The following is an excerpt from the November 24, 2008 issue of Spinoff & Reorg Profiles.  I’m posting it now to set up for a coming post on what I call “investment battleships.”

Last Thursday [11/20/08], the S&P 500 marked a dubious milestone, surpassing the 1973-4 and 2000-02 slumps to become the biggest U.S. broad index crash since the Depression (although, to rival the 1929-32 crash, it would need to fall by half again).

This naturally leads to the question of whether the broad index is now cheap. The answer seems to be, “slightly.”

The 125-year U.S. index price/earnings record compiled by Yale economist Robert Schiller implies long-term mean reversion to an index PE10 ratio of about 16, where PE10 is defined as current price divided by the average of inflation-adjusted earnings over the past 10 years. With relatively high reliability, 20-year investment returns tend to be better when PE10 was well below that level at purchase time; returns tend to be worse when the purchase was made well above that level.

Mean reversion oversimplifies, by ignoring the relationship between earnings yield, interest rates and inflation; however, it is a useful long-run rule of thumb, reflecting reasonable expectations of current net earnings yield on volatile but growing assets.

Today [remember, this excerpt was written in Nov. 2008], the S&P 500’s PE10 is about 14 — below the long-run average, but well above the bottom of previous crashes. PE10 went below 10 in 1974, and below 6 in 1932. So while the market today is rather cheap by historical measures, it has occasionally been 30% to 60% cheaper, relative to this particular average earnings measure. [We now know that the S&P did fall another 15% from November 2008 to the 2009 trough.]

This argues for a good, if unspectacular, long-run prognosis for the index as a whole. By contrast, the earnings streams of many individual stocks are now for sale far below traditional prices, with excellent long-term promise for those who can afford to wait.

The predictable exposure is recession; the more complex exposures are in three interrelated areas, all with unpredictable volatile outcomes.

Dollar stability – The dollar is supported by central banks in nations now entering sharp recessions. They have domestic incentives to continue support, but if a retreat did begin, there would likely be a multinational race for the exits, resulting in dramatic dollar decline.

Inflation – Not only is price stability unlikely, but experts even disagree about the direction. Commodity-driven inflation has abruptly given way to deflation. Next year, we will see intensely, deliberately inflationary fiscal stimulus, with certain trillion-dollar federal deficits. The result could go either way.

Long rates – Fiscal stimulus will be financed by offshore lenders, with their own problems, and without infinite capacity or patience. As borrowing greatly increases, the stage may be set for Treasury auction revolt and further loss of control over long-term rates.

The best path through this minefield appears to be cheap companies with substantial foreign earnings, competitive advantage (ability to raise prices, often exhibited by high return on employed capital), and low debt. These features partly inoculate against dollar instability, inflation, deflation and high interest rates. A fourth necessary feature is investor patience, since even the best firms will likely see a wild ride in coming months.

Among spinoffs from recent years, Coach (COH) is perhaps the best fit for these conditions, and quite appealing just now.

Coach has more than tripled since that day, which is gratifying, but that’s actually not the most important message here.  The critical thing is that our downside was protected.  If credit had remained impossible to get, Coach could have financed itself from cash, even as indebted rivals like Bulgari might well have failed.  If the dollar had collapsed, Coach’s US production for export to Japan and China would have worked out fine, even as the “Chimerica” offshore production model would have collapsed.  If inflation had taken off, Coach’s strong brand and low capex would have helped sustain margins.  At that price — it was under 10 times earnings — Coach was what we like to call an investment battleship, all but impervious to whatever storms the global economy might bring.

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In the late 1970s, Warren Buffett was already a guru to value investors, but unknown to the general public.  As a result, he was brilliant, experienced, yet accessible:  a traditional value investor I know simply invited him to lunch.

Over the meal, Warren asked what kind of investing he was doing.  The investor answered with embarrassment, “Well, nothing fancy.  For want of something better, I’m just sifting through Value Line for the lowest-P/E companies that still have an investment-grade credit rating.”

Buffett answered simply, “Yeah, that’ll work.”

Since then, that investor’s portfolio not only beat the S&P handily, but suffered only two down years in over three decades. He now runs a 9-figure investment partnership.

This wasn’t rocket science.  As mentioned at in an earlier post, it was a game of long-term, low-rate compounding, and the self-discipline to stay on that track.

