TIME TO HIBERNATE FIRST POST

[Cigarbutt]

Media headlines from the last few days: “The longest winning streak in decades is annihilating bears”, “America: confident and consuming”, “9 reasons the stock market is optimistic about 2017”, “Animal spirits are back”, and “Around the world, confidence is on the rise”, “Euphoria returns to markets” and “The case for Dow 30,000 in Trump's first term”. These days, overall, the story line seems to be so good…Can it get any better? Even significant net losses on investments can arise “as a result of fundamental changes in the U.S. in the fourth quarter that may bolster economic growth and business development in the future”…In his last letter, Mr. Buffett supplies us with his usual long term justified common sense optimism. Despite all that, it’s time to go back to my lair.

 

This is my first post. It will run longer because of that and will serve as an introduction.

 

I still prefer to read (and write on) printed financial reports and involvement in investment blogs is very recent. A few weeks ago, I started posting on the Stockhouse board…Interesting but, apart from intermittent nuggets, it was mostly useful to assess the playing field. Choose your opponents, some say. By chance, I came across this site. Over time, I have become a regular visitor and now feel I can prospectively contribute punctually. I have looked back many threads. My postings will probably mirror my investing style with periods of intense activity and focus interspersed by very long periods of apparent sleep. Like most, I really respect Mr. Buffett as an investor. My investment decisions though are more Graham-like in good times and more Fisher-like in tough times. Unconventional and contrarian I am and that suits me fine. Investing occupies a part of my free time which has grown at a comfortable rate in the last 15 to 20 years. Like many on this board, I really like the idea of compounding over long periods. Lumpy returns are OK. My strengths are overshadowed by weaknesses and biases but, I keep learning and, over the years, I have been able to opportunistically apply unrecognized simplicities of effective action. Investment results have allowed me to pretty much retire in my early 40’s. I tend to choose very selectively. I dig bottom-up but try to appreciate the context. I happened to be on the right side of the trades before and after the 2008-2009 episode. Perhaps, that nourished an overconfidence bias. Have been mostly selling since then (way too early, it seems, in certain cases). These days, I feel pretty much like during the months following my sale of Nortel in 1999 at around 36$ on the way up ie I felt like I was missing all the fun. Investment is truly fascinating.

 

I find that many investing ideas on this forum are outside my circle of competence which remains patchy. Also, right now, I really don’t see value in the stocks that I follow and elsewhere, apart from the occasional cigar-butt. The stocks that I follow (the potential long term compounder type) would need to go down by at least 50% before I would start to get excited… Maybe, I just need to retire? Recently, I even sold my core positions. My only “long” position now is a debenture in liquidation that is about to enter the last stretch (claims process). Last year, I sold all my holdings in Fairfax... This was pretty much a permanent holding and yes, I am turning my back against one of my mentors. Ouch! This is a Corner of Berkshire and Fairfax Board after all and, reluctantly, for the first time in 20 years, I will read the annual report from the other side of the fence. Interesting time, isn’t it?  This presidential volte-face is and will remain a nagging and perplexing head-scratcher…

 

It would then seem to be an inopportune time to get involved in an investment forum, especially this one. I accept that others do well even if I don’t. From my perspective however, I doubt that this time is different and suspect/hope that I’ll eventually spread my wings again as the pendulum swings. Sometimes the wildness lies in wait. I may be just out of step and inappropriate anti-conformism may prevent me from embracing the present market environment but, for now, I feel comfortable waiving potential future returns. Unless convinced otherwise, I will watch from the sidelines, play defense and carry on my unspectacular preparation. Oh well, some of you may see Cassandra here. But, reflecting on this Greek mythology tragedy, I submit that, in the end, the tragedy is that Cassandra was right. In no way, do I know the future. It’s just that now does not feel right. The primary driver here is the absence of options in my opportunity set. I understand and concur with Mr. Buffett’s optimism but, now, I’m also kind of worried about the “short interruptions” that can happen from “time to time”.

