Sunday, July 29, 2018

After years of underperformance, are value stocks worth buying?

Last month, Sean Markowicz of Schroders wrote an article titled "Where's the value in value investing?" Mr. Markowicz mentions that before the 2007-08 financial crisis, value stocks almost always outperformed growth stocks as measured by rolling ten-year returns, but since then growth has outperformed value on the same measure:














This is partly because "the 12 month forward price-to-earnings ratio of growth stocks has risen by 55% compared to only 11% for value stocks" and because "growth stocks, unlike value, have a greater proportion of their cash flows occurring in the distant future... This makes them akin to long-duration assets, which are more sensitive to changes in long-term rates. As a result, growth stocks have benefited far more than value stocks from rates falling to record lows."

Markowicz summarizes his message by stating that "the valuation picture seems fairly supportive of value’s relative return prospects."

While the article makes a lot of thought-provoking points and is worth reading, I disagree with its conclusion. I don't want to say that value is doomed to continue underperforming growth, but I don't think buying value stocks is a good trade ex ante, for several reasons.


Value and how it's defined

My main disagreement with the article relates to how it defines value. It calculates value's performance relative to growth by comparing a basket of stocks with the lowest price-to-book ratios (the value stocks) to a basket of stocks with the highest P/B ratios (the growth stocks). This means that the actual valuation of value stocks will vary significantly with the market's overall valuation and the dispersion of P/B multiples. So today's value stocks may be radically different from the value stocks of yesteryear, making value's historical outperformance potentially less meaningful than it appears.

I think it is less meaningful: despite their long underperformance, value stocks are noticeably more expansive than they were the last time value was out of favor. In 2000, when the technology bubble peaked, many "old economy" stocks had fallen 25-50% over the prior 18 months and were trading at low P/E ratios. For instance, Autozone and Sherwin-Williams traded at 10-11x earnings despite growing their earnings per share steadily for years. Some companies with more mundane financial results traded at even lower prices, e.g. Universal (UVV) and Ball Corp (BLL) traded at 5x earnings in March 2000.

Maybe I'm not looking hard enough, but I don't see anything like that today. Most companies with steady EPS growth are trading at or above the market's P/E multiple, and the ones trading at single-digit P/Es tend to be cheap for good reason: the business is cyclical, they're failing retailers, they were part of a leveraged buyout and carry a huge debt load, etc.

By buying stocks cheaply, value investors try to create a "margin of safety"--they hope that even if the underlying business disappoints, they'll avoid losing money because the price they're paying for the stock discounts a lot of potential bad news. In my opinion, absolute valuation is what creates a margin of safety, not relative valuation or relative performance. If investors buy a stock at a discount to its net working capital, they won't suffer crippling losses even if the company has to liquidate. If they buy a stock at 5x earnings, they'll earn back their investment in five years, freeing them from the need to make assumptions about the distant future.

Obviously, that's an oversimplification: companies that trade below their net-net value occasionally incur large operating losses, and companies that trade at low P/Es can squander the E on ill-advised acquisitions. But in general, buying absolutely cheap stocks is both safe and rewarding in a way that relative-value investing isn't.

Energy stocks provide a good test of absolute versus relative valuation. After the price of oil collapsed in 2014-15, many energy bulls made relative-value arguments: energy stocks had become an unprecedentedly small part of the Standard & Poor's 500 index, their underperformance vs. the index had reached extreme levels, etc. At the same time, most energy stocks weren't particularly cheap when valued individually: the ones that had earnings traded at high P/Es and would trade at high P/Es even assuming oil rebounded. Many were also poorly managed and prioritized production growth over shareholder return. Ultimately the relative-value arguments didn't matter: energy stocks kept falling until the oil price bottomed, and since then they've barely kept pace with oil futures despite their significant financial and operational leverage to higher oil prices.


