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The Market from the Top Down, the Federal Reserve, and the Economy

PAR’s pessimism is due to a dearth of bottom-up bargains. (Few businesses can be purchased at prices that deliver a margin of safety.)

A top-down analysis reveals a significantly overvalued market, which merely confirms the dearth of bargains. Shiller’s CAPE, Buffett’s PE, Tobin’s Q, and profit margins are at or near all-time highs (other than during the dotcom bubble) while interest rates are near historic lows.

Shiller’s CAPE

As of July 3, the CAPE was 26.6, which would require a 31% drop to reach its post-war average of 18.4 (including the dotcom bubble in that average).

Shiller’s CAPE (S&P 500 Index /10-Year Average Earnings)

Source: Multipl.com and www.econ.yale.edu/~Shiller/data.htm

I have been writing about the CAPE for a while in letters and on my blog. Although it has been above its long-term average since early 2009 (and for most of the time since 1990), it is not a good indicator for short-term market timing.

At these CAPE levels, stocks are unlikely to deliver much more than low single-digit returns per year over the next decade and the market is vulnerable to large corrections. Since 1881, with the exception of the dotcom bubble, every time that the CAPE reached 24 (April 1901, November 1928, and January 1966) inflation-adjusted losses of 29% or more followed within 4.5 years and peak-to-trough losses were much higher. In this cycle, the CAPE first reached 24 in November 2013. But the market has also severely corrected when the CAPE was lower than 24.

William Poundstone wrote the following in his latest book, Rock Breaks Scissors:

“Today’s investors have every right to feel cursed. They have had few opportunities to buy at average (CAPE levels) much less low ones…The average return at (a CAPE of 23) is something like 2 percent over the coming 20 years. Never has the twenty-year stock market returned as much as 3 percent annually (after inflation) when the (CAPE) was 23 or higher.”

Largely because of the CAPE level, as of May 31, 2014, GMO thinks that US large-cap and small-cap stock real returns will average -1.5% and -4.5%, respectively, each year for the next seven years.

Market Cap-to-GDP (AKA Buffett’s PE) 

Buffett’s favorite measure of market price-to-earnings is the ratio depicted in the chart below, which indicates that the market is about 45% overvalued.

Source Listed in Chart

GMO believes that whenever a measure of market prices (relative to market fundamentals) is two standard deviations from its long-term average, then that market is in a bubble. According to GMO’s definition, Buffett’s PE indicates the market is currently in a bubble. However, Grantham prefers the CAPE (along with other measures) over Buffett’s PE and he believes the S&P 500 will not enter bubble territory until it reaches about 2,250. As of July 4, it’s only 13% away from that mark. 

Tobin’s Q

Tobin’s Q Ratio is a measure of the market’s price-to-book ratio. It equals market value relative to the cost to replace the assets of the businesses in the market. The numerator is the same as the one in Buffett’s PE Ratio. The Q indicates that the market is about 41% overvalued.

Source Listed in Chart 

Profit Margins

Corporate profit margins are at all-time highs. Because high profit margins attract competition in free markets, Jeremy Grantham of GMO calls margins the most mean-reverting statistic in finance and economics. If margins decline, EPS will decline, leading to a decline in stock prices. 

Corporate Profit Margins

Source Listed in Chart and dshort.com

John Hussman of Hussman Funds notes that investors who pay high prices for high profit margins are almost always disappointed in profit growth later.

Source: Hussman Funds

Interest Rates

Interest rates are important because declining rates translate into a higher present value of cash flow, which translates into higher asset prices. It is hard to imagine rates falling much more from here after the 33-year bull market in bonds, but it is easy to imagine rates rising, which will cause present values (and markets) to decline, all other things being equal. 

Source Listed in Chart

The Federal Reserve

“This goes down right now as the mother of all reflation strategies by the Federal Reserve…The cycle starts off with asset inflation, followed by credit inflation, followed by price inflation, and then by wage inflation.” –David Rosenberg, on CNBC’s Squawk on the Street 6/24/14

It appears that a major reason for the market’s rise since 2010 has been the extraordinary measures used by the Federal Reserve to offset the effects of the financial crisis. Quantitative Easing 1, 2, and 3 (QE) has created an environment for company stock buybacks and M&A activity largely by lowering the cost of corporate debt issuance to finance buybacks and M&A. 