 

This site appears to overall provide a constructive forum that allows respectful collisions of ideas. We’ll see. By the way, looking back at various threads, I was impressed for instance by the thread on Canadian preferred shares especially concerning the Aimia preferreds. This was especially frustrating since I had extensively analyzed the company on my own concurrently and decided to pass, not noticing and taking into account the significant value proposition that Mr. Market specifically offered for the preferreds.  Very rarely, investing is simple AND easy. This was a big miss as this was going right up my alley and I had significant dry powder to use. Error of omission. I have been impressed by many other posters as well.

 

Long term, I am looking forward to participate in investment ideas/themes posts.

 

GLTA.

 

[ScottHall]

Welcome, Cigarbutt.

[Gregmal]

Welcome, and great post. I wouldn't say I disagree entirely although I'm still moderately invested. What I have seen, especially since the election, is that complete and utter dog shit is going bananas. For no reason whatsoever. Pure mania (cough TSLA)

 

I'm a believer that one should always have a smaller core of decent large cap companies that present "relative value" solely because no one really knows where the market will end up and being entirely in cash or net short is basically a gamble(IMO). Companies like GM, AGN, CSCO, T, etc. The truth is this environment can go on longer than anyone expects. There were plenty in 2011-12 who were full blown bears. 5 years later and look where things are. But all in all, I'd concur with most of your sentiment. Looking for an undervalued compounder in this environment; yea right, good luck. Maybe in the oil/material names, but thats it.

[stahleyp]

Is this the euphoria one you talked about?

 

http://www.economist.com/blogs/buttonwood/2017/02/recovery-trade

[Cigarbutt]

Yes, that's the right link. Indeed, one has to go further than the headlines. As the article mentions and similar to what Gregmal alludes to above: "you never know what will happen next".

There are two sides to a coin.

[scorpioncapital]

I think Fisher described a behavioral problem with market timing, namely, once you bought this quality stock you always wanted, there is no certainty that your macro-call is correct, nobody really knows if the company is expensive - and he argues in his books, EVEN IF the stock is expensive, that is no reason to sell. Then, after many years of compounding, even if the stock drops 50% after you sell it, he says many people don't get back in or even if it does drop, it can still be higher than the selling price. Lots of moving variables.

The big danger is leverage, but I'm not personally going to 100% cash especially since it's not entirely clear there is euphoria. 0.75% interest rates and 20x-25x P/E on quality stocks does not strike me as expensive. There have been times when blue chips were like 40 to 50x P/E at rates of 3-4%. If anything, at these low levels, even penciling in 3 more rate hikes to 1.5%, what is stopping stocks from reflecting these low rates and going to 50x P/E ?

 

[Liberty]

Welcome to the forum, thank you for your well thoughtful intro.

 

Cheers!

[LC]

If anything, at these low levels, even penciling in 3 more rate hikes to 1.5%, what is stopping stocks from reflecting these low rates and going to 50x P/E ?

 

Low growth prospects. I think the general consensus is many of these blue-chips are close to saturated in their markets.

[SharperDingaan]

Welcome to the board.

 

We were reminded many years ago that investing is about USING the capital, & riding BOTH the yield AND quality curves.

 

Always keep the core positions in quality, leverage into lesser quality only when yields have crashed.

Once mean reversion occurs sell off the lessor quality, pay off the margin, pay yourself a healthy distribution - and do something life changing with it. It works very well ;)

 

SD

 

[Cigarbutt]

scorpion capital,

Thank you for the insight. I wonder if there is such a strong link between general valuation levels and so called risk-free interest rates.

To tie in with a concept shared by SharperDingaan, some solid investments were sold in the recovery after the GR in order to get rid of investment leverage which I don't use generally and which I don't plan to use anymore.

The key for me is not really the general valuation levels but the fact that, in my own limited universe, I just don't see compelling opportunities.

Hopefully, in this forum, I can help uncover some and be assisted by others on this forum in doing so.