Implicit macro and sector bets

Buying value stocks involves making implicit macro and sector bets. Interest rates are a major influence on value's relative performance:


(Source: Claus Vistesen)

This influence works in a couple of ways. One is the dynamic that Markowicz mentions, in which growth stocks tend to be longer-duration while value stocks tend to be shorter-duration. Another is that value stocks, as measured by price to book, disproportionately belong to the financial sector. Since banks borrow short and lend long, i.e. they typically borrow money through overnight deposits or short-term certificates of deposit and make multi-year loans, the shape of the yield curve affects their profitability. All else being equal, banks should earn higher profits when the yield curve is steeper.

So long as the European and Japanese central banks practice ZIRP and financial repression, I doubt the US yield curve will steepen dramatically. When foreign institutional investors buy US bonds, they often finance the bonds by borrowing dollars on a rolling three-month basis. This hedges their currency risk. If the US curve steepens while the European and Japanese curves stay relatively flat, longer-term US debt financed with short-term USD borrowing becomes more attractive to foreign investors, and any movement they make into US debt should re-flatten the curve.

This doesn't mean interest rates--and by extension bank profitability and value stocks--can't rise, but it makes a sustained rally less likely.

I believe that the preponderance of banks among value stocks has also affected value's relative performance in another, more obscure way.

Banks have two unique risks that don't affect other industries. One, they depend on the trust of their depositors and lenders and can quickly fail if they lose that trust. Two, regulators can force them to issue new equity during a crisis or at the bottom of an economic cycle, diluting shareholders at the worst possible time. These risks hit many banks in 2007-09. E.g. Washington Mutual failed, and Citigroup had to massively dilute its shareholders to survive. Despite rising 600% from its 2009 low, Citigroup shares are still 87% off their 2007 high.

I believe that value's underperformance since the financial crisis is partly a byproduct of these risks hitting banks. Bank stocks declined during the crisis, failure and dilution made the decline permanent, and this has depressed the rolling ten-year returns for value stocks. This dynamic isn't supportive of mean reversion. If a bank underperforms the broad market because it had to take a "hard reset" by issuing new equity at the bottom, that doesn't imply it will subsequently outperform.

To be fair, the article touches upon this, but it's something that I would have emphasized more. The article also mentions that the value's underperformance vs. growth shrinks when the value and growth indices are adjusted to reduce the financial and technology sectors' respective weightings.


A couple of final comments

• I think the stock market is more competitive than ever before and that this will suppress returns for many styles of investing including value. Academic research into "investing factors" has increased interest in statistical-value strategies, and the proliferation of hedge funds means that cheap small- and micro-cap stocks that institutional investors traditionally ignored are no longer ignored and are less likely to stay cheap. Don't assume that value will outperform growth in the future just because it typically has.

• Good relative performance doesn't guarantee good absolute performance. Value stocks could outperform growth stocks while actually falling, for instance if glamour stocks like Facebook, Amazon, Netflix, and Google fell 25-30% during a correction while value stocks fell 10-15%.

Thursday, July 26, 2018

The new Nifty Fifty: today's one-decision stocks

On Twitter, Ryan P. Dolan asks, "If we are in a Nifty Fifty 2.0 environment, beyond the obvious members (AAPL, AMZN, GOOG, MSFT, FB, NFLX, TSLA, MA/V, etc), what other companies would you include?"

It's a good question. I agree with Mr. Dolan that today's stock market echoes the Nifty Fifty era of the early 1970s. Many large-capitalization stocks are trading at high price-to-earnings and price-to-revenue multiples, but unlike during the technology bubble of 1999-2000 and the housing bubble of 2003-06, the speculative excesses we see now aren't limited to one industry or sector of the economy.

Instead, like in the early '70s, investors are bidding up glamorous companies--ones that are growing quickly or have high returns on invested capital--irrespective of their industry. The Nifty Fifty was a mix of established-but-still-growing blue chips and newer, sexier companies; likewise for today's market leaders.