In 2013, S&P 500 company buybacks totaled $477 Billion, the most since the 2007 peak. Fortuna Advisors estimates that since the 2009 lows, buybacks juiced cumulative returns from a natural 80% to a steroid-like 178% reached in the first quarter of 2014.

(http://www.washingtonpost.com/business/corporations-cant-stop-gobbling-up-their-own-stock/2014/05/09/83c8ddb0-d6e6-11e3-aae8-c2d44bd79778_story.html)

Of course, it is what happens at the margin—the last trade—that determines your portfolio value. The stock of corporate buybacks over the last three years will be of little consolation in a declining market unless you have already sold into buybacks and are holding the proceeds in cash. 

Further evidence of a Fed-fueled market include: 1) margin debt used to purchase equities is as high as in the dotcom bubble; 2) the junk bond market has been raging again; and 3) IPOs—insiders who want to cash out before the punch bowl is pulled away—are as high as in the dotcom era. 

Correlation is not causation, but there is good reason to believe the Federal Reserve’s extraordinary balance sheet expansion since the crisis (depicted below) is responsible for much of the froth.

Source: ZeroHedge.com

A 2000 publication from the CFA Institute’s Research Foundation studied asset class returns during periods of expansionary and restrictive monetary policy. It should give pause.  

The study (http://www.cfapubs.org/doi/abs/10.2470/rf.v2000.n3.3912) covered the years 1960 through 1998. The average monthly nominal stock market return in expansionary periods was 1.64%. The average in restrictive periods was 0.38%. All eleven periods of expansionary monetary policy over those 38 years resulted in a positive monthly average real return, but five out of the ten (50%) restrictive periods resulted in negative average monthly real returns. Clearly, the maxim “Don’t fight the fed” has a lot of truth in it.

David Tepper

One investor who refused to fight the Fed was the highest earning hedge fund manager in 2013. On September 24, 2010, David Tepper presciently said the following on CNBC:

“Either the economy is going to get better by itself in the next three months…What assets are going to do well? Stocks are going to do well, bonds won’t do so well, gold won’t do as well…Or the economy is not going to pick up in the next three months and the Fed is going to come in with QE (and the stock market will rise because of that).” 

Tepper repeated that analysis several times into 2013. Today, we know he was right because the Fed came to the rescue with QE several times. 

So, it should be a concern that the Fed has already begun to pull back. QE is tapering and will likely end by October 2014, and three of the seventeen Federal Reserve officials responsible for setting the fed funds rate believe it will rise in 2014. Twelve think it will rise in 2015. Only two of the seventeen believe fed funds will not rise until 2016. Nine of the seventeen believe the fed funds target rate will rise from its current 0%-0.25% to at least 1% next year. Three believe it will rise to 3% or higher, which would be a striking change. 

(http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf).

But, make no mistake, whenever the fed funds rate rises, many investors will be surprised. According to the Research Foundation’s Fed study, the average equity return following a Fed interest rate policy increase was most pronounced in the month of the policy change, indicating that it wasn’t expected. The second-most pronounced effect of an increase came in the next month following the policy change. For the first month in a tightening period, stocks declined an average 2.05%.

So, what does Tepper think now? At the SALT Conference on May 14, 2014 he said:

“…there (are) times to make money and there (are) times not to lose money. This is probably (a time when) you’re supposed to think about preserving some of your money. If you’re 120 percent invested, it’s probably too much. You can still be long, but you probably should have some cash…I am nervous. I think it’s nervous time.” 

Tepper’s fund cut its net long exposure from 100% in December 2013 to 60% in May 2014.

(http://www.cnbc.com/id/101674055) 

Employment

While the market rose 144% since January 1, 2009, the underlying fundamentals of the economy have been weak, which is further evidence that the market has been largely driven by the Fed. GDP declined in the first quarter by a whopping 2.9%. Bad weather cannot explain the long-term weakness in the ratio of Employment-to-Population (E/Pop), which has barely budged from the nadir (58.2%) since the crisis abated. The chart of this ratio does not look like an economy that can justify a 144% rise in the S&P 500 Total Return Index since January 1, 2009 or 178% since the nadir. 