Note:  this piece is NOT about precious metals. To each his own, but this author prefers assets with a yield (whether distributed or not);   gold, silver and their shiny friends generate no yield, so we don’t own or advocate them. The following is adapted from the January 2010 edition of Spinoff & Reorg Profiles, but remains at least as relevant today.

There has been talk since late 2009 among value investment managers about shorting long-dated Treasuries — especially after well-regarded value investor Charles de Vaulx (manager of the International Value Advisors funds, protegé of SoGen Funds manager Jean-Marie Eveillard, and a self-described lifelong long-only investor) revealed he had 1% of his IVA Funds in ProShares Ultrashort 20+ Year Treasury (TBT).

The speculation makes sense — the Fed must eventually wind down intervention in that market — but it is disconcerting to see value investors stray so far, buying instruments with no measurable book value or direct yield, and which hedge poorly against “armageddon,” in that they depend upon financial counterparties that may fail under just the extreme conditions in which they should pay best.

This illustrates the box into which investment managers — especially bigger ones — are painted. Demand, prices, credit and currency exchange rates all remain unusually unstable and unpredictable, compared to the pre-2007 world. The S&P’s price ratios are again at the high end of their historical range, with yet little evidence of sustained industrial recovery.

Moreover, value investors continue fear a macro wipeout: hyperinflation, protracted deflation, stagflation, currency collapse, etc. No one agrees which one, and it is difficult to judge conditions by public data when the global financial system is increasingly intertwined with government (for example, how do we judge the residential mortgage market when nearly all new loans are federally subsidized?). Under such conditions, the fundamentals respond as much to political necessity as to economic logic.

This almost unprecedented uncertainty over macro conditions greatly amplifies the usual investor uncertainty about specific choices. Almost no tactic is simultaneously robust to inflation, deflation, currency fluctuation, broker collapse, credit crisis, etc. Even determining what to do with cash has been complicated — it now yields nothing, or less, yet is exposed to whatever currency it is denominated in, and to whatever financial institution to which it is entrusted.

For the investor convinced of an impending wipeout, but unsure which terrifying portent will prove true, one path through the minefield — surer than cash under some scenarios — is a stable, unencumbered, yielding asset whose yield is denominated in utility (in the economist’s sense), rather than currency. This may sound too general to be actionable, but actually describes the requirements fairly clearly:

• Low debt, so that yield is immune to shocks in the cost of capital.
• Low capital requirements, so that yield is immune to shocks in the price of plant & equipment.
• Stable demand, so that yield is immune to shocks in general economic activity.
• Sustainable competitive advantage, so costs can be passed on to buyers, rendering yield immune to wild swings in input prices.

It’s difficult to simultaneously satisfy all of these constraints except with a portfolio. Still, we keep coming back to tobacco firms — Lorillard (LO), Altria (MO), Philip Morris International (PM), etc. — as a good fit. While they are no longer cheap, and while debt is not as low as we would like, they do satisfy all requirements pretty well, and remain priced below the market’s long-run average P/E ratio.

—

Asia vs. Philippines, and the Power of Long-Term, Low-Rate Compounding

Philippine President Benigno Aquino III intervened this month in efforts to restructure flag carrier Philippine Airlines (PAL.PSE);  managers were barred from spinning off inefficient ground operations or laying off workers, while labor was instructed not to strike until after Christmas.  PAL is reportedly near bankruptcy, despite its dominance in one of the more pricey, uncompetitive airline hubs in Asia.

This is interesting not for its direct investment potential, but as a microcosm of the sad trajectory of Philippine industry generally, and as a nation-scale illustration of the power of compounding.  For both the airline and the country, present travails contrast with a long and once-prosperous history, while populist meddling hobbles restructuring and may help explain stagnation.

Few now remember that PAL is the oldest surviving airline in Asia, operating continuously since the 1930s.  Almost as few will remember that just 50 years ago, the Philippines was east Asia’s third most prosperous country, behind only Japan and Malaysia in GDP per capita (this excludes Hong Kong and Singapore, which were still British colonies).  Today, as once-destitute neighbors like South Korea reach 1st-world prosperity levels, the Philippines has fallen to the bottom of the east Asian heap, and well below the average for sub-Saharan Africa.

