Capital Cycles Changing? - Weekly Blog # 595

Mike Lipper’s Monday Morning Musings

Capital Cycles Changing?

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

                             
The critical lesson of living we must deal with is that all of life is cyclical. As investing is an abstraction of living, investors must deal with cycles. Our cycles occur along the spectrum of capital, going from capital appreciation to capital preservation or from highlighting goals of success to those of survival. A somewhat parallel spectrum is arrayed between “growth” and “value”, as we choose to define them. It is often useful to determine where we are in the spectrum by relating current values to those at the extremes. The activists believe they can consciously time their movement from one extreme to another, while  historians are generally more comfortable mid-range. This dichotomy was evident during the past two weeks.

Where Are We Going?
Far too many words have been written recently giving directional advice without understanding where we are in the investment and market cycles. The distinction between the two related cycles is that investment cycles begin with intelligent and prudent transactions, while market cycles record sudden shift in prices. Somewhat suddenly two weeks ago, “value” stocks and funds began performing better than the prior leaders marching under the banner of “growth”.  This past week the momentum in favor of “value” was absent or subdued. This is not surprising as growth has been a consistent winner for ten years and in the first four days of the week transactional volume was low. “It takes a long time to turn a battleship” was one of the lessons taught us in the Naval Reserve Officers’ Training Corps (NROTC).

Is There a Change Happening?
When one is in a turning phase it is almost impossible to be certain of the future direction. Is it a ninety degree, one hundred and eighty degree or three-hundred-and-sixty-degree turn? There are at least four bits of evidence that something out of the ordinary is happening.

1. Falling prices have seen more volume than those rising in this week’s transactions. (More dollars are leaving than coming into the market.) 
2. On Friday there was a surge in the transactions of asset management stocks, e.g. T. Rowe Price (*) traded almost 3 times its average volume of the prior four days.
3. High-quality debt yields declined more than intermediate-quality debt based on the latest week’s yields. (Bond prices move inversely to yields, so the desire to own high-quality paper with reduced income is a sign of concern for both bond and stock prices.)
4. WeWork’s proposed IPO price, after dropping by two-thirds, was withdrawn. (In the weekend edition of the Wall Street Journal, my friend Jason Zweig intelligently questions the myth that private investing produces better results than publicly traded investments. The significance of this belief is that many tax-exempt institutions and wealthy individuals have put substantial amounts of their capital into private securities, believing that their lack of liquidity and disclosure are exchanged for better performance, often caused by their  IPOs. I am familiar with several cases where this didn’t work out.)

(*) T. Rowe Price, the premium publicly traded asset manager, is in both our Financial Services Fund and personal accounts. They are predominantly an investor in publicly traded securities. However, in some of their funds they have been an early investor in private companies. The maximum share that I have seen in their equity portfolios is 7% in privately held securities. Many of these have been good investments and losses have been small over the many years they have been investing in privates.

What is “Growth” and “Value”
Investors use labels as an abstraction to convey a series of integrated, complex concepts. The essence of “growth”, “growth stock” and “growth stock fund” is the rising of stock prices above those found in the general stock market on a secular basis over multiple market price cycles. This definition ignores both short-term and economic cycle price swings around an upwardly sloping trend line. Another way of expressing this concept is that growth companies have profitable products and services, which are met with increasing acceptance by both customers and investors. There is a problem with that definition in that the label is unlikely to be permanent for all time, due to its dependence on the perceived ranking versus their competitors. However, some companies have appropriately maintained the label for a long time. The trick for investors is to identify when that the label is slipping. Renewed, skeptical analysis is needed.

There are many ways to define “value”, because value is in the eye of the beholder. The original investors were the primary investors betting on the success of the venture. The follow-on investors were cashing out the originals and had to question the offered price relative to other alternatives. The second set of investors thought of value in terms of a discount relative to present prices. The history of Security Analysis is that it was developed as an offshoot to accounting. The original course by Ben Graham and Dave Dodd started with the analysis of the assets behind bonds, which were selling below both their maturity price and the statement value of the assets. We were taught to schedule the cash conversion schedule of the assets. Greater weight was readily given to  assets converted to cash, like finished inventory vs. plant and equipment etc. This led to a group of buyers who were labeled “net-net buyers”. Ben Graham, Warren Buffett and the late, great Irving Kahn were some of these.