I'm going to take a stab at his question and offer a Nifty Fifty 2.0 below. The original Nifty Fifty was an informal, unscientific list, and so is mine. For instance, Apple doesn't trade at exorbitant valuation multiples, but it's undeniably a market leader and glamour stock, so I'm including it. Notwithstanding that, each company on my list has a market cap is $10 billion or more, along with some or all of the following characteristics:

• It's popular among hedge funds
• It's been described as a quality business, compounder, or disruptor
• Its leader has been described as an outsider CEO or a great capital allocator
• It has a price-earnings ratio above 25
• It has an up-and-to-the-right stock chart
• Much of the stock's performance since 2009 has come from multiple expansion



The new Nifty Fifty

Activision Blizzard (ATVI)
Adobe (ADBE)
Align Technology (ALGN)
Amazon (AMZN)
Apple (AAPL)

Autodesk (ADSK)
Automatic Data Processing (ADP)
Berkshire Hathaway (BRKA, BRKB)
Blackrock (BLK)
Boeing (BA)

Booking Holdings (BKNG)
Broadcom (AVGO)
Charter Communications (CHTR)
Copart (CPRT)
Costco (COST)

Danaher (DHR)
Electronic Arts (EA)
Facebook (FB)
Fiserv (FISV)
Google (GOOG, GOOGL)

HCA (HCA)
Home Depot (HD)
Idexx Laboratories (IDXX)
Intuit (INTU)
Intuitive Surgical (ISRG)

JP Morgan (JPM)
Lowe's (LOW)
Marriott (MAR)
MasterCard (MA)
Microsoft (MSFT)

Netflix (NFLX)
Nike (NKE)
Nvidia (NVDA)
Palo Alto Networks (PANW)
Paypal (PYPL)

Rollins (ROL)
Roper Technologies (ROP)
Ross Stores (ROST)
Salesforce (CRM)
Sherwin-Williams (SHW)

Take-Two Interactive (TTWO)
Tesla (TSLA)
Texas Instruments (TXN)
TJX Cos. (TJX)
Transdigm (TDG)

United Health (UNH)
Verisk Analytics (VRSK)
Visa (V)
Wayfair (W)
Workday (WDAY)



Honorable mentions

Interactive Brokers (IBKR) is a cult favorite that's grown steadily, has a revered CEO, and trades at a high multiple, but I excluded it because its free float and trading volume are relatively small.

I wanted to limit the list to American companies, but Alibaba (BABA), ASML (ASML), Brookfield Asset Management (BAM), Constellation Software (CSU), JD.Com (JD), Shopify (SHOP), Spotify (SPOT), and Tencent (TCEHY) are foreign companies that are beloved by American investors, have well-known growth stories, and trade at rich valuations.

Thursday, June 28, 2018

Will tight monetary policy and loose fiscal policy push the dollar higher?


I recently read Jack Schwager's trader-interview book The New Market Wizards, which includes an interview with Stanley Druckenmiller. Many people consider Druckenmiller one of the best investors alive, and he lives up to his reputation in the interview, sharing a number of fascinating anecdotes and ideas.

One idea in particular caught my attention. Druckenmiller tells Schwager that:

I never had more conviction about any trade than I did about the long side of the Deutsche mark when the Berlin Wall came down. One of the reasons I was so bullish on the Deutsche mark was a radical currency theory proposed by George Soros in his book, The Alchemy of Finance. His theory was that if a huge deficit were accompanied by an expansionary fiscal policy and tight monetary policy, the country's currency would actually rise. The dollar provided a perfect test case in the 1981-84 period. At the time, the general consensus was that the dollar would decline because of the huge budget deficit. However, because money was attracted into the country by a tight monetary policy, the dollar actually went sharply higher. When the Berlin Wall came down, it was one of those situations that I could see as clear as day. West Germany was about to run up a huge budget deficit to finance the rebuilding of East Germany. At the same time, the Bundesbank was not going to tolerate any inflation. I went headlong into the Deutsche mark. It turned out to be a terrific trade.