Ratio of Employment-to-Population (January 2006 through May 2014)

Source: BLS

Unlike the unemployment rate and the Labor Force Participation Rate, the E/Pop ratio implicitly assumes that every unemployed person of working age is looking for work. It may be the best indicator of economic robustness. The E/Pop has not been this low since the effects of the “malaise” of the 1970s, yet the S&P 500 Index has hit all-time highs dozens of times already this year. (http://www.bls.gov/opub/mlr/1981/02/art4full.pdf) 

We probably should not anchor on the post-war high E/Pop of 64.7% in April 2000, or even the post-dotcom bust of 63.3% last reached in March 2007, but the 58.2% read in October 2013 is a post-1983 low. The latest figure is from June 2014. It is just 59%.

The Other Side of the Inflated-Market Argument

To help combat confirmation bias, I now present the other side to the top-down view that markets are inflated and approaching a bubble. Most of the counter-argument centers on four ideas: 1) there are flaws in each of the metrics outlined above; 2) after six years of anemic economic growth, the economy is due to break out; 3) forward PE ratios (today’s price relative to analysts’ earnings per share estimates for 2015) are not extraordinarily high; and 4) it’s different this time, so the Federal Reserve will not be able to tighten because the economy will not be strong enough. (Note to blog readers: the argument that stocks are the best alternative is not addressed  here because the letter makes clear that PAR believes all markets–stocks, bonds, housing, etc.–are inflated beyond levels that are justified by fundamentals.)

Point four contradicts the other points. For example, if it is different this time and the economy is not strong enough for the Fed to tighten, then it is hard to argue that forward earnings will be good or that the other metrics would point to better conditions if they weren’t so flawed. At least in the pessimistic case, all compasses point in the same direction. 

I think I understand all of the identified flaws in each metric above (e.g.  flaw: “the CAPE in 2012 was distorted by two recessions, which is unlikely to be repeated”) even if I disagree with the rationales for why they are flaws (e.g. Shiller used a ten-year horizon to capture long cycles). Also, the various flaws have always been in the measures, which make trends important. It is the trends that are troubling. 

I do not know where the economy is headed and I don’t know where earnings will be next year. But, I do agree with Steven Levitt and Stephen Dubner, who wrote the following in their latest book, Think Like a Freak:

“It has long been said that the three hardest words to say in the English language are ‘I Love You.’ We heartily disagree! For most people, it is much harder to say ‘I don’t know.’”

David Dreman demonstrated that analyst EPS estimates have been far off the mark for a long time. But, analysts have to keep on guessing because their institutional clients demand it and they cannot tell their clients the truth: that they just don’t know what forward EPS will be and that they could deliver more value to clients if clients would let them focus instead on what can be known about a business. Given analysts’ abysmal records in forecasting EPS, how can anyone find comfort in forward PE estimates? 

I hope the economy surprises to the upside and justifies today’s high stock market prices. All PAR can do is stick with its Separate Account Value Investing (SAVI)* discipline and buy stocks only when PAR finds a margin of safety, and “buy” call options that never expire on every company in the market (i.e. hold cash) when margins of safety do not exist. Those call options will be valuable one day.

Discipline is the key.

* SAVI is a separate account platform with Charles Schwab in which PAR invests client funds using PAR’s value investing processes. Clients have complete transparency into PAR’s activity in their account and clients control their separate account. Client funds are not commingled in the SAVI platform, so clients receive asset management tailored to their needs.

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At this month’s CFA Institute Annual Conference in Seattle, Sharpe said that Smart Beta made him sick because it implied that index investors had to be “dumb beta.” Sharpe believes the so-called dumb beta investors would eventually gravitate to Smart Beta strategies because no one is that dumb for long, and then the advantages of Smart Beta would simply melt away into average beta.

As regular readers know, Fama and French (F&F), and later Lakonishok et al. (LSV)  (See F&F and LSV tab above) demonstrated as early as 1992 that two factors consistently resulted in outperformance in the long run: Value and Small Cap. It is largely these two factors that put the “smart” in “Smart Beta.” F&F and LSV were not the first academics to publish papers on the value and small-cap factors, but they certainly popularized the factors in academia. Before these academics came along, we had research from practitioners Ben Graham from the 1930s through the 1970s; Warren Buffett from the 1950s to today; and Seth Klarman from the 1980s to today; that demonstrated that value strategies consistently outperform the market in the long run.