Because of a much higher level of public disclosure and computer searchable financial statements, there are relatively few net-net opportunities in most developed countries markets. In its place some have used the discount from book value or net asset value for fund vehicles as a substitute. For the most part this has not worked particularly well because balance sheets record historic asset acquisition prices adjusted for annual depreciation and impairment costs. Book values are rarely written up according to accounting and regulatory rules. Recent attempts to capture the discount on closed end funds has not been successful. First, it takes time, effort, and often money to displace the present management. Second, there is likely a difference in price form the last sale at the end of a day and the actual price received in liquidation.

So Where Are the Value Opportunities Today?
There are quite a few that are the equivalent of Sherlock Holmes in the mystery of the dog that didn’t bark. The focus should be on what is not on the balance sheets of both assets and liabilities. One example is real estate for an operating company. Royce & Associates (**) has a fund that invested in Steinway, the concert piano manufacturer, which was not growing. However, uncaptured on its balance sheet was the air rights above its low-level 57th street show room and their large facility in a rapidly changing section of Queens. This proved to be very profitable when the real estate was liquidated. Much like a chain of cigar stores on many prominent corners in Manhattan, which lost money as tastes shifted, but had very long-term leases on their stores.

Today, in many companies the most valuable asset is the lists of customers and what they purchase. Two examples are stocks that I own personally, neither of which I expect to liquidate even though they have understated book values. Apple’s one billion customers names and spending habits proved that an asset could predict future sales, much like when car owners traded in their vehicles every one to three years. Another company that is assembling a combined customer information databank is CVS, which is combining its pharmacy and health insurance customers. Not only are there repeat business opportunities, but the potential to identify new demand as new drugs and services are developed. I suspect Amazon could create the same type of value, which is essentially a derivative of DE Shaw’s ability to predict market prices.

Is There Another Approach?
Believing in cyclicality, I often look at the worst performing investment objectives compared to the best. (This works for a group of funds, but not necessarily for individual funds where differences in skill levels are apparent.) In the last five years the average growth fund of all sizes, both domestic and international, averaged a gain of +7.57% compared to value funds which gained +3.50%, or effectively half. Thus, one can see my initial attraction to the possible shift in favor of value. Even with this instinct when investing new money we are more weighted toward growth for long-term accounts, but we are slowly increasing our exposure to value. The reason for the slowness is that we could still have another strong bull market led by growth. We are very close to record price levels, with the Dow Jones Industrial Average behind -1.55%, S&P 500 -1.12% and NASDAQ -2.55% from their record highs. We are paying attention to the NASDAQ as it is the most speculative of the indicators and is the one that has recently shown significant selling volume.

(**) My son who is the senior investment strategist for Royce Associates and was not involved in that decision.

Need Help?
If you would like to discuss any of these thoughts or how to structure your portfolio, please contact me.



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Investing Your Time for Better Results

Introduction

In my 2008 book MONEYWISE, I suggested that one’s investment results are more a function of how one spends his or her time on investing and giving than the size of the original capital or the initials after one’s name. This week I had reasons to think about what George Soros, Jesse Livermore, Irving Kahn, Warren Buffett, and two bank CEOs have said.  Each of these gentlemen had worthwhile messages for investors, perhaps particularly at this time when so many people are indecisive as to their investment posture.

George Soros and Jesse Livermore on market direction

[While I have met Mr. Soros and supplied his firm fund information in the past, I do not really know him but respect his skills. Jesse Livermore may well have traded a margin account through my Grandfather’s brokerage firm, I did not know him.] The source of the thoughts that I share with you is from a reader who publishes his own personal weekly blog, Teddy Lamade of Brown Advisory. Teddy quotes George Soros as saying, “Markets are constantly in a state of uncertainty and flux. As a result, money is made by discounting the obvious and betting on the unexpected.” This is in effect the motto of those of us who have been called contrarians. On the other hand, Jesse Livermore said, “The public wants to be led, to be instructed, to be told what to do.” He indicated that people will become a mob as they want the comfort of others going in the same direction.