Today the United States has a similar combination of tight monetary policy and loose fiscal policy. The Federal Reserve has begun raising interest rates and shrinking its balance sheet ahead of its European and Japanese counterparts, while the US fiscal deficit is set to surge following a large corporate tax cut.

So after reading the interview, my initial reaction was to assume that the current regime is positive for the dollar. But after further research, I think the U.S. today has enough differences with Druckenmiller's two examples that any comparison is meaningless. I want to emphasize that I'm not a macro expert, so some of these arguments may be flawed, but here are what I see as the differences:


• The dollar is already relatively high.

In 1980, the dollar had fallen by half against yen and mark during the previous decade. In November 1989, the mark was off its highs versus the dollar and had been flat for the previous three years despite a large and rising trade surplus. Whereas today, the dollar's real effective exchange rate is near a decade high:


A chart of the trade-weighted US dollar index also puts the dollar's strength in stark relief:



• Anecdotally, sentiment is also high.

The consensus of Wall Street currency strategists seems to be that, since the US growth has accelerated at the same time that economic data have surprised to the downside in many other countries, the dollar can only continue to rise for the foreseeable future.

By contrast, as Druck mentions, in the early 1980s “the general consensus was that the dollar would decline because of the huge budget deficit.”

Likewise, he tells Schwager that in 1989, “[Buying Deutsche Marks] was made easier by the generally bearish sentiment at the time. The Deutsche mark actually fell during the first two days after the wall came down because people thought that the outlook for a growing deficit would be negative for the currency.”


• The U.S. current account and NIIP are weak.

In the late 1970s and early 1980s, the U.S. ran trade deficits that were relatively small by today's standards, and it had a strong net international investment position. Germany's trade surplus steadily grew throughout the 1980s.

Today the U.S. has both a weak NIIP and a weak current account. A chart from Horseman Capital illustrates how much the US NIIP has deteriorated since the early '80s:


Simply, the U.S. has less wherewithal to run government deficits without incurring major risks.

Also, my hunch—and I'll reiterate here that I'm not a macro expert, so this may be completely wrong—is that the NIIP plays a major role in determining whether deficits are good or bad for a currency. 

Most investors have a home-country bias, i.e. they prefer to invest domestically so long as domestic investments have a competitive risk/reward. So if a country increases its supply of government securities (expansionary fiscal policy) and also guarantees that those securities earn high returns (tight monetary policy), and its citizens own significant foreign assets (a positive NIIP), some of them will sell those foreign assets to buy the newly-created domestic securities, which will push the country's currency higher. Whereas if its citizens have significant international debts (a negative NIIP), this dynamic isn't possible.


• The “return on deficit” will be lower.

In the early 1980s, the U.S. experienced two recessions that kept its economy below potential. In 1989, Germany had a significant identifiable need for investment in the form of integrating East Germany. By contrast, today the U.S. is nine years into an economic recovery, the unemployment rate is low, and there are many anecdotal signs of labor shortages.

An economy with minimal spare capacity and full employment will be less responsive to fiscal stimulus than one that with significant spare capacity and unemployment, so I would expect the current US deficit to be far less stimulative than the two deficits Druckenmiller mentions.

And even before the tax cut, the U.S. government was running large deficits in the midst of a long economic expansion. This suggests that a large part of the deficit is structural, so rather than being economically beneficial it's a sign of weakness.

Saturday, December 9, 2017

Book review: "Long-Term Front-Running" by Michael Fritzell

Many stock traders try to make money by predicting the immediate future: Will tax reform spark a stock-market rally? Will Apple beat earnings estimates next quarter? Et cetera.