Though surrounded by shining examples, and despite its strategic location, decent seaport sites, cozy relationship with the U.S., and the best English fluency in east Asia (again excluding the British city-states), the Philippines under Marcos missed the memo on export-led growth, and perennially lagged its neighbors.  For this and cultural reasons, its birth rate remained pre-industrial, and population tripled after 1960.  There are now more Filipinos than Vietnamese, Thais, Koreans (even if reunified), Germans, French, Italians or English;  in fact, with the highest birth rate in east Asia, they look likely to outnumber Japanese within 20 years.  For all that, the country remains relatively invisible on the world stage, because of slow industrialization.

There was no single moment of failure.  Though there were a couple of economic impairments along the way, the Philippines lost the prosperity race mainly through a small but consistent shortfall in GDP growth per capita, compounded year after year for decades.  How small a shortfall?  Since 1960, it has lagged the slowest Asian success story, Malaysia, by “only” 2.5% per year (nominal), and Thailand by less than 4%.  If it had instead delivered even Thailand’s per capita growth, it would today have aggregate GDP comparable to South Korea or Taiwan, and economists would visit Manila seeking lessons, instead of offering them.

From a Western perspective, the east Asian economic “miracle” appeared to emerge suddenly, but this is the usual misapprehension of hockey-stick exponential growth.  Asia’s success stories did not suddenly strike it rich.  They did not find oil or gold, or buy into the seed round of Facebook.  They instead exploited a series of low-risk tactics to compound at a relatively consistent 8-10% CAGR, without serious impairment, for decades.  That was enough.  Those who could not or would not do the same were left behind.

Like a Mandelbrot image, this principle appears the same at every scale, from individual investors all the way up to nation-states:  choose a series of low-risk tactics to generate consistent, slightly supernormal returns over a long period, without serious impairments, and you will win.  Food for thought.

Over the past five years, the Value Investing Congress has grown from a hanger-on at the Berkshire annual meeting into a respected independent conference, featuring talks from some of the biggest names in value investing.

Registration is $3000 to $7000, depending upon various factors.  Including travel expenses and the opportunity cost of work time lost, the true total is an average of perhaps $10,000.

Just for fun, how might we calculate when and whether this is a good deal?

At minimum, the VIC looks worthwhile if both of the following conditions are satisfied.

1. You have already read every excellent book on the subject.  There are dozens. Good books are sometimes less exciting than flying to conferences, but they have far higher ROI, so you should completely exhaust this educational “asset class” before diversifying.
2. You have a reasonably high net worth.  How high?  Think of it this way. Based on today’s cyclically adjusted P/E, the expected 20-year forward real annual return on the S&P is about 2% (I will post on that interesting subject soon). Suppose you can reliably increase that return by half (an extra 1% per annum) by attending the VIC every year.  Then you should pay something less than 1% of net worth to attend.  Thus, your net worth should be at least $1m or so to justify the trip.

The above presumes the VIC has only educational value.  If the goal instead is just to have fun, or to network, or to meet like-minded people, then it is either a marketing expense or a vacation, and so the ROI calculations are different.

Joel Greenblatt’s Magic Formula, popularized in The Little Book that Beats the Market, is a simple(ish) two-factor stock screening method that, according to backtest, outperforms other screening methods, such as low P/E.

I like the Formula, and use it. In my opinion, though, it does have one big risk worth correcting for:  the Magic Formula rewards a weak balance sheet.

As an example, imagine two widget makers, Silverback Inc. and Consolidated Schmendricks.  The two are nearly identical — same products, sales, income statement, balance sheet  – with one difference:  Schmendricks is currently stiffing its suppliers, so its accounts payable are double those of Silverback’s.

The Magic Formula judges business quality by return on employed capital:

ROEC = EBIT/(current assets – extra cash – current liabilities + PP&E)

In the example, Schmendricks will have much higher return on capital, because it is defaulting on accounts payable.  Thus it will be ranked much higher by the Magic Formula.

I’ve chosen an extreme example to illustrate the principle, but the problem exists even away from the extremes.  For example, suppose Schmendricks were funding its operations entirely with commercial paper instead of cash.  Same problem:  the pile of short-term liabilities result in a weaker balance sheet, but a higher Magic Formula rank.  In general, the Magic Formula does not consider credit risk.

