Three Major Sources of Investment Losses

Introduction

Essentially I am a student of investment performance. For the most part I use the global universe of mutual funds as my laboratory. In addition, I serve on a number of investment committees that employ external managers as well as own individual securities. Recently, I suggested that in addition to looking at the rank of our endowment performance that we isolate five to ten winners and a similar number of losers. I was much more interested in the second group. There were many similar characteristics of the winners however there were fewer in the laggards.

As an investment manager for serious investors my first job is to avoid losing large amounts of money for my clients. With this particular task in mind I have identified three main causes of many large portfolio losses.

Major Source # 1: Gross Domestic Product (GDP)

The academic definition of GDP is the sum of the goods and services produced within a national economy. From that top down level other economic projections are made by economists that in turn produce investment strategies of portfolio managers and strategists. There are numerous problems within this approach. First, much of the data collection going into the aggregate GDP number is flawed. The source is usually government data which can be easily manipulated for political purposes to such a significant degree that the former Premier of China indicated that he did not trust GDP as it was “man made.” He used other data produced by the private sector to help him guide the Chinese economy.

There are substantial portions of the US economy that go largely unreported. Not only is the “informal” or underground economy uncounted, the value produced by the volunteer sector is also unknown as is the work carried on within the home for no direct monetary compensation. Paul Samuelson, the great MIT economist and the author of one of my college economy text books pointed out that if a man married his maid and she continued to clean his home as his wife, the GDP would shrink because the maid’s income would no longer be counted.

In the modern world the production of GDP is done for political leaders to guide their economic policies. Because the politicians have most of their political power within their borders, they are essentially focused on domestic job creation. This is not the way consumers look at their purchases which are focused on quality, price, style, and availability from any acceptable source. Managers must manage both domestically produced products and imports and their relative prices. Investors need to follow their investments in companies that have both domestic and foreign activities as well as follow world trade flows and currency fluctuations.

Thus in the real world GDP is not of much use to us as consumers, managers, and investors. Therefore, be very careful of any manager that starts his/her investment strategy based on changes of the level of the GDP. That is not the real world and only useful in dealing with the politicians and the uninformed media.

Major Source # 2: Reported Earnings Per Share

As soon as earnings per share numbers are published, investors are bombarded with slews of “Non-GAAP” statistics often adjusting most of the operating numbers on the income statements. Managements want investors to focus on these adjusted numbers not the reported numbers and the differences can be meaningful, from a loss to a profit excusing some non-recurring occurrence. Managements are often getting paid through stock price changes, but the statistical services are using the reported numbers. So whether the stock and the market is cheap or expensive relative to earnings is a function of which set-off earnings are being used.

As a professional analyst, I prefer to focus on operating earnings excluding in many cases net interest income, but adding actual and additionally needed capital expenses. In essence I am looking to determine the net cash generation of the business after expenditures and debt service. Thus different investors can come up with different valuations from the same financial report. For the professional investor the published financial statement is the beginning of the analytical discussion not the end. Therefore, a manager that relies exclusively on reported earnings could be misleading both investors and him/herself as to the significance of the report.

Major Source # 3: Investment Predictions

Charlie Munger and Warren Buffett place very little reliance on economic or corporate predictions. This is contrary to most of the financial community which rotates, sometimes violently, on changes in predictions. Many studies of investors' behavior and particularly of their losses show that high levels of confidence as to the future can lead to poor results. If one emotionally needs to make predictions, make them often, but go back to the base case each time to see the nature of the differences and the strength of the prediction. The odds are that we will be wrong much more often in our predictions than in our analysis of the present. Our view of the past will be occasionally wrong as well.     

Applying this Week’s Thoughts

Each week Barron’s publishes a confidence index that compares the yields of the best (high quality) bonds and intermediate (lower investment grade) bonds. Over time if the relation between the yields widens, high quality stocks will rise. For the last several weeks that is exactly what is happening with the yields on the higher qualities being flat and the yields on the intermediates rising. Over the latest 12 months the high quality yields have dropped from 3.64% to 3.23% where as the intermediates’ yields have risen from 4.68% to 4.92%. The way I interpret the data, the intermediate yield gain is showing a measurable increase in an estimate of the default risk which to me is more significant than a somewhat larger decline in the best bonds’ yield. I am a little more confident in the analysis of what the present market is saying than I am in the future prediction.

Question of the week: How do you measure your confidence ?

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Value Trap by the Book

Introduction

One of my functions for clients is developing the menus of 401k and 403b rosters of funds. Quite properly the sponsors of these programs wish to offer a relatively low-risk equity alternative along with presumably higher performing funds. Many institutional as well as individual investors also seek lowered perceived risk investments. Each of these potential investors gets attracted to funds that have ‘value’ in their name. As has been said often, “One should not judge a book by its cover.” The perception of value may be quite different from the reality.