Long-Term Front-Running suggests a different tack: instead of guessing at the near future, investors should try to predict which companies will take off in the next few years and buy their stocks before other people catch on. By getting in before the crowd, they'll benefit both as the company's earnings rise and as investors catch on to the story and award the company a higher price/earnings multiple. In my experience, the best-performing stocks are usually a product of those two things paired together, so investors who look for “compounders” should find the book interesting.

Short-term traders should also find it interesting. Trading off immediate events can induce tunnel vision and make one's trading strategy essentially reactive. Looking past the near term should give traders both more perspective and less competition.

A big strength of Long-Term Front-Running is its versatility: it discusses both corporate fundamentals and investor sentiment, both macroeconomic and company-specific events and processes, etc. It also touches on the importance of “reflexivity,” i.e. how perception can affect reality in the financial world and create positive feedback loops.

Unfortunately, in a way the book's versatility is also a drawback. Since it covers a lot of ground in just 100 pages, its specific ideas are mostly rules of thumb, i.e. guidelines on what to do in typical situations. And as I get more investing experience, I've come to believe that many of the best investment opportunities involve atypical situations.

For instance, Fritzell writes that “The best time to bet on a commodity is when inventory is tight; future supply is likely to be low while demand is racing ahead.” This is generally true, but the shale-drilling revolution provides a counterexample. There have been times in the recent past when natural gas inventories were low, yet prices didn't rise. The shale revolution seems to have overwhelmed the traditional relationship between inventories and future prices.

Lest I seem too critical, I'll say that I enjoyed many of the book's rules of thumb. For instance, it includes a checklist for identifying corporate fraud that I found very useful. I also liked its case studies, particularly the one about Delclima, an Italian HVAC manufacturer that began life as a neglected spin-off but soon became a stock market darling.


Notable and quotable

To give you a flavor of the book, here are some of my favorite passages:

The potential to tap future customer demand can be summarized in the term “consumer surplus.” It can be defined as the difference between the price customers are willing to pay and the what the product costs. If there is a huge gap, then the company is potentially sitting on a goldmine.


Return on invested capital itself is not a useful metric: it often reflects a cyclical peak in the industry or the mature phase of the ramp-up of a particular technology.


Products that aren't particularly functional – Tamagochi, baseball cards, Beanie Babies, etc. - are fun for a while but we usually get tired of them. If the product is fashionable and also serves a real functional purpose – for example UGG shoes or Canada Goose jackets – they may survive for a longer period of time.

(In my opinion, this mix of fashion and function explains much of Apple's popularity. Apple's smartphones cost much more than competing phones—they clearly have a fashion premium. Yet they're also cheaper and more functional than what preceded smartphones—the iPhone is like a mobile phone, laptop, digital camera, watch, and GPS rolled into one. The combination of so many things in a convenient device lets people justify paying the fashion premium.)


Not every company is able to take advantage of industry growth... in a commodity industry, ruthless competition may take away most of the opportunity for gain, despite a solid underlying growth trend.


Sometimes people criticize new technology due to certain weaknesses but fail to realize that those weaknesses will disappear over time. Online streaming in the early 2000s was unbearably slow, but with the spread of fixed broadband, online streaming was almost certain to take off.


High credit growth not only pushes money into the stock market, it also improves the value of assets used as collateral in loans, improving creditworthiness and fueling further credit growth.


Whenever a particular method of investing becomes popular, flows into that strategy start to accumulate. Those flows can by themselves help that strategy perform and attract further inflows.

Thoughts on convertible bonds

A convertible bond becomes “busted” when the issuer's stock price falls so far below the strike price as to render the conversion feature nugatory. When this happens, the convertible begins to trade like a regular bond. For instance, if bonds of similar size and credit quality trade at a 9-10% yield to maturity, the convert will typically trade at a price—almost certainly a big discount to par—that gives it a similar YTM.

Busted converts were great investments during the 2001-02 market downturn and again during the Global Financial Crisis. Their strong performance during those periods of stress piqued my interest, and I read as much as I could about the convert market, assuming that it would offer similar opportunities during the next crisis.