Since F&F and LSV published their research in the 1990s, there has been an overwhelming amount of academic research that demonstrates that value strategies outperform. Most of that research proves that value outperforms for reasons that are not related to risk, therefore value has consistently delivered alpha in the long run.

Most Smart Beta strategies are nothing more than systematic ways for managers to capture some of the factors that are known to deliver this alpha in the long run. The adoption of this approach in a more systematic and passive way somewhat proves Sharpe’s theory that no one stays that dumb for long. However, value and small-cap strategies outperform over long periods not necessarily because value and small-cap investors are smarter than everyone else, but because behavioral flaws and institutional constraints do not permit EVERYONE to FULLY capture the alpha in value and small cap. I remind you that it did take over 150 years for Smart Beta to be born.

Only small investors with contrarian streaks (see my future post on Investor DNA) can fully exploit these factors. Even Smart Beta strategies will fail to fully exploit these factors because of the amount of capital that Smart Beta will need to invest. Much of that capital will have to be allocated to large cap firms, but most of the alpha in these factors is found in relatively unknown and un-followed small-cap firms.

So, my answer to Sharpe’s queasiness is this: Smart Beta is just a label. Would he have taken less umbrage if that label were “Behavioral Beta” or “Factor-Focused Beta?”

http://advisorperspectives.com/newsletters14/Bill_Sharpe-Smart_beta_makes_me_sick.php

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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“…around 50% of our assets are in cash, and that’s a very high absolute number, now around $14 billion and rising…”–Seth Klarman

I recently came across this quote from Seth Klarman of the Baupost Group, which he said during a speech that he gave at James Grant’s Investment Conference in October 2013 (http://www.grantspub.com/mygrants/viewarticle.cfm?aid=4995).

If anything, Seth has less capital employed now than he did then.

If I had to pick one investor with whom I felt closest philosophically (and operationally), it would be Seth. PAR is currently sitting on cash equal to 55% of client capital because our bottom-up process has revealed few bargains and PAR has just about enough invested in the bargains PAR has uncovered.

As readers of PAR’s holiday card may have noted, I now view cash the way Buffett’s biographer believes Buffett views it: Cash is an option on thousands of companies and each option has no strike price, no expiration date, and no premium cost other than the lost purchasing power due to inflation. At current inflation rates, the premium is low.

This is the strongest argument to the oft-asked question: Why should I pay [Investment Manager] to hold cash? The answer, of course, is that they are paying [Investment Manager] to have the discipline to buy perpetual options on companies that will one day provide a margin of safety. [Investment Manager] “finds” these perpetual options by selling positions that become fully valued in inflated markets. It takes discipline to sell at or near full value when markets have been rising. Clients who believe that they could do the same as [Investment Manager] need to be introspective and seriously question (and answer honestly) whether they held significant amounts of cash in 2007 and employed it fully in 2009.

Coming into 2014, the market in general was overvalued as evidenced by the CAPE, Tobin’s Q, profit margins, etc., but patient investors will get their opportunities. Those with dry powder, who have been sitting on a perpetual option on every company–i.e. sitting on cash–will be the ones who exploit those opportunities.

My friend Chris Cannon attended Grant’s conference last fall and took some notes from Klarman’s speech that day that I have condensed. Enjoy:

“Seth is a great worrier.  He worries top down but invests bottom up.  He says top down analysis is a lot like sports talk radio – lots of talk and opinions…

Most investors/portfolio managers feel a gun to their head to get fully invested.  This is a weakness…

…if (Baupost) thought the world was going to collapse tomorrow then they wouldn’t return the cash. So he can’t figure out the timing.  But if it does collapse he will ask his investors for more cash…

His biggest concern is that his investors take the cash he returns them and place it with a manager putting up big numbers over the past few years, especially the last two. “This is a recipe for disaster.”  He’s encouraging them to protect it…

Nobody in the White House or the Fed has any practical business experience and handing the reigns to another academic seems totally nuts to him…

He thinks big cap companies (like Jeremy Grantham’s high quality) aren’t mispriced enough for him to do anything interesting with them…

(Because of LBO recaps and refinancings, Y)ou don’t need an economic downturn for a crack up (in high yield), just slightly higher yields… So a crackup in high yield is very, very, likely…

It’s embarrassing that after a crisis that nobody saw, government policy continues pouring on more gas to fuel more speculation to get things (stocks, real estate, debt) back to the same place we were, or maybe even worse now…

It took him at least 15 years of repeating his ideas so clients can see them really work and then they sink in.”