 

[scorpioncapital]

There is a very strong correlation between risk free rates and valuations. If the risk free rate tomorrow jumps to 20%, you can be sure stocks are not going to be trading for an average market P/E of 20 (or 5%) yield. You can just buy the government bond and get 20% , why would you buy a stock yielding 5%? On the other hand, if rates are zero, 5% is looking somewhat better. It looks even better if earnings can grow better in a low-inflation environment than a high one. But I think you have a point that within a certain range, it doesn't matter so much. It's the outliers that are dramatic...like now. Less than 1% for a decade is pretty far out. So is 20%. I believe there was a study published that showed that as rates move up modestly to some neutral level, stocks actually do very well, rising quite a bit more along the way. Beyond this critical level, they start to encounter some turbulence. Where this is is hard to say. I think Buffett in a lecture to students a few months ago said it was 4% and that stocks were extremely cheap if rates don't go above that. So while we don't know what rates will do they have a very big effect on whether stocks will turn out to be very cheap today, or very expensive, or perhaps the most likely case, something in the middle. Btw, Ken Fischer (http://www.financialsense.com/art-hill-technicals-ken-fisher-2017-market-outlook), son of Philip Fischer  , made a good observation about market forecasters. For 2017 he said because the consensus is more of the same, it could very well be + or - quite a bit either way.

[thefatbaboon]

I don't really understand this less/more opportunities thing many investors refer to. 

 

Personally, I never have many ideas.  Last year I had a couple ideas. The year before I had a couple.  This year i've already had one and hope I'll have one or two more.

 

Sometimes I have too many ideas like 08,09.  But as I can't guess when massive crashes come I cannot go to cash or raise my hurdle rate in expectation. So my money runs out and the surfeit of ideas is of no use. 

 

Using simple arithmetic and the historical fact of the great infrequency of severe crashes I can calculate that it is FAR better to assume every year is normal and look for and take my normal couple ideas than it is to prepare for unpredictable crashes.

 

Obviously if you're not finding ideas then you're not finding ideas - and of course you musn't go buying things you don't want. But the financial world is massive and financial information abundant and I bet there are many good investments out there to be found. 

 

Unless of course you see an important market crash around the corner?!

 

 

 

 

[CorpRaider]

I often wonder how much of the motivation for WEB's recommendation to just average into passive index funds is due to a great reduction in the compulsion to try and market time.  It seems likely that a resignation to obtain the market return, whatever that is, would eliminate many of the opportunities to make decisions and improve the dollar weighted returns for the vast majority of investors (I wonder if it would not be of a greater impact than the cost savings/advantage of the low cost index funds).  I suppose if one employs absolute valuation hurdle that would make your decisions systematic, one would potentially be an exception.

[SharperDingaan]

We've always found that our circles of expertise drives our 'idea' timing. O/G is cyclical, so we tend to be buyers around the troughs, net sellers on the way up, and T-Bill investors on the way down. Same expertise but we'll look like 3 very different investors, depending on where we are in the cycle. And the more circles you have ... the more manic you will look.

 

Absent the central bank manipulation of the last 10 years, few would even question whether a forecast low rate environment is highly stimulative - yet suddenly that isn't the case anymore? Or is more likely that the people telling you (hires within the last 10 years) just haven't had any experience with this environment - & simply don't know any better? leaving you with a macro opportunity to be exploited?

 

To do value investing well, you are by default - counter-culture; & able to think for yourself.

Just the thing for this kind of environment.

 

SD     

[Cigarbutt]

scorpioncapital,

Thank you for your thoughtful post and link.

I don't want to spend to much time on the general level of interest rates and this may be an idea for another thread for those interested, but here are a few potentially relevant comments.

 

Mr. Buffett in the 1970's elegantly showed that, despite the high interest rates prevailing then and despite the institutional inclination to hold bonds, the best long term bet was on stocks. I think that, looking at his long term track record since then, most would agree that he had a point.

 

However many have showed with math and graphs that, with a starting point around 1980 to now (ie starting point with very high interest rates), investors in long term government bonds did better than stock indexers. !?

 

Like many investment macro topics, there are many many variables to consider. The direction or trend of interest rates is perhaps more important than the level itself.