After a couple days of reading, I no longer think that will be the case. Actually, my reading suggests that converts will be relatively unattractive going forward, for several reasons:

The market has shrunk. Since 2007, the face value of outstanding convertible bonds has fallen from approximately $700bn to $500bn worldwide and from $300bn to $200bn in the United States. (By comparison, Apple's market cap is $870bn.) There are two reasons why the market is smaller: One, many companies issue converts to save money on interest, and historically low interest rates obviate that. Two, convertible arbitrage funds are major buyers of converts, and since the GFC they've been forced to use less leverage than they'd previously used, reducing their buying power.

With arbs using less leverage, there's less potential for forced selling to create bargains. Investor psychology has also changed. The convertible selloff after Lehman Brothers' bankruptcy was so ferocious in part because it took people by surprise. Nothing like that had happened before, at least not on the same scale. Now investors know it's within the realm of possibility, which I think makes it less likely to happen again. As the old cliché goes, a watched pot never boils.

Transaction costs during the post-Lehman selloff were exorbitant, with bid/ask spreads equal to 7% or more of the midpoint price for many converts:

(Source: The Handbook of Convertible Bonds by de Spiegeleer and Schoutens)

The market was chaotic and illiquid, with December 31, 2008 13f-hr filings showing that various hedge funds had one bond—Ciena's $300mm May 2013 issue—valued at anywhere from 48 to 53 cents on the dollar. Buying converts in 2008 was a great trade on paper, but trading costs made the true returns lower.

Convert issuers tend to be smaller, more speculative, lower-quality companies. Many of these companies also have debt that's senior to their converts—typically, converts are subordinated to all other existing and future debt issues. The GFC was painful but brief; in a protracted recession, converts would likely experience much higher defaults.


Tech industry over-represented

Technology companies are over-represented among convert issuers. I think this is because a convert is most attractive when the issuer's stock is volatile but it has low credit risk. Usually the two conditions don't go together: a company that's less likely to default will typically have a less volatile stock price. But tech companies often trade at high valuations because investors expect them to grow quickly. Hence the stocks are very sensitive to investors' beliefs about the future, and they can be quite volatile without implying anything about the companies' creditworthiness.


Issuers with net cash

In looking at dozens of convert issuers, I found a surprising number that had more cash than debt. Even more surprisingly, the net cash didn't necessarily make them safe credits.

Many tech companies issued convertibles during the dot-com bubble. In 2001, after the bubble had burst and the tech industry was suffering, some of these companies still had net cash. How their converts performed from that point on depended on how they had financed themselves. Some issuers that had raised money primarily through converts defaulted, while the ones that had raised money through a mix of equity and convert issuance almost all survived. In the latter group, many converts paid off at par even after the issuer's stock had fallen 95-99%.

A couple of tech issuers managed to stay afloat only by repurchasing most of their outstanding bonds at a big discount to par. These buybacks meant that they technically satisfied their obligations, but most of their bondholders didn't benefit.

While the dotcom-era tech issuers generally treated their creditors well, that wasn't the case during the GFC. Many issuers with net cash took creditor-unfriendly actions:

ADC Telecom bought back stock in late 2008 while its converts traded at 45 cents on the dollar.
Ciena made a big all-cash acquisition in 2009 as the GFC appeared to be ending, taking it from a net cash position to a significant net debt position. Integrating the acquisition was more difficult than expected and Ciena lost money for several years.
Energy Conversion Devices invested most of its cash in growth initiatives, only to find that its niche solar technology wasn't cost-competitive with polycrystalline solar cells.
TTM Industries made a big acquisition in 2009 that took it from having working capital in excess of all liabilities to having significant net debt, primarily bank loans that were senior to its converts.

Energy Conversion Devices went bankrupt within a few years. The other companies survived and repaid their converts, but the expectation that their net cash provided a margin of safety turned out to be wrong.