Value definitions

There is no universally accepted definition of value. Most investors believe that within the rubric of ‘value’ there is some attention being paid to the risk of permanent loss of capital. The marketing and distribution forces within the money management industry often attempt to demonstrate that advisors focus on value by quoting the price/book value statistic. According to this logic, the lower price/book ratio is better. A ratio below 1 is meant to be a sign of a real bargain. I believe this may well be a trap.

What is book value?

This is not the place or the time to produce a treatise on double entry accounting principles. The term ‘book value’ has a specific accounting definition. An investor searching for value needs to understand that there are a number of links between the income statement and the balance sheet. One of the key concepts is that the income statement is required show all of the costs that should be charged against the current period’s revenues. This is fairly simple to do for the cost of labor and supplies consumed during the period. There is a problem however on how to allocate some of the capital that has been invested in longer-lived assets like buildings, acquired customer lists and patents. Accounting rules dictate how much should be charged to the current period. The remaining portions of these costs are capitalized and are found in various entries on the balance sheets. They are included in the so-called book value. (In its simplest terms, book value is calculated by deducting from the assets all liabilities divided by the number of shares currently outstanding to arrive at a book value per share number.) Currently, auditing requirements demand an annual review as to whether these assets are at least worth what they are stated on the balance sheets. If they are worth less, they are to be written down on the balance sheet and an impairment charge is to be made to the income statement. Under conventional accounting procedures there is no provision to writing assets up.

Sound security analysis and effective loan officer research techniques should include reviewing these assets on internal spreadsheets. These augmented financials could lead to a justifiably higher price for the stock, the company, and/or an increase in collateral value for loans. These upward adjustments to book value cannot be published by the company issuing the financial statements.

“The Market” knows

While appropriate adjustments to stated book value are not published, market prices often reflect these changes. Years ago a successful, wise trader told me that a stock is only worth what it is selling for at the moment, not some theoretical accounting value. On Friday two of America’s strongest banks reported their first quarter results. Some in the media called attention to the fact that Wells Fargo* was selling at 1.29 times its book value and JP Morgan* was selling at 0.91 times its book value. Remembering what my old trader said, the market was suggesting that it was deducting an impairment charge for the “fortress balance sheet bank” (JP Morgan), and not for the bank with the largest home mortgage business (Wells Fargo). Considering that a portion of the former’s good earnings came from reversals in its bad loan reserves, the market could be right.

* Please note in terms of disclosure that I personally owned shares along with many other financial service stocks in my personal portfolio. Neither stock is included currently in the private financial services fund that I manage. The comments in this blog should not be interpreted as a recommendation to buy or sell these securities.

The corporate finance view on ‘value’

Both Warren Buffett and I studied at the feet of Graham and Dodd at Columbia. He studied under Benjamin Graham and I was with Professor David Dodd. Both instructed us to reconstitute financial statements in order to determine at least liquidating value. Part of the exercise was to eliminate most, if not all inventory value; also to re-price the outstanding debt at its current market value among other adjustments. The genius of Mr. Buffett was to recognize the economic value of the “moat” around the company that protected the firm’s market share. In many of Berkshire Hathaway’s** acquisitions, I believe the size of the “moat” relative to the price was an important element in the final decision. In some cases, key personnel were very much part of Berkshire’s valuation of the “moat.” (I know in the purchase and sale of financial data products and companies, the customer relations experience was a critical factor that I used in valuing the various opportunities before me.) These and similar approaches are used by corporate finance groups to determine acquisition value.

** As noted in earlier blogs, I personally own shares in Berkshire Hathaway, as does the private financial services fund that I manage. The mention of this stock should not be construed as a recommendation to purchase.

My concept of ‘value’

I try to divide potential investments into two large buckets. The first is one that future events will cause the stock to raise. Often this may have to with new products, processes, sales strategies and competitors’ problems. In the other bucket are stocks that are selling substantially below their current liquidating value, or at a price that a reasonably smart strategic buyer would pay for the company.

How to apply in fund/manager selection?

Avoid those managers that emphasize the value of published price/book ratios. Work with managers that know enough and have enough good contacts within an industry to come up with an independent valuation. Due to the time to research available companies, the preferred managers typically have relatively low portfolio turnover rates. However, these managers must have a history of reacting to their own misjudgments and exiting from what looked like great values.

All long-term successful investors use trial and error techniques. Thus the success of any particular investment is far from guaranteed. The truly great investors recognize their errors and quickly move on, so some portfolio turnover is a good thing to see. The essence of value-focused investing is to reduce the chances of large avoidable losses.

How do you find and invest in good values?
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