 

Also, right now, one may say that interest rates are suppressed (some say manipulated). How will this play out? I simply don't know. But I don't like it.

 

For instance, not unlike thefatbabboon, in the last few years, I have uncovered only a few interesting ideas (even less relatively speaking). Illustrating how low interest rates entered into my decision process, many of the opportunities I spotted were owner-operator led type of growing businesses with enduring moat. Progressing through the 10-Ks and as IV value was crystallizing, ending up with the last couple of years, many of those selected few started to incur very significant debt (at extra low rates for now) in order to essentially buyback their own shares (at an already massive premium to book value) in order "to return funds to shareholders". Because of low interest rates, I felt that the companies literally destroyed value that had taken years to build. Only this is not visible yet.

 

So, interest rates don't matter to me that much in terms of the overall landscape. It disturbs me though when it annihilates capital allocation rationality.

[cmlber]

scorpioncapital,

Many of those selected few started to incur very significant debt (at extra low rates for now) in order to essentially buyback their own shares (at an already massive premium to book value) in order "to return funds to shareholders". Because of low interest rates, I felt that the companies literally destroyed value that had taken years to build. Only this is not visible yet.

 

So, interest rates don't matter to me that much in terms of the overall landscape. It disturbs me though when it annihilates capital allocation rationality.

 

When you combed through the universe of potential investments and landed on the "selected few," what kind of returns were you expecting those businesses to generate if held in perpetuity?  Surely more than 5-6% right?  So how is it "destroying value," to issue debt yielding 4-6% to buy back securities you expect to earn substantially more?  What about that is an annihilation of capital allocation rationality?

[scorpioncapital]

No surprise, Buffett comes out today and says stocks are cheap unless rates rise - http://video.cnbc.com/gallery/?video=3000596522

 

Rates are like gravity. They have a huge impact on valuation.

He also takes a swipe at market timers who think they can weave in and out of stocks based on valuation :)

[Cigarbutt]

Yes, Mr. Buffett comes out and he seems to say that stock prices are fairly valued now in large part due to present low interest rates. It is fair to assume here that, for his capital allocation decisions, he uses a satisfactory hurdle rate with a margin of safety. That creates cognitive dissonance for me and I’m struggling with that. Before I change/adapt, I have to understand though. Thanks for the challenge. Again, I don’t intend to drift this thread to the general levels of interest rates vs valuation of markets in general, but I will expand on a specific aspect of this (firm’s cost of capital for debt versus stock buyback decision) with my next post, as an attempt to answer cmlber.

[CorpRaider]

cheap side of fair, actually.

[Cigarbutt]

cmlber,

 

First of all, if you don't agree with my personal hibernation hypothesis, that's fine. But, I would like to take that discussion further. What works for you may not be what works for me and vice-versa. Let's learn and improve here. My hurdle rate for the last 15 years has been 15%. I have achieved this over time despite keeping almost always (except 2009-2011 when I was about 125% invested long in stocks) a large cash balance. I am trying to figure out, with your help maybe, how I could, over time, reduce cash balance and improve returns without sacrificing margin of safety. Remember, to have results above average, there are two steps: you have to be different from the average AND you have to be right. Also, my universe is relatively small. I just want to broaden my sandbox.

 

Your points are valid. A lot of data point to (at least in N.A.) a dearth of reinvestment opportunities for firms. Companies and management need to adapt to the financial market environment. Especially with the institutional imperative, it must be very hard for entrepreneurial CEOs to let cash accumulate. Also, I agree that, in the end, stock buyback is simply a capital allocation decision. In addition, in the past, I can remember a few occasions where I passed on a rewarding (not for me in these cases) opportunity because of my possible inability to adjust my hurdle rate to the new environment and realizing many years after that the stock return was in fact largely attributable to sound stock buyback by management. Ouch!

 

Having said that, specifically, concerning the "selected few" that I analyzed and in which I was ready to put 20-30% of my portfolio, the problem I had was related to the extent of the debt issued (bringing coverage ratios to off the chart territories) and the price paid (P/IV) for the buyback. We all have to do our homeworks, but in many instances, I find that companies tend to pay a (very) high price. In the cases I digged into, I estimated the P/IV to be a lot more than 2 (often more than 3). This was/is a source of dissonance as, otherwise, management had shown tremendous capital allocation capabilities.