By looking at issuers' recent actions, investors may be able to find net-cash issuers that are more favorably disposed to creditors:

In 2002, Juniper Networks had $1.7bn of cash and $1.15bn of outstanding convertible bonds. That May, it acquired Siemens' networking business. Juniper had enough money to buy the business entirely for cash, but instead it paid in a mix of cash and stock, leaving it with a net cash position. A few months after the acquisition, it bought back ~18% of its converts at a discount to par. In 2003, it tendered for the remaining bonds at par.

In 2007, Arris Group acquired C-Cor. Like Juniper, Arris made the acquisition with a mix of cash and stock that left it with a net cash position. It later bought back some of its converts during the GFC and stated in its 2008 10-K that “Maintain[ing] a strong capital structure, mindful of our 2013 debt maturity” was a key part of its corporate strategy.

Book review: "Common Stocks and Common Sense" by Edgar Wachenheim

Common Stocks and Common Sense has the same format as Peter Lynch's One Up on Wall Street: it's a loose autobiography of a fund manager with a few case studies, some homespun philosophy, and a lot of rule-of-thumb advice.

Unfortunately Wachenheim is no Lynch, and I strongly recommend against reading this book. I'm sorry to be so harsh, but most of the ideas in Common Stocks are dangerously simplistic--this is an investment book by an investment manager who doesn't really understand investing.

I'll give a couple examples.


Centex

Wachenheim began investing in property developers in the 1990s. In 1999, he bought shares of Centex on the assumption that the largest developers were becoming growth stocks: the savings-and-loan crisis in the early '90s had cut off credit to many smaller developers, so the biggest companies were taking share and growing much faster than the sector as a whole. Centex was trading at $12, but he forecast that it would reach $63 in a few years as sales rose in a straight line, margins increased with scale, and investors rewarded Centex with a higher price-to-earnings ratio on higher earnings.

"Because the homebuilding industry was becoming a growth industry... I valued Centex at 12 times earnings [in 2003]," he writes, adding, "I was literally jumping up and down with excitement."

There are a few problems with this rationale:
1.) The savings and loan crisis was over by 1999, so it wouldn't have been an impediment to smaller developers from then on. If anything, small banks might have been more willing to lend to developers because they were losing out to larger banks in mortgage origination, a volume business, and needed other places to put their deposits to work.
2.) Developers earn much of their money from land appreciation. If they buy a plot of land and then land prices rise faster than their cost of borrowing, they can earn huge profits. Since building houses is a competitive business with low barriers to entry, land appreciation is sometimes their only source of profit. And land doesn't care who owns it--a large builder doesn't have land-appreciation economies of scale. So when Wachenheim forecast steadily rising margins, in my opinion he misunderstood how these companies make money.
3.) Profits from land appreciation are mean-reverting. If land prices surge, developers can earn fat margins on their existing inventory, but when they buy new plots of land they'll have to pay the new, higher prices and margins will come back down--assuming prices don't rise perpetually.


Wachenheim concludes by writing:
In the fall of 2005, Centex’s shares were selling at about $70. We had earned close to a sixfold profit on our investment. I should have been ecstatic, but I was not. The shares still were trading at far less than 10 times earnings. 

The investment was a complete winner, but I felt that it could have been even more profitable if the housing bubble had not occurred because the homebuilders eventually would have earned respect and sold at much higher PE ratios.


Union Pacific

Wachenheim bought shares of Union Pacific in early 2004. Here I'll let him speak for himself:
[Union Pacific] did not appear to be a particularly exciting investment opportunity, but the stock market and our stocks had been strong in 2003, and we did not have alternatives that appeared to be more attractive...

