-carrying capacity, Buffett felt that he should maintain these reserves and accepted the discipline of having to sell some favored positions to fund purchases of better bargains. I am particularly focused on the Conoco sale, made after adding to this position earlier this year. Yet in his letter he states he still believes oil will sell for higher prices in the future to which I concur.

As is appropriate, Mr. Buffett states his views on the current housing credit crisis. Though the letter doesn’t volunteer the information that he is betting on both sides, publicly he urges home buyers to look to their purchase for enjoyment and utility, not for profit and the opportunity to refinance. Less publicly stated, but in the innards of the letter, is the disclosure that the company owns the second largest real estate broker in the country, and that Berkshire will continue to buy local real estate agents at reasonable prices.

No summation of Warren Buffett, his letter, or his work would be complete without a recognition of how great a showman he is, and a genius at cleverly manipulating public opinion through skilled conversations with the press. His PR acumen will be demonstrated at this year’s annual meeting of Berkshire Hathaway, where he has invited three high profile journalists to pose questions to himself and vice chairman Charlie Munger. Included are Carol Loomis of Fortune (who has written more great insightful pieces than any author that I have read), Becky Quick of CNBC (which guarantees electronic media coverage), and Andrew Ross Sorkin of The New York Times (which fits Mr. Buffett’s political tendencies).

Bottom line: One can learn much from Mr. Buffett, but don’t try to copy him, you don’t have the same equipment. He and Berkshire Hathaway will survive. The economic outlook over the next couple years may be challenging, but as the structure of the new world departs from the old, the opportunities for investment bargains will be great.