 

In my humble opinion, for many of the buybacks happening now (seems like a mirror image of corporate debt expansion), companies pay too high a price, increase debt ++ in a period of unusually low interest rates and good times and tremendously reduce financial flexibility going forward. That was quite certainly the case in the few cases that I looked into deeply and suggest that there may be something more systemic about this phenomenon. If you identify firms which do the buybacks soundly from the capital allocation point of view, that's fine with me obviously. Maybe, you could share one or some of those examples.

 

In the end, I think that an endpoint for the price paid may be useful. For our friend, Mr. Buffett, his own endpoint is at 1.2 to stated BRK book value (which includes some intangibles). I would tend to use a similar endpoint with adjustments for specific companies. Basically, I submit that a buyback at a ratio of 2 or more of P/IV (not stated book value) is suspect especially if excessive (even the low price kind) debt is used.

 

What do you think?

[SharperDingaan]

Buybacks are situational. There are no general rules.

 

Imagine you have an asset worth $110M, a revolving floating rate loan of $100M, and 100M shares.

The loan is currently at 5%, revenue is $8M, interest is tax deductible, and the tax rate is 40%. Assume the asset is a hospital wing that you have refurbished & leased back to the government - revenue doesn't change.

 

Gross profit today is $3M (8-100*.05=3);  net profit after tax is $1.8M (3*(1-.4)). EPS is $0.018/share (1.8/100).

BV = $10M (110-10) or $0.10/share. BV/E = 5.56x (0.10/0.018). Interest tax saving of $2M/yr (5Mx40%MTR).

 

A crash happens, central banks lower rates to 1% to stimulate the economy

Gross profit is now $7M (8-100*.01=7);  net profit after tax is $4.2M (7*(1-.4)). EPS is $0.042/share (4.2/100).

BV = $10M (110-10) or $0.10/share. BV/E = 2.38x (0.10/0.042). Interest tax saving of $0.4M/yr (1Mx40%MTR).

 

The company is clearly coining it post crash. NPAT at $4.2M is 2.4x higher than it was at $1.8M - but according to the falling BV/E ratio; the times are utter Sh1te.

 

So the company uses the miss perception ...

It persuades its banker to lend it an additional $12M to buy back ALL its shares at 1.20x BV (they read WEB)

Assets = 110, Liabilities = 112, Equity = -2. Gross profit is now $6.88M (8-112*.01=6.88);  net profit after tax is $4.13M (6.88*(1-.4)). EPS is infinity ($0.0413/0 shares). At the end of the year equity = -2+4.13 = 2.13M

 

This is an infrastructure example, & illustrates why they are so attractive.

Rework the example in a rising rate environment, and the payback period is how long you need rates to stay low.

Its short.

 

If you went only by a generalized BV/E ratio (market view), you would have totally missed the boat ....

... Underlining the counter-culture, & independent thinking required of a good value investor.

 

SD

 

 

 

 

[cmlber]

cmlber,

 

First of all, if you don't agree with my personal hibernation hypothesis, that's fine. I am trying to figure out, with your help maybe, how I could, over time, reduce cash balance and improve returns without sacrificing margin of safety. Remember, to have results above average, there are two steps: you have to be different from the average AND you have to be right. Also, my universe is relatively small. I just want to broaden my sandbox.

 

Having said that, specifically, concerning the "selected few" that I analyzed and in which I was ready to put 20-30% of my portfolio, the problem I had was related to the extent of the debt issued (bringing coverage ratios to off the chart territories) and the price paid (P/IV) for the buyback. We all have to do our homeworks, but in many instances, I find that companies tend to pay a (very) high price. In the cases I digged into, I estimated the P/IV to be a lot more than 2 (often more than 3). This was/is a source of dissonance as, otherwise, management had shown tremendous capital allocation capabilities.