I am not being diplomatic, but analytical when I state that both of these managers are correct. One should recognize that George Soros above all else wished to survive and go on to future paydays. Jesse Livermore was much more interested in the size of his winnings during the game.

My current investment outlook is that for awhile the trading instincts of Livermore will lead us to higher levels of stock prices as the crowd of investors on the sidelines or in broad market index funds and ETFs will become a mob chasing various pundits and politicians in the obvious trends that Mr. Soros feared. This in turn will lead to financial and psychological collapse. This is the psychological underpinning to my +20%/-20% call which could happen sometime soon either this year or next.

The hard search for value

The dichotomy between Soros and Livermore is why finding great investment value is so difficult and is the basis of the lesson that Charlie Munger taught Warren Buffett after Buffett’s training by Benjamin Graham. Livermore was a believer in price momentum as all who participate in the ultimate bullish phase of a market surge. Ben Graham’s point of departure in seeking value was price. When he started his writing as a guide to students at Columbia University, he was ably assisted by Professor David Dodd, who for many years had the difficult task of teaching myself and others Securities Analysis. In addition, Graham had a teaching assistant named Irving Kahn who just passed away at 109 years young. (More on my friend Irving will be found below.)

Dodd had much more of an accounting background than Graham. This is why he instructed us to reconstruct financial statements before we applied any ratio analysis. For example, writing in the Depression Era of the 1930s he wrote down or completely off any inventory, particularly work in process and raw materials. He wanted us to include unfunded pension amounts before determining book value. We then had to do similar exercises on competing firms. Often he had us look at corporate financials from the standpoint of the bond holder. In some cases with proper analysis the stated equity value should have been greatly reduced. With bonds selling at steep discounts from their par value, if one could get enough bonds one could force the corporation into bankruptcy with the bond holders representing the new equity. That practice as is being done today is called “loan to own.” In some ways Graham, Dodd, and Kahn in their Graham Newman fund became the equivalent of today’s activist investors, but often using bonds as their entry point. Max Heine, who later founded the Mutual Shares Fund that eventually Mike Price sold to Franklin Resources, played a similar game. Others had followed similar practices on railroads so much of the rolling stock of America fell into financial hands. Thus, many so-called value investors were essentially adjusted book value investors looking for the ultimate liquidation or sale of their companies. As we came out of the Depression and World War II periods, general prosperity lifted stock prices so it was more difficult to find statistically cheap investments. In recent years it became even more difficult. In the past it might takes months that stretched into quarters of the year to find suitable candidates. Today with almost all the financials available on easy to manipulate data banks and a large number of activists who want to play, the number of statistically cheap investments has shrunk.

As with almost all trends that eventually are played out, newer versions appear. Irving Kahn, Ben Graham’s teaching assistant and founder of Kahn Brothers, was a successful broker/investment adviser who became the prototype of the new Value investor. Irving went beyond the numbers into what was the company’s particular advantage. Often he found some gems through his life-long interest in science and often found some pioneering work at reasonable stock prices. Irving believed in the global professional securities analysis business. While he was an important founder of the New York Society of Securities Analysts, he was also a member of the London Society  and had some successful investments in Japan when few others did. Until recently he traveled extensively and we met his late wife with him on one of his many analysts’ trips.

Irving got started in the investment business in 1928 and was conscious of my Grandfather’s firm on which he was complimentary. As a future- oriented investor he was aware of periodic market declines which is why he combined what many might have said was aggressive stock picks with half his portfolio in or near cash. Basically what he did was to redefine value to include the corporate advantage that some today call moats on top of his statistical analysis. He and his sons would require managements to keep shareholders first in their deliberations. In many ways he was among the first modern investors.

The lessons that Warren Buffett learned

Like many followers of Berkshire Hathaway, Saturday morning was devoted to reading this year’s letter from Warren Buffett and Charlie Munger. While I could devote a lot of time and space as to what was said and why most investors in the stock will be happy with it, I would like to finish this post with comments about value investing.