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I have found the story of Allan Mecham to be fairly typical. You have probably never heard of Mecham because his fund is structured as a hedge fund, and so SEC rules prevent him from advertising and state that he must limit the number of his investors to a few hundred who must be wealthy.

The companies he buys trade at a discount to their intrinsic value because the “smart money” will not buy them, usually (but not always) because the company is too small to attract the attention of large investors. If the smart money does buy them, they usually do not stay with the investment for very long; the typical non-index mutual fund turnover rate is over 100%. In many ways the story of investment in these companies parallels the predicament of Mecham’s fund. The smart money that will not invest in the companies that Mecham buys shares a philosophy with the smart money that will not invest in small, concentrated, contrarian funds.

The following are the typical characteristics of the philosophy and processes used by small, value investors such as Mecham. They:

• Make investment decisions alone because groupthink generally leads to poor investing results. As Mohnish Pabrai once said, it is doubtful that Warren Buffett would have made one of the most successful investments of his career–taking a stake in American Express that amounted to 40% of his fund’s assets–if he had to answer to an investment committee or justify the investment to a pension fund consultant;
• Are usually somewhat quirky and do not have the pedigree or use processes that Wall Street understands, at least not before they have $1 billion in assets under management (AUM). After a billion dollars in AUM, Wall Street understands even gibberish. To Wall Street, Buffett was just some quirky guy in Omaha before he had a few billion in AUM. And, by Wall Street, I mean every potential investor in Meacham’s fund–seeders, incubators, funds of funds, pension funds, family offices, and other high net worth investors. At a recent family office (FO) conference that I attended, every speaker said that FOs–once the mainstay investor in small, quirky, value-investing startups–have gone the way of big institutions seeking to invest only in large, well known managers who have the infrastructure to gather assets;
• Because of the “institutionalization” since 2000 of the processes used by FOs and other high net worth investors, it is nearly impossible to find funds like Arlington that launched after 2000. We now know of the huge success stories such as Arlington, Klarman’s Baupost; Einhorn’s Greenlight; Pabrai’s Pabrai Funds; and Tilson’s T2 partners. These once-tiny value funds all launched before 2000–almost all with less than $1 million AUM–and grew through word of mouth. Can you name one that launched after 2000? Those that launched after 2000 have had little chance to raise capital in the new institutional environment;
• Are contrarian–buying when others sell, and selling when others buy
• Are structured as hedge funds because 1. SEC rules severely restrict the way mutual fund managers operate (e.g. SEC rules force diversification–”di-Worsification” as Peter Lynch liked to say–limit the ability to manage risk by hedging and selling short; and limit the ability to use leverage to exploit extraordinary contrarian opportunities and special situations); 2. mutual funds must be able to meet redemptions every day and so are not conducive to long-term thinking; and 3. mutual funds have higher startup costs;
• Do not try to predict where the market is heading but hedge market risks when the costs of hedges are cheap such as when everyone thinks the market can only go higher. In fact, they usually do not make explicit predictions for the companies in which they invest because they know that those predictions are rarely accurate (See the evidence for this in any of about one hundred sources such as Dreman’s Contrarian Strategies (Just added the latest edition to the bookstore above))
• Do not take in a lot of money because they know that true value opportunities are few and that sitting on a lot of unused cash would only hurt their investors’ returns. Even if the smart money suddenly realized that funds like Mecham’s were safe investments that delivered excellent long-term results, Mecham would not likely take in much more than he is managing now;
• Know that senior managers rise to the top of their organizations because of their inordinate salesmanship abilities and so meetings with companies are likely to lead to biased analyses. Meetings with management should therefore be avoided, or kept short and limited to extracting a vital piece of information that could not be obtained any other way;

I have a personal story. I write this blog anonymously because I do not want to run afoul of SEC rules regarding solicitation. A high net worth investor–a doctor from North Carolina–managed to track me down because he liked what he read here and wanted more information in order to invest in my fund. My law firm said he had to fill out a questionnaire before I sent him any information.