One might reasonably argue, “but if this is such a problem, why didn’t it show up in the backtests?  Why didn’t higher default rates reduce the historical performance of the Magic Formula?”  The answer is that there is something missing from the backtest data set:  over the tested period, the cost of capital was falling almost monotonically, and there was no credit crisis.

Under those happy conditions, on average, the more levered company wins:  they can always roll debt over, and usually at a lower price, so insolvency risk remains low, almost without regard for capital structure.

Unfortunately for the Formula and for all investors, the cost of capital bottomed out at almost the same time the Little Book was released.  Suddenly, credit risk is a consideration again.

As a result, I suspect the Magic Formula will not perform as well when the cost of capital is volatile and generally rising, unless one adds an additional factor to control for credit quality.  Since the cost of capital is now much more uncertain, and looks likely to rise almost monotonically in the next 30 years, one might want to consider credit rating in choosing among the stocks that rank well under the Magic Formula.

Note that simply screening for low P/E has the same problem.  Credit risk generally did not matter for 30 years, but now it does.  Value investors in the 1970s did not use P/E alone, but rather a combination of P/E and financial strength.  We are headed there again, I suspect.

Investors often analyze competitive strategy in the companies they buy, but rarely apply the same logic to their own businesses. They should do it more, because equity investing is more perfectly competitive than most industries they analyze.

The platitude, “to invest, you need an edge,” is essentially tactical, not strategic. If I know something you don’t, then my advantage is, by definition, fleeting. What makes an edge repeatable?

The repeatable edge is the foundation of competitive strategy. The few investors I see routinely applying this concept to investment strategy include Joel Greenblatt (see Chapter 1 of  Stock Market Genius) and Seth Klarman. Perhaps not coincidentally, both have enjoyed long-term returns above 25% annualized.

Berkshire Hathaway offers a very tired, but still apt, example of a repeatable edge. For 40 years, Berkshire has grown largely through cash buyouts of family-owned companies with high return on employed capital. Berkshire credibly offers them investment-grade cost of capital, rational capital allocation, and almost total autonomy. Few others could offer it, and if they did, few sellers would believe it. Such credibility was built slowly over decades, and would take that long to replicate. As a result, Berkshire is, repeatably, the sole bidder for such companies.

At much smaller scale, consider Paul Sonkin, co-author of Value Investing:  from Graham to Buffett and Beyond, instructor at Columbia, and manager of the Hummingbird Fund. Sonkin focuses on the tiniest microcaps, where his fund can accumulate a 5% position despite its small size.  Because of Sonkin’s celebrity in the value investing world, when his name appears in a 13D filing, the company is scrutinized by hundreds of new investors; if the situation really is cheap, then the price suddenly converges to value.

For example, consider Monarch Services (MAHI.PK) in early 2009.  The company had not filed a 10-K or 10-Q for some time, but was disclosing plenty of information informally via 8-K.  The company sold at an obvious discount to a liquidation distribution that was nearly certain to occur;  yet price did not respond.  Then Sonkin disclosed his 5% position on May 29, 2009.  Over the next few weeks, shares were up around 50%.  Over that same period, there were no filings and no other news from Monarch — the only new public information was that Sonkin owned it.

Whether or not this advantage is deliberately pursued by Sonkin, it is sustainable, ethical, and not easily replicated. In contrast, I often recognize the names of Spinoff & Reorg subscribers in microcap 13D filings, but the price typically does not react, presumably because these investors are less widely followed — even though some have a longer and better track record, and more assets, than Sonkin. Were these investors more famous, if only among other value investors, then the 13D filings themselves would be a catalyst. But fame takes time and investment, and brings costs and risks, so it is a barrier to competition.

At the most general level, competitive strategy often just means avoiding competition, and more often than not, the route is to exploit a rival’s inflexibility. Berkshire exploits inflexible features of other public holding companies, such as management turnover, pressure to manage divisions closely, and pressure to use leverage to increase return on equity.  By offering the opposite, BRKB remains sole bidder.  Similarly, value investors often exploit their rival investors’ inflexible needs for liquidity, or low volatility, or a short planning horizon;  this is why the value advantage is not simply competed away.

What is your competitive strategy as an investor?

This piece compares traditional value investing with certain value-oriented features of venture capital.  It is a response to Greenbackd’s post, VC, Value Investing and FaceBook.  This is just for fun — I don’t do VC, and I counsel against it.