In Buffett’s early years he followed Ben Graham’s model of investing in “mediocre companies at bargain prices” which produced gains but with some losses. That changed with the advent of Charlie Munger on the scene who converted Warren to buying great companies at fair prices. This has worked much better than the value-oriented investments in the past. The other general comment that is worthwhile to all investors is the need to be prepared for periodic 50% drops. (I will be happy to discuss my other comments on the Berkshire letter. At some point I may devote a lot of space to it or hold it to report with my impressions of the Berkshire annual meeting weekend.)

What to do?

As Shakespeare would say “to your own self be true,” follow your instinct. If you are a growth investor enjoy the crowd’s surge and ride out periodic dips of 50%. If you are a value investor you will need to practice patience and look for value beyond what is just plain cheap.

The beauty of the L Time Span Portfolios^TM is that either or both growth and value oriented managers can be utilized. In most of our managed accounts we use both in different proportions based on the individual accounts needs.

Question of the Week: Where are you on the Growth-Value spectrum? 

 

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Four Investment Quandaries for 2013+

·       Debt, a four letter word

·       Killing off the Individual Equities Investor

·       Asset Allocation: Correlations?

·       Learn from today’s investors

Investment analysis is like a narcotic or a very difficulty habit to kick.  At the beginning of the week, I may not have an idea about what I will post the following Sunday night.  Though I am exposed to a myriad of communications, in many ways the most valuable inputs are the conversations I have with investors and investment professionals.  This week I will focus on four suggestive thoughts, or quandaries for 2013.

The worst four letter word

Growing up I was told that it wasn’t nice to use certain four letter words like F*@k or S*#t. What my Mother never told me was the worst four letter word of all; a word that has bedeviled mankind for centuries. That great economist William Shakespeare put the following words into Polonius’s mouth, giving guidance to his son Laertes, “Neither a borrower nor a lender be.” The four letter word is debt.

There are three essential problems with debt. The first is that it must be paid back, often at inconvenient times. The second is the additional payment of interest, which can be either fixed at the time of the loan or flexible, but each is based on the assumption that the rate is high enough to pay the lender to forgo spending and has a sufficient risk premium that is an accurate gauge of the odds on getting repaid in full and on time. The issue here is what appears to be the appropriate lending rate at the beginning of the period may not be the right rate at the end of the period when conditions have changed. The third problem is collateral that in theory guarantees to the lender that he will get his money back in full and on time. Securities can often provide the margin for a loan. Of course, if the securities go down in price the value of the collateral may become less than the size of the loan. Some upstanding people, companies, and nations have been able to borrow based on their good names. J.P. Morgan is reported to have said that he loaned money on the basis of a man’s character. There is a problem with this as fittingly portrayed by Shakespeare again, in “The Merchant of Venice,” in the legally sanctioned, but inhumane attempt to collect on the collateral on a defaulted loan.

The main purpose of debt is time-shifting. The borrowers want an asset that at present they cannot pay for, and the lenders are willing to delay their own spending if they get paid for this indulgence. Unfortunately what has become the custom is that new debt is raised to pay off expiring debt. The question facing both the borrowers and the lenders is what is the optimum level of debt that can be added on top of a given level of assets? This is called debt capacity. It is usually calculated on the basis of assets and/or income that are not encumbered by other debt. What is usually done for nations is to compare their outstanding debt, most often without concern for future debts, to the their Gross Domestic Product or GDP. This number is the estimated annual generation of goods and services within the country. (Two weeks ago, I blogged on the approach of looking to a more complete analysis of both the assets and liabilities for the US.) Nevertheless I will stay with the convention of looking at a nation’s debts as a ratio of its GDP. Europe’s deficit as a unit is now 131% of its GDP. China has a 120% ratio, all of Asia excluding Japan is 104%. (Hong Kong 275%, Singapore 137%, Malaysia 117%, Indonesia 33%) These reported ratios include personal and corporate debt as well as sovereign debt. Thus globally there is too much debt. 
 

In the US, as is often the case, the private segments of the economy are moving differently than the government sector. The private sector is deleveraging its debt structure whereas the federal government is adding to its debt by issuing bonds that are largely being purchased by the Federal Reserve System to neutralize their impact on the level of interest rates. The combination of the private sector deleveraging and the Fed’s increased borrowings leaves the US debt level, according to one source, at 62% of the GDP which is down slightly from prior readings. 