The doctor filled out the paperwork, but I could only send him the PPM after I received his information and determined that the fund was a suitable investment for him. The PPM is boilerplate but I told him that I could not take any investment from him until he had taken a little over a month to digest it. He still has not seen the results that the fund delivered, but he did ask general questions about the fund, which I launched in 2010. The information I gave him demonstrated that my fund started with ten times the assets and ten times the number of partners as Mecham’s fund, and from what I gathered in the article, twice the number of fund employees as Mecham.

Doctors like the one who contacted me were once the angels of startup funds like mine and they reaped the rewards; yet, it has been almost three months since I heard from him. As of today, I have nine investors in my fund made up of one family member, one former fund employee, six former colleagues from prior firms in which I worked, and one former client from a firm in which I last worked in 1997; no one that I have known for fewer than fifteen years.

The traditional investors who invested in funds like mine no longer invest in funds like mine. It is sad, and not just for entrepreneurial fund managers. Maybe it is the Madoff effect or severe risk-avoidance after two bubbles burst last decade, but it is especially sad for anyone who needs to fund a future liability–i.e. everyone. The story about Mecham opens with him in a conference room in New York City surrounded by potential investors who are peppering him with questions, trying to gauge his ”sophistication.” It would be funny, if it weren’t so sad.

http://www.smartmoney.com/invest/strategies/the-400-man-1328818316857/#tabs

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The speakers included:

Fred Speece, Moderator, Speece Thorson Capital

Aswath Damodaran, NYU

James Valentine, CFA, AnalystSolutions

Andrew W. Lo, MIT

David Maris, Healthcare Analyst

Nicholas J. Colas, ConvergEx Group

Jean-Marie Eveillard, First Eagle Investment Management

David Cowan, GMO

Richard Bernstein, Richard Bernstein Advisors LLC

Michael L. Mayo, CLSA

Howard S. Marks, CFA, Oaktree Capital Management 

Although I quote some speakers more than others, it is not necessarily because the less-quoted speaker was any less interesting. After writing the notes for the first speaker, Aswath Damodaran, I realize that this will be a long post, so I am breaking it up into several parts. 

Fred Speece, Conference Moderator: Introduction

•          Occam’s Razor: Don’t make valuation more complicated than it has to be
•          Remember the importance of dividends: they made up 44% of returns since 1926
•          Know your stuff: fundamentals and valuation

Aswath Damodaran (AD) of NYU; The Dark Side of Valuation: Across Life Cycles and Businesses

The speech is on the essentials that can be found in his latest book of the same title, which I just added to the bookstore above. Professor Damodaran loves discounted cash flow models and walked us through several valuations that he performed over the years, some of which can be found on his blog (see blogroll to the right);

 Young Companies:

•  Valuing young companies in young industries is a challenge: don’t succumb to nouveau valuation methodologies like the 1990s’ “value per eyeball;” don’t be swayed by stories like “there are 2 billion new consumers” in Chindia; and when someone starts talking about paradigm shifts remember it is because he has no explanation for what is happening;
•  AD ran his model on Amazon (AMZN) in 2000 and came up with a value of $34. The stock was trading at $84 at the time. His first thought was “What am I missing?” (I think this is a perfect example of the experience most thoughtful investors have. So many investors pay ridiculous prices for companies because of the story or a paradigm shift, and not for the business’s fundamental value, that it leaves thoughtful investors scratching their heads. Successful  investors refuse to attend those parties);
• Work backwards (or as Charlie Munger would say, “Invert!!!”). AMZN could not have had margins and revenue growth that far exceeded brick and mortar retailers for too long. Eventually the cost to grow AMZN’s business would increase and AMZN’s competitors would adapt by competing directly on AMZN’s turf. The e-tailers and retailers’ margins and growth will converge. What will the values of those businesses look like when they do converge? (INVERT!!!);
• Whenever he told professionals of his lower valuations for companies like AMZN, he usually heard dismissive comments like, “You are just an academic, you don’t know the ways of Wall Street;”
• Keep it simple (the S word again);
• “If you are a pessimist at heart, don’t bother trying to value young, growth companies because they are all overvalued;”
•  “There is always a scenario that you can run in which the market price can be justified” (no matter how ridiculous). Our job is to resist basing our valuations on those;
•  ”No matter how careful you are in your projections, you will be wrong 100% of the time” (yes, very true!). You will never get all of the numbers perfectly right in every period. Then what is the point in running these models? “You just have to be more right than the market or next best analyst.” (Part of the reason I rarely do discounted future flow models is because of the inherent optimism bias in such models. When it comes to valuation of assets, I am a skeptical pessimist. I started my career as a credit analyst—possibly the most skeptical people on Wall Street— because it came naturally to me. So, if a skeptical pessimist like me knows that he should not use models that base valuations on projections because they are likely to be too optimistic, what does an irrational optimist who has no self-knowledge come up with in their discounted future flow valuations? I suspect it is something close to the market consensus);
• “Bias is the biggest enemy of good valuation;”
• “Thank God for institutional investors because they buy when everyone else buys and sell when everyone else sells, which creates opportunities for us;”