 

No disagreement (or agreement) on the hibernation thesis.  My point was simply that if you found a few companies you wanted to put 20-30% of your capital in, how on earth could you say they are destroying value by buying back stock with low cost debt?  The two statements are totally inconsistent.

[Cigarbutt]

cmlber,

I think we may leave it at that for now.

Price is what you pay and value is what you get.

Price is easy, it appears as a precise number in your liabilities.

Value is in the eye of the beholder. Opinions vary here. This is what makes it fun. Isn't it?

Maybe, we can reopen the discussion in the future with a specific case. Good luck.

 

 

[Cigarbutt]

SharperDingaan,

Your example is interesting. In the end, isn't this about opportunistic number crunching?

I agree that buyback decisions need to be flexible and contextual. To keep the link with the topic of the thread, my point is that, in some cases, I felt that these decisions did not make financial sense and, maybe, there was something systemic about all this for a typical CEO: What do I do with all this free money? There is no free lunch, a defunct economist said. Who is going to pay? is my question.

With all due respect though, your example might not make it in the open.

Your example assumes that BV/E = MKT/E. When higher monetary authorities put the price of money on the floor, market participants tend to reach for "attractive" yields and MKT prices tend to levitate. In our present beloved financial nirvana, isn't this what is happening with the prices in infrastructure, REITs and other levered by nature creatures? I submit that it may be hard to do buyback at sensible market prices.

Also, your 100% buyback example results in only a 10% increase in total debt, not exactly an earth-shattering event in the capital structure. In many potential opportunities I looked into lately where buyback seemed to become the main game in town, the increase in leverage became incredibly high and entirely easy money context specific.

This thread is about hibernation but I have a feeling that, at some point, this will become a recurring topic when discussing specific securities.

I mentioned that buybacks at sensible prices without excessive debt can make a lot of sense. The present easy money era may present a window opportunity with a very short payback for some. When/if the tide recedes, we may find out that some others should have kept their suits on. I may be wrong but I am in a pretty good spot to watch, just in case.

By the way SD, I looked back some threads/posts. In my life, despite very real limitations, I have been able to spot brighter and better people. It has made a huge difference for me. I realize that, if there are more face-offs, I'll try to step up my game.

[SharperDingaan]

No big deal - we're all here to learn.

A few 'truths' from o/g, where this kind of thing is fairly routine.

 

Bankers are salesmen - their product is money, & they don't want you paying it back. Use it.

Paying a loan back lowers interest revenue, lowers 'spread' $ to pay employees, & results in layoffs. Use it.

 

(1) Hence you set up credit facilities when the sun is shining, creating fee revenue when its hard to find.

(2) When the cycle is rising you borrow every cent you can, against forward (higher) reserve valuations. The initial $ go into drilling to raise total production (cash-flow), intermediate $ go into acquisition for reserves (collateral), & later $ go into buybacks. The objective is to spend the money on things that cant be unwound later without a loss, boost eps (share price) & your bonus, and boost the bonuses of the bankers lending you the money. The true predators will also be using part of their bonuses to buy puts on their competitors (avoiding any conflict of interest).

(3) When the cycle turns, you simply squeeze the orange. In the initial rounds, bankers desperate to keep their bonus/jobs will bend for you (its why you boosted their bonuses in the good times). In the middling rounds you'll work together to minimize the asset & loan write-downs (more bending). In the later rounds you'll be forced to sell assets (often to the predators who benefited from the puts), & will spend some time in the penalty box.

(4) The cycle turns again, you spend a year or so 'turning around' - and go back to (1).

 

At different stages of the cycle, different people will be involved. Everybody benefits (including shareholders), and its  preferable if the trough-to-trough time is intermediate versus overly short or long. Predators routinely turn into angels, and back into predators.

 

As an investor, recognizing that these cycles exist (in many industries) is helpful - but it is clearly way more advantageous if you can also recognize how to exploit them.

 

It does have its surreal sides though ...

Next time you ask your banker for a loan - which one is the pusher, & which one is the junkie?

 

SD