Translating the economic figures into the bond market, the following three facts are of interest:

1.    Some Investment Grade (corporate) debt is yielding less than some sovereign debt. This would indicate that the market believes that corporates are safer than some nations. One possible reason for this is that Europe, with 7% of the global population,  spends 50% of global social spending.

2.    The yield on the S&P 500 is higher than an index of BAA bonds. Again, the market is suggesting that lower investment grade credits are safer than dividends on the S&P 500 stocks. At the same time this represents an unusual opportunity to view large cap stocks as a more productive source of current income than investment grade bonds.

3.    We may not be out of the sub-prime mortgage mess. The Federal Housing Administration (FHA), is by far the largest guarantor of conventional mortgages. Not only does it already in effect own a number of defaulted mortgages, but there is pressure from Congress and the Administration for the FHA to loosen its underwriting standards. Only a significant recovery in house price and possible individual incomes will bail out the taxpayer liability.

“Who killed Cock Robin”

The somewhat shotgun wedding of the New York Stock Exchange and IntercontinentalExchange (ICE) publicly demonstrates the fact that while derivative trading particularly not based on stocks is very profitable for an exchange (and therefore broker/dealers), trading in individual stocks is not. As an analyst and owner of brokerage firm stocks, for some time I have taken the position that listed equity agency business for brokerage firms is not profitable. Try to get a brokerage account opened to buy 100 shares a quarter of General Motors. What you will quickly find in a broker (if one will talk to you at all), he or she will attempt to sell to you some complex structured product or a high fee fund or possibly introduce you to using a margin account (interest bearing and securities loan revenues). This reaction by the peddlers of our business has been successful in discouraging individual investors from buying and holding individual stocks. Thus, the title to this section, “Who killed Cock Robin” is an English nursery rhyme, but the real killer of interest on the part of individual stocks is the regulatory agencies, particularly the US Securities and Exchange Commission (SEC). In 1968 the Commission forced the beginning of the end of fixed-rate brokerage commissions, which were totally replaced in 1975. Prior to those dates there was a vibrant and useful retail research and individual sales business by brokerage firms. Institutions received tons of reasonably high-quality research and other services from “Wall Street.” Continuing this trend of not understanding the impacts of its actions, the SEC permitted multiple locations where a trade could take place which denuded the central marketplace’s liquidity. Carrying this approach further, the substitutions of penny decimals for fractional prices made professional traders withdraw their capital from the marketplace. The way all markets work is that there has to be a perceived profit potential for the professional participants to play. Without the professionals in the game the market will shrink in size and its use as an important economic indicator will be vastly reduced.

I do not mean to be negative on the announced deal, because the holders of my private financial services fund and I benefited. Our holding in NASDAQ OMX rose 3% on the day of the announcement. My guess, the thinking is that NASDAQ itself may be in a merger situation or that the change in control of the NYSE means that it will be a less fierce competitor for new listings and daily trading. While this may benefit my fellow investors and me, it won’t do anything positive for the individual investor and could hurt.

Is asset allocation really about correlation?

At this time of year, institutional investment committees have meetings to decide on the appropriate mix of assets for their portfolio responsibilities. Historically this was a decision made for them in that the initial funds in both the US and UK were balanced funds with a reasonably fixed percentage in bonds and stocks. Balanced Funds and their modernized versions are still an important part of the mutual fund business. The whole excitement about asset allocation was generated by a flawed study of corporate pension funds that showed that funds with a higher percentage in equities did better. For the most part there were only two asset class accounts, bonds and stocks. Later on other classes were added in terms of venture capital, private equity, international securities, commodities, gold, timber and various forms of real estate. Then 2008 came along, with the exception of US Treasury Bonds all the other asset classes declined and often in roughly the same percentage declines.

My approach to this question is first to have an opinion as to how closely the correlations of the asset classes will be over time. Using US mutual fund investment objective averages over ten or more years, most fall within 100-200 basis points in terms of annual returns which suggests to me that on a long term basis it is difficult to pick winning asset classes.