There was another reason to own shares of Union Pacific rather than holding cash. Over a period of many decades, the stock market, as measured by the Standard & Poor’s (S&P) 500 Index, has enjoyed an average annual total return of roughly 9½ percent—and our best guess was that returns could average somewhere around 9½ percent over the next few decades. When we purchase a stock, we believe that it will appreciate by far more than the stock market appreciates. However, what if we are wrong and the stock appreciates only as much as the market? Then, if the stock is typical, it should earn an average annual return of about 9½ percent over time, which is much better than holding cash.


One important lesson

While the specific ideas in Common Sense are useless, the book does teach one very important lesson: that intellect isn't only determinant of investing success.

Wachenheim has been a fund manager for 30 years and has handily beat the S&P 500 index during his career. His ability to do so despite a weak understanding of the stock market shows, in my opinion, the value of intuition. By intuition, I mean a mix of common sense and knowledge that one has gained from experience but can't necessarily articulate. Wachenheim writes that he sold Centex in late 2005, at the exact peak of the housing bubble, because he thought housing starts had risen too quickly and there were anecdotal signs that the market was overheating.

Notably, Wachenheim's idea about large property developers having economies of scale became popular after the housing bubble took off. Having a bad idea can be profitable if many other people later adopt the same bad idea.

Thursday, November 30, 2017

Articles of interest

Auto lending
The Wall Street Journal reports that used-car prices have been resilient in 2017 despite a sharp increase in expiring leases.


China
Brad Setser critiques the popular argument that China's credit growth is losing its stimulative power.

The Wall Street Journal describes how HNA Group's international acquisition binge has faltered, writing that "Instead of targeting profitable companies, HNA sought assets with considerable revenues that would hasten its rise up the Fortune 500."

According to Dow Jones Newswires, Chinese house buyers are using consumer loans to get around restrictions on real-estate lending, with one researcher estimating that "at least one third of short-term consumer loans issued since March have gone toward property purchases."

Caixin Global speculates that Chinese microloans' risk of default is higher than it appears, noting that many borrowers are in the habit of repaying debts to one lender by borrowing from another.


Commodities
Reuters reports that a Chinese coal miner has amassed a $3bn long position in copper futures, presumably contributing to the metal's year-to-date price rise.


Crypto-currencies
Alpha Vulture argues that Bitcoin is overhyped and describes some of its inherent flaws.

Cole Frank of the Council on Foreign Relations states that while Chinese capital outflows might have contributed to Bitcoin's rising price in 2015-16, that has not been the case this year.


Emerging markets
Miguel Kiguel, a former Argentine government official, writes about the aftermath of Argentina's 2001 debt default.

Al-Monitor reports that many of Turkey's large infrastructure projects are earning poor economic returns.

In a two-part interview (part one and part two) Porter Erisman discusses his new book Six Billion Shoppers, offering his thoughts on how e-commerce has developed in emerging markets and how and why it differs from e-commerce in developed countries.


Incentives
Ockham's Notebook writes about Goodhart's Law and how it contributed to problems at American Realty Capital/VEREIT.


Investing strategy
The Wall Street Journal interviews Joel Tillinghast about his investing principles.

Giles Parkinson of Aviva offers some potential explanations for why American stocks have outperformed their foreign counterparts over the past thirty years.


Media
Vanity Fair reports that Amazon "is poised to spend around $4.5 billion on their video streaming this year... only $1.5 billion less than Netflix’s $6 billion budget for their 2017 content."

Similarly, Variety reports that the cost of producing streaming video programs has surged as an increasing number of deep-pocketed companies produce an increasing amount of streaming content.


Oil
John-Paul Burke of Horseman Capital argues that OPEC's actions are responsible for oil going into backwardation and that this will constrain shale production growth.


Retailing
IHL Group argues that news reports of a "retail apocalypse" overstate the problems retailers face.


Short selling
Russell Clark of Horseman Capital describes his short-selling strategy in a public presentation. I consider this a must-read because Clark's strategy is radically different from the ones that most short sellers use.


Valuation
Crescat Capital's latest investor letter includes a lot of sobering statistics about the stock market's valuation.