Mike Lipper’s Monday Morning Musings
Are We in Boiling Water? And Understanding Value
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Where are we (in the market)? Many of us have traveled with impatient children that too frequently ask “are we there yet?” What they should be asking is, where are we and what difference does it make? Plenty. This is where a frog and a pot of water is useful. Placing the frog in a pot of cold water will be greeted by the frog jumping out. Place the frog in mildly heated water that is a comfortable temperature and the frog stays put. If you raise the temperature slowly the frog is not conscious of the slowly rising temperature until it reaches a boiling level, which kills the unfortunate frog.
In terms of the current US stock market expansion measured by the popular indices, is the temperature rising? There is some evidence from the last four weeks that we should be getting ready to jump out of the market indices led market. Over the past four weeks ended October 8th, the average S&P 500 Index fund gained +3.31%. This compares to gains of +4.35% for the average Large-Cap Growth Fund and +5.60% for the average US Diversified Equity Fund, comprised of 7,336 funds. Earlier in 2020 index funds were clearly in the lead, for three reasons:
- They were fully invested and thus had no retarding cash
- They had no brokerage and other operating expenses
- They had a large commitment to information technology stocks
What is causing the change waking up us frogs? Both brokers and the media need investors to transact to meet their commercial needs. Considering that in the current year we had a record decline and recovery in terms of annual rates of change. As this is unusual, it generates nervousness. In September the shrillness of the political campaigns upset some investors, causing them to question whether their current investments will serve them well in the next couple of years.
Turning to specific concerns, the final publication of the majority report from a House Committee advocated for a new type of anti-trust legislation that would splinter large info-tech corporations. Evidence of these concerns can be found in the short positions of the tech heavy NASDAQ market, which rose 3%. This compares to the short positions on the NYSE, which rose only 0.5 %. Volatility has risen over the last three weeks compared to levels a year ago. The performance of the NASDAQ Composite has led the Dow Jones Industrial Average (DJIA) and the S&P 500 for some time, but it is no longer the clear leader.
Getting Ready to Jump to “Value” Stocks
Advocates of change are reducing exposure to tech in favor of adding to “value”. As with many labels, it covers a wide range of different types of actions and securities and could well be jumping from the “frying pan into the fire”. In terms of the professional academic literature, the earliest text I know about was titled “Security Analysis” by Benjamin Graham and David Dodd, who were professors at Columbia University during the Depression. The book was so successful in academic circles that it went through five editions. I was extremely lucky, as I took David Dodd’s Security Analysis course toward the end of his distinguished career.
In reading his text in class, it became clear that he was describing value as liquidating value. This was a very good way to make respectable investment returns starting in the depression. Remember, this approach was that of an academic, not a business person, so there was reliance on published financial statements. As students, our first task was to recast the balance sheet by revaluing the assets and liabilities. The critical key to the analysis was to value the preferred shares and debt at their current market value, not their stated value on the balance sheet. Furthermore, assets were revalued to what they could bring in a quick sale. This meant that only finished product inventory had any real value and that was subjected to a discount. Plant and equipment were assigned little to no value. The next step was to augment the balance sheet with undisclosed assets and liabilities, including items such as leases, rights-of-way, and the net value of pensions. This type of analysis led to the conclusion that some bankrupt companies could be worth more than the lackluster common stock price. This type of analysis allowed Graham and Dodd to buy and liquidate companies in their fund.
Max Heine, founder of Mutual Shares, and Ruth Axe, founder with her husband of the Axe Houghton funds, did similar operations of railroads. Axe Houghton at one point controlled the Missouri Pacific Railroad by being the dominant holder of a cumulative preferred issue, which had not been paid dividends for many years and had to be paid off before the railroad could be sold with its attractive right-of-way real estate assets. (In a similar way, as a small investor I participated in a defaulted cumulative preferred, which over time was gaining voter control of the board of Pittsburgh Steel.) The key point of this deeper understanding of “Value” is that one does not rely on published balance sheets, but uses them as a beginning to find other assets and liabilities to recast a more realistic picture.
“History Does Not Repeat Itself, But It Does Rhyme”
In some respects the search for attractive value investments may be similar to the period of Graham & Dodd’s depression analysis, at least in questioning book value as shown on published balance sheets. There have been many accounting rules changes, but a few things remain the same. In most cases land is carried at cost and buildings and equipment are carried at depreciated value. While at this point in our recovery I don’t know what the future will bring from the pandemic, my working assumption is that WFH (work from home) will reduce the number of people in office buildings and will likely impact the value of the buildings. There may also be less value in being in major cities. (I do recognize that some of these properties may be successfully repurposed, usually by private real estate people.) We have already seen a remarkable shift in the use of equipment to produce masks and similar products. Nevertheless, I question whether that will be the case in the new era.
This Week Brought an Example of a New Right of Way Deal.
The Missouri Pacific example of using the right of way real estate value to generate a higher than current market price still works today, but in a different form. This week, Morgan Stanley announced they will acquire Eaton Vance with a combination of stock and cash, at a 40% premium to the price it was selling prior to the surprise announcement. In some respects it was similar to depression type value creation. Eaton Vance is one of the oldest mutual fund management companies, starting life as the principal underwriter for the first publicly traded mutual fund, Massachusetts Investment Trust. It later started its own funds and through a Boston merger entered the investment counsel business. Over the years it raised money through sales to various brokerage firms and investment advisers. In recent years, it was successful in developing imaginative fixed income funds and low-cost index portfolio products.
These distribution relationships were not on their balance sheet, but was what Morgan Stanley found attractive. (Morgan Stanley itself is the largest brokerage firm using Eaton’s funds.) Morgan Stanley found that 95% of Eaton Vance’s sales were to US and Canadian clients. They were under distributed internationally, which is where Morgan Stanley has considerable strength. There is another element that makes this merger attractive to the acquiree. The CEO of Morgan Stanley publicly announced that he was wrong to have sold Van Kampen, another fund management company with a strong distribution organization. Morgan Stanley also sharply curtailed its capital absorbing fixed income trading a few years ago. They will be using a limited amount of its accumulated capital for this deal. All companies make mistakes, but few admit to them. I believe a former “sinner” is more likely to be a good partner in the future.
There are a couple of additional personal pluses to this deal. In the development of my own firm, when we generated sufficient capital beyond our operating needs we began investing in our clients. The main purpose was to avail ourselves of a shareholders’ view of our clients. In 1981 I purchased some shares in Eaton Vance for the firm. Luckily, when Reuters acquired our assets in 1998 they did not want our small portfolio, as they did not see the intelligence value of the holdings. Thus, today we are the pleased owners of a few shares that cost under 9 cents a share due to splits. (To demonstrate that it is better to be lucky than smart, over the years we have sold some of these shares for other portfolio operations.) As a member of a number of investment committees, I believe long term ownership of reasonably diversified portfolios of common stocks to be very capital productive over a long period of time.
Concluding Thoughts
We may or may not be at a pivot point in the stock market. If not, it is only a matter of time before performance leadership changes. At that point, some of the leadership will be labeled value. However, I believe future success in terms of stock prices will not be based on published book value. Attractiveness will be the result of finding unrecognized assets and ways to reduce liabilities. So, Professor Dodd will once again be correct.
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/10/what-is-nasdaq-saying-to-whom-weekly.html
https://mikelipper.blogspot.com/2020/09/there-is-incredible-shortage-weekly.html
https://mikelipper.blogspot.com/2020/09/headlines-excite-dictate-or-respond-not.html
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