Jason Zwieg’s latest piece in the Wall Street Journal on a young 107 year-young investor and manager, Irving Kahn, takes a different point of view. At his age he is invested approximately 50% in well-researched global small caps and the rest in cash. I have worked with Irving for many years on analyst society activities. He and his late wife Ruth were on an analyst trip with my wife Ruth and me in Italy more than 25 years ago. They both set a blistering pace which was a challenge for us younger types to keep up. Out of all of these experiences, I have developed a real respect for his acumen; besides he is one of the very few people alive that remembers my grandfather’s Wall Street firm. If the committees have Irving’s research skills, I would approve of their allocation if not some other forward looking approach was warranted. We should be watching and listening.

Learn from today’s investors

Most individuals do not have CFA certificates or have logged more than 50 years as an investor, but we can learn from what they are doing as shown in the following examples:

1.    As already indicated, on a personal level they are paying off their debts. If one disregards student loans, consumer debts are declining. Savings as calculated by the government is rising a bit. Individuals are slowly, but I believe surely are going through their own austerity program particularly in terms of being more astute shoppers.

2.    While retirement flows are continuing to benefit from 401(k) and similar salary savings plans, the purchase of mutual funds for individual retirement accounts through directly marketed mutual funds is well off  peak gross sales. This may be in response to investors' own actual or feared employment picture. Possibly they are using what would have gone into their IRAs to reduce their debts or to improve their homes for a future sale.

3.    The most intriguing demographic trend of all is that there is a substantial increase in the number of singles. In many cases these are, according to Gary D. Halbert, white women who have made the decisions at least temporarily to forgo Children and Marriage.

The young appear to be worried about their future and they should be. Our debt burden and less than wise investing will make their lives more difficult. However, after worrying in American fashion, they will find innovative ways to improve their condition. This is one of the major differences between Americans and Europeans.

You can’t agree with everything I have said.  Please discuss your thoughts with me by reply email.

I hope on Tuesday you can relax with family and friends, not worry about these quandaries and that the rest of the week won’t be too eventful.

____________________________________

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Value Traps of Smart Value Investors

Smart investors, who try to buy low to sell high, look for what they perceive as bargains that the general market does not see. Originally under the founders and authors of their seminal text first published in 1934, Security Analysis, Graham & Dodd * focused on finding both bonds and stocks selling below their intrinsic value. In the early days this was focused on finding securities not only below their properly adjusted book value, but when possible below their “net-net” levels. “Net-net” was shrinking book value to just cash, and easily selling current assets versus all liabilities. While some of these opportunities do exist today, they are extremely rare in a world of so much electronically sorted published data. More often than not these opportunities are found in the distressed securities world when there are insistent sellers who must be out of the named issuer quickly.

(*) I took my securities analysis under Professor David Dodd.

With the disappearance of a large number of net-net opportunities, well trained investors looked for additional opportunities. These investors led by Ben Graham himself, Warren Buffet, and Irving Kahn, found additional ways to pick winning stocks. This coming Friday, Irving is to receive a Lifetime Achievement Award from the New York Society of Security Analysts, celebrating his 105 years of successful life and contributions. What these gentlemen did was to move the goal post forward from a current price/value relationship, to valuing a future price significantly above the current price. One of the keys to this analysis is that the future value was available today at a reasonable price. Thus, many value oriented managers today look for (future) growth at a reasonable price (GARP).

Reasonable price

There are two critical elements to the determination of reasonable price. The first is a high expectation that the future earnings will be realized. Usually this belief is based on some events happening that are anticipated to be positive for the stock in question. The chances that the good news will work are measured, in my mind, as execution risk. More on this risk later as part of the discussion on value traps.
The second critical element in determining reasonable price is: reasonable compared to what? In this case there are two approaches. The first, favored by leading value investors is relative to returns available currently from US Treasuries. If one expects, as I do, that interest rates on US Treasuries to rise to adjust for inflation and a decrease in the relative perceived safety of US paper compared with other assets, then a value stock buyer needs a substantially higher expected return than the current nominal rates. The second approach as to reasonable price is to examine the specific expected return compared with some concept of market. This relativistic approach believes that the market is mispricing the specific opportunity and will correct this undervaluation at the time of the expected sale.