 Mature Companies in Transition

•  “Run two models: a status quo model and one where an ideal manager—you—could optimally restructure the firm;”
•  “Unless you are a depressed person, your restructured firm will always be worth more than the status quo firm;”
• How do you get more cash flow out of existing assets? “Two ways to lower the cost of capital that few think about: 1) match funding to lower default risk in the company’s bonds (and so pay less in interest); 2) make products less discretionary (e.g. branding).” Cell phones were a discretionary product when they first came out. Now they are indispensible;
• “Watch out for legacy costs” (I always look for unfunded pension and health liabilities before I invest in any company. Many companies and municipalities are going to be bankrupted by these costs. These important liabilities should be placed in the liabilities section of the balance sheet and deducted from book equity, but they are not. They are relegated to footnotes that take time to be dissected);
• “I always sell when a growth company makes a large acquisition.” Acquisitions are the worst of all possible growth strategies for improving shareholder wealth. The worst of the worst is acquisitions of public companies because the buyer must pay a significant premium over market value;
• The best managers for companies and industries in a decline are those who do not fight it. The best harvest in a decline. Eddie Lampert’s problem is he cannot harvest and sell the real estate as he had planned through the decline of Sears and Kmart;
• Truncation risk—i.e. default—cannot be accounted for by adjusting discount rates (that is obvious and truncation risk is the most dangerous for valuing deep value companies. An equity analyst needs to have strong credit skills in order to account for these risks);
• Financial services companies are opaque (So true, we gave up trying to analyze multinational banks a long time ago. A quote by Joe Rosenberg in the 12/5/11 Barron’s says it all: “…it’s impossible to figure out what banks own, even if you are on the inside.” I have been saying the same thing since 2007; there is no way that Prince and Corzine had a clue of what was happening right under their noses);
• By AD’s estimation, Citigroup could devote all of its free cash flow over the next five years in an attempt to meet the new Basel rules and that still would not be enough to pass. How on earth can they be paying a dividend?

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An Interview with Seth Klarman and Charlie Rose from Facing History and Ourselves on Vimeo.

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Tebow is not the only quarterback who comes to mind. Ever hear of a guy named Joe Montana? Montana played at a little known football college called Notre Dame. He was recruited by ND, but in 1977 at the beginning of his fourth year in the program (an injury gave him five years of eligibility) Montana was still listed third on the depth chart behind Rusty Lisch and Gary Forystek.

ND started the season 1-1 in 1977 and Montana did not play until there were eleven minutes left in the third game of the season with ND trailing by more than a touchdown. He rallied ND to a victory (Data provided by Wikipedia) and never lost his starting job after that. In fact, ND did not lose another game that year after he got the chance to play.

ND finished 1977 with a win in the Cotton Bowl over then-number-one ranked University of Texas and ND was voted the National Champions. All Montana did in college was win, usually late as he led his team in one comeback after another.

You would think that such a clutch performer who led his team to a National Championship would be viewed favorably by the experts in the NFL, but the scouts did not think very highly of Montana. They ranked his arm strength as particularly weak. So, the following quarterbacks were drafted ahead of Montana:

First Round: Jack Thomson, Phil Simms, Steve Fuller 

No other quarterbacks were chosen in that draft until Montana was taken with the last pick in the third round, number 82 overall. All Montana did in the NFL was win four Super Bowls, win three Super Bowl MVP awards, get selected for eight Pro Bowls, and get elected to the NFL Hall of Fame. He is widely considered to be the greatest quarterback of all time.