I know a few Silicon Valley VC partners, and met dozens when I lived in Palo Alto. Hard to generalize about their investment judgment. The smartest see around corners and walk through walls. Some only buy value (DCF with conservative assumptions). Certain others should just keep their mouths and wallets shut.

VC is foreign to value investors because, for a decade, most big startup exits have involved an arcane strategic dance with huge, profitable incumbents (MSFT, GOOG, AAPL, HPQ etc.).  These gorillas know the biggest risks to their franchises come from below.  Good VCs exploit that fear, building a portfolio of strategically threatening startups, and selling them to risk-averse incumbents.

The surprise is that, at the best VCs, valuation in a private sale may still derive from cash flow, but not the cash directly generated by the startup.  Instead, it may derive from the cash flow AT RISK to the incumbent, if they fail to forestall a startup by buying it.

FaceBook’s backers may be playing that game.  If the company were generating $100m a year in free cash, they probably would already have taken it public.  So the high private valuation ($33b), together with the lack of public valuation, suggest they are not ready for IPO, but instead simply positioning for a private exit.

That $33b valuation is easy to generate, and need not cost much. Call it a marketing expense. If the VC pays one dollar to buy 0.00000002% of FaceBook, the post-money valuation is $50 billion. This nominal value creates psychological anchoring among potential buyers, increasing the likely selling price. At exit, the VC need not see a return on that one dollar — instead, it makes money on all the shares it bought earlier, at a fraction of the price.

Who buys? Well, FaceBook now claims more traffic than Google.  This is a bargaining chip in the great game.  FB can claim to be a route to salvation for a Web advertising also-ran like Yahoo or Microsoft.  It can claim to be a credible threat to Google’s dominance in advertising. These and other arguments can be quantified in terms of the cash flow LOST to Google if they DON’T buy.

Google can run a conservative DCF on that, and might pay a lot of money for it, just to forestall perceived strategic risk.  They probably won’t pay $33b (20% of their market cap), but they might pay $10b, and might feel like it was a bargain because of the anchoring effect.

For top VCs (and only top VCs), this game has worked.  But it can’t last. It relies upon low cost of capital and low risk premium.  When (not if) those conditions change, it may become infeasible to finance a loss-making 500-employee company for long enough to reach such an exit. But for now, it is not entirely without logic.

Because only a few well-connected industry insiders are equipped to evaluate the exit odds, this is not a game you or I want to play.  But there is, in some cases, and for some VCs, a certain tenuous (and inverted) grounding in value fundamentals.

The Wall Street Journal recently impugned Benjamin Graham’s P/E ratio in two articles, The Decline of the P/E Ratio and Is it Time to Scrap the Fusty Old P/E Ratio?”

Some investors, and perhaps also the Wall Street Journal, may not fully appreciate that the P/E ratio is just a special case of present value (aka discounted cash flow, aka DCF), in which growth is assumed to be zero. This special case is simple to understand and calculate, but comes with limitations.

When earnings growth is constant, and if earnings are initially E, then the present value is:

PV = E * (1+g)/(r-g)

…where g is growth and r is discount rate.  If you assume zero growth, this simplifies to:

PV = E/r

Think about what this means.  The value of earnings E is simply E divided by its required yield.

In corporate finance classes, present value, of course, typically assumes r as an input, and solves for PV.  P/E ratio inverts this.    PV is the independent variable, namely today’s market price P.  Then solve for r to find your earnings yield:

r = E/P

Now invert this, and it starts to look familiar:

1/r = P/E

Thus you can think of P/E as a highly simplified approximation of present value, in which you assume growth is zero.  But growth is never actually zero.

And what is a satisfactory required yield?  Depends on your alternatives.  AAA yields vary, and inflation varies.  As the market attempts to incorporate changes in these competitive conditions into prices (efficiently or not), its P/E ratio naturally varies.

If this makes P/E look like a poor yardstick, remember Ben Graham’s goal in promoting it.  He sought not precision, but rather simplicity and conservatism.  He sought to make investing accessible to the common man.

The discounted cash flow equation is a blunt instrument, highly sensitive to tiny estimation errors in growth rate and discount rate.  MBAs get wildly wrong answers all the time using DCF.  By contrast, reducing investing to a simple ratio generates many false negatives, but few false positives, and thus achieves Graham’s goal of investment conservatism.