Memorial Day vantage point

In the United States we celebrate Memorial Day on Monday. Our blog community includes members from at least 18 other countries, thus I need to avoid aiming all of my thinking on the US. This country, along with numerous other countries, looks back at least once a year to celebrate all of those who gave their lives, and I might add their innocent youths, to protect their country from those who wished to dominate them. On days like this I become a bit retrospective thinking not only of those we have lost, but also of their lost opportunities. As a confirmed investment addict, in time, my mind shifts to lost opportunities in stocks. I think about those who have fallen and in too many cases not to rise again. Just as our military leaders study the past battles to learn how to avoid the ensuing casualties, I look at the history of stocks to see what I can learn that is useful going forward.

Good Analysts/Portfolio Managers/Fund Selectors

William Shakespeare puts the words in the mouth of Marc Antony in describing the assassins of Julius Caesar who are standing before him, “So are they all, all honorable men...” Many good investment people have fallen into a way of thinking, that at least for some time has proven to be value traps. Since no one that I know has always had only winning positions, we all can learn from a retrospective look at our analytical skills with the hope of reducing the number of casualties in our portfolios.

Looking Back at Value Traps

Ford (truck sales), GM (slowing car buying economies in China and US plus a politically motivated seller), Sears (under-investment in desirable inventory), Intel (missing the switch to tablets), Microsoft (demand slowdowns in the developed world), Dell (adding new products and services without fixing the old and thus missing revenue estimates), Johnson & Johnson (not doing good enough in products and certain developing countries) is a brief list of what has proven to be value traps. Within the parenthesis after the company name is an extremely brief highlight of its perceived problem. In each case the companies are large with substantial assets, including well known names and reputations. Many have been followed for years by very bright analysts and portfolio managers who now have the responsibility for these stocks at current prices that don’t represent the values they perceived. In most cases, what they failed to weigh sufficiently was the execution risks imbedded in the names. Some of the problems were beyond management controls, e.g. the twin slowdowns in the economies of the two biggest car buying markets: China, (the largest) and the US. In a number of cases managements dropped the ball in not having the right products at the right prices. As not all investors fell into these traps, it is quite possible some were skeptical of the execution hurdles.

One of the recurring traps that people fell into was looking at the cash on the balance sheet and deducting it from the price of the shares and dividing the result by the earnings of the company to show how “cheap” the stock was priced. There are three reasons that this has proven in some cases to be a mistake. First in a number of instances a good bit of the cash is overseas and they do not account for the tax costs of bringing it back home. (In some cases the overseas cash has to stay put to satisfy various commercial and regulatory needs.) Second, we know from studying portfolio managers that carry large cash positions on the way down, through the bottom, and only recommit cash after a significant advance. In this example, cash is just too comfortable. Third, there is a risk that operating managements will make mistakes in the use of their hoarding, e.g. bad acquisitions of companies and/or securities.

Duration risk

In the standard analysis of future value, one needs to assign a period of time between the present and the recognition by the market of the enhanced value. Assume that today’s price is $5 and the expectation is that its future value is $ 10. If the recognition period is one year, the annual rate of return is 100%. Using the same metrics, but assuming that the duration of the recognition period is 100 years, the annual average rate of enhancement is 1% per year. What has proven to be the admitted problem for the believers is not that their expectations are misplaced, but it is just taking too long.

Now what?

While I am not an economist, I do have two very different observations of future actions. The first is to recognize that all of the listed value traps (and many others), are large market capitalization stocks. As a group, large capital stocks have risen less than small caps. As is my practice I will use mutual fund indices produced by my old firm. Through Friday, Small-Cap Growth funds were up +33.87% for the one year period, whereas Large-Cap Growth funds were up +24.5% and the Large-Cap Core funds +22.31% and Large-Cap Value funds +20.47%. Ever since the market hit bottom, large cap has not been as productive as small cap. In the current period of instability, I believe that there is more comfort in those required to be invested to own large caps. Thus, I would not treat this blog as a call to get out of what has been value traps, but to adjust the underlying analysis as to execution and duration risks.

The other approach on this Memorial Day weekend is to be thankful that we survived the past and to look at the new opportunities that are being created for us. Big winners come from successful big dreamers. I hope to find not those that restore value to their 2007 highs, but ones that see potential doubles and more from here. (If you have any of those, please share them with me.) I expect to find them in successful disrupters of current perceptions.

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