Okay, so maybe you heard of Montana, but have you ever heard of a guy named Tom Brady? I will admit I did not like the guy until this year when I saw an ESPN film called “The Brady 6.”  It is the story of Brady and the six quarterbacks who were drafted ahead of Brady in the 2000 NFL draft.

You can and should watch “The Brady 6″ on YouTube (I embedded part I below), so I will not bore you with Brady’s story here. But, I found one thing especially noteworthy: the experts at the NFL combine had ranked 576 college quarterbacks in the speed and agility categories in the multi-decade history of the NFL Combine. Brady’s overall ranking in the history of the combine was 576.

The football experts rely on these combine numbers the way baseball scouts heavily rely on batting average for hitters and velocity for pitchers; the way fund analysts rely on pedigree for performance prospects and beta for risk measurement. Oh, and the experts all felt that Brady had poor arm strength.

The two quarterbacks who earned 100 wins in their careers in the fewest number of starts were Joe Montana and Tom Brady. Watch the Brady 6; it may forever change the way you think of experts in sports and elsewhere.

Today, we have Tebow, who is being criticized for a supposed lack of NFL-caliber skill, and the criticism is often nasty. The silence from Denver’s front office, scouts, and coaching staff has been deafening. It should be noted that Tebow was drafted by a different front office and coaching staff from the current one in Denver.

Yet, today I found out that Tebow is 4 -3 5 – 2 (5-3 6 – 2 after the win against the Jets) in his first seven starts in Denver compared with Hall-of-Famer John Elway’s 1 – 6 record in his first seven. Tebow is now 4-1 this year after Denver started 1-4 without him and he has Denver in the playoff hunt. Tebow has something like eight touchdowns to one interception in that seven game span and Elway had those numbers reversed. The knock on Tebow has been that he does not have the arm strength to be an NFL quarterback. It sounds familiar.

Maybe the experts will have gotten this one right in the end. After all, Tebow did have more success in college than Montana and Brady; he did win two National Championships at The University of Florida and a Heisman Trophy. And, unlike Montana and Brady, Tebow was taken in the first round of the NFL draft.

I am choosing NFL quarterbacks for this criticism of experts, but you could pick any position in the NFL, or any position in any other sport, and you will find that experts often get it wrong. Or, you could choose experts in any field from finance to climate science. Many are not just proven wrong, but fantastically wrong. Perhaps it is because those who are deemed experts are usually the ones who are the most sure of themselves; they make the best media, board room, or draft room presentations, but perhaps they are not necessarily the best at understanding talent or analyzing complex phenomena. Often times, the one who is the most aggressive and talks the loudest wins the day.

Michael Lewis’s great book Moneyball is all about experts who get it wrong, leaving cheap bargains available for savvy analysts who can see through the nonsense. Here are some reasons that experts make mistakes in evaluating baseball talent: evaluating a player based on whether or not he has a square jaw (“a baseball face”); whether he looks good in jeans; or whether he has a pretty girlfriend. That is the kind of analysis that experts provided before Moneyball, and many still have similar biases.

One such bias in baseball that has not disappeared is a bias against “soft tossers;” i.e. pitchers who cannot consistently break 90-miles per hour on the radar gun. Remind you of the supposedly weak arms of Montana, Brady, and Tebow? Baseball pitching experts are enamored with velocity and are blind to practically every flaw in a pitcher who can throw hard. But, if a pitcher does not throw hard they will ignore him even if he has few flaws, even if he can knock a fly off a catcher’s mitt, make the ball move, change speeds, and collect wins. Never mind that the greatest pitcher in the last thirty years rarely used velocity to get hitters out, but could hit practically every spot he wanted to within an inch or two, move the ball, and change speeds: five-time Cy Young winner Greg Maddux.

So, should we rely on experts to the degree that we do? Warren Buffett points out that  experts concluded that his and other value investors’  accomplishments were either lucky–like a coin flipper who gets heads twenty times in a row–or that there is just not enough data to evaluate their success. His now-famous story is of 225 million orangutans spread evenly throughout the country who mindlessly flips coins; by sheer luck 215 of them will get heads twenty times in a row. But, he says that if forty of those 215 orangutans are from the same zoo, maybe they are on to something.

Were the experts right, but the outlier successes of the Montanas, Bradys, Madduxes, Buffetts, Klarmans, and Einhorns to be expected as merely the lucky random ones who fell under the far reaches of the bell curve?

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