The 13th Labour of Hercules

[giofranchi]

Latest White Paper by James Montier.

 

giofranchi

The_13th_Labour_of_Hercules_Capital_Preservation_in_the_Age_of_Financial_Repression.pdf

[bmichaud]

Phenomenal piece.

[giofranchi]

Phenomenal piece.

 

I agree, I think it is a very good piece. But… it seems to me that it fails to address the most crucial questions of all: how much capital to put into stocks today? And what to do with the rest of it?

He makes this example: “Let’s say you think equities are priced to generate 5% real.” I understand that example is very useful to explain Exhibit 7, but what about the present situation? Previously he stated: “GMO’s current S&P500 forecast is 0% annually”. So, if I read Exhibit 7 correctly, when equities are priced to generate 0% real, it doesn’t really matter whether financial repression lasts 5, 10, or 20 years: your % weight in stocks should be 0 anyhow. Right? But let’s make a more optimistic scenario for stocks, let’s assume the S&P500 is priced to generate 4-5% real and financial repression lasts 20 years. Even under these conditions you should not allocate to stocks more than 50%-60% of your capital. So, two considerations:

1) How many on this board are 40% out of stocks? I guess almost nobody.

2) Even if you think it is right to be 40% out of stocks, where else to put your money? From the beginning of the piece it is very clear that bonds are not the place to be, and cash will lose its purchasing power. Gold? Well, if you look at gold as cash that cannot be printed, maybe 5-10%… You are still left with 30% of your capital to allocate… where?!

It doesn’t seem to me Mr. Montier answered that question satisfactorily enough.

 

giofranchi

 

[Packer16]

I think the answer to your question is in the latest GMO letter.  The low fixed income and other returns assume that interest rates and equity return to "normal" in 7 years.  If there is still financial repression then the FI returns will go up by the change in yield curve portion of the return.  The message I take away is that if financial repression is expected to continue overweighting stocks is not an unreasonable alternative. 

 

Packer

 

[LC]

I'd take a page from Warren & Charlie's book and say muni's, but with rising rates and defaults...what's so wrong with cash!?

 

In addition...the article seems too paranoid. The Era of Uncertainty? I am almost certain that Americans will be eating hamburgers, drinking Coke, living in single family homes, commuting via car, using their phones, using medical care, burning fossil fuels to heat their home in the winter and using electricity to cool it in the summer, and watching TV in 10 years. What exactly, is so uncertain? Interest rates?

 

I can see it now, grandmothers everywhere in the sweltering heat exclaiming how they refuse to turn the central air on because interest rates are too high. Or my friends and family refusing to use their phones because of "macroeconomic uncertainty". Corporate profits are at all time highs, therefore I refuse to drink Coke. I'd like an RC Cola, please!

[giofranchi]

I think the answer to your question is in the latest GMO letter.  The low fixed income and other returns assume that interest rates and equity return to "normal" in 7 years.  If there is still financial repression then the FI returns will go up by the change in yield curve portion of the return.  The message I take away is that if financial repression is expected to continue overweighting stocks is not an unreasonable alternative. 

 

Packer

 

I know and I understand what you mean. Yet, every bubble in history was supported by some idea and justification. It is not like people all of a sudden get mad in mass and then a bubble ensues. There was always some reasoning behind, that was true… until it wasn’t any more.

Today it is: if interest rates are bound to stay at zero for many years into the future, all asset classes are worth more than in the past, stocks included. No matter stocks are already priced to yield no real return over the next 7-10 years, according to the latest GMO letter… No matter negative real rates have led time and time again to the formation of bubbles…

I am not saying I am out of the market! I am just saying that I am comfortable leaving some money on the table and playing it safe.

 

giofranchi

 

[Kraven]

I think the answer to your question is in the latest GMO letter.  The low fixed income and other returns assume that interest rates and equity return to "normal" in 7 years.  If there is still financial repression then the FI returns will go up by the change in yield curve portion of the return.  The message I take away is that if financial repression is expected to continue overweighting stocks is not an unreasonable alternative. 

 

Packer

 

I know and I understand what you mean. Yet, every bubble in history was supported by some idea and justification. It is not like people all of a sudden get mad in mass and then a bubble ensues. There was always some reasoning behind, that was true… until it wasn’t any more.

Today it is: if interest rates are bound to stay at zero for many years into the future, all asset classes are worth more than in the past, stocks included. No matter stocks are already priced to yield no real return over the next 7-10 years, according to the latest GMO letter… No matter negative real rates have led time and time again to the formation of bubbles…

I am not saying I am out of the market! I am just saying that I am comfortable leaving some money on the table and playing it safe.

 

giofranchi

 

I think these are fair points.  However, I think there is a lot of focus on the market as a whole being overvalued or at least fairly valued and not enough on individual undervalued securities.  While the market itself might return little to nothing over the next 7-10 years (I have no idea), that doesn't mean that one can't make money on individual securities. 

 

Gio, not directed at you, but I do find that for a board where many people pride themselves on their security analysis there is tremendous focus on the aggregate market.  Obviously a downturn will pull everything with it for some period of time at least, but an undervalued security will float up at some point.  And what is the alternative?  It would be to just stay in cash.

 

Just a further thought on this.  I find as well that people seem to confuse a pricing based market downturn with a decline caused by broader economic forces (such as a recession or something).  Often people will say the market is due for a downturn so best to hold BRK, FFH, MKL, etc.  That has never made sense to me.  If we get a downturn simply because the overall price of the market gets too high, those stocks will come down just as much as anything else.  There is no pricing safety in a BRK for example.  If the market falls 30% so will BRK most likely.  If it's a recession that's being predicted, then perhaps the alternative is to hold cash. 

 

Since I make no predictions about anything I just continue on my merry way.

[Packer16]

I agree with you about bubbles that is why I am listening intently to H. Marks.  His latest on sentiment is below.  I am seeing some signs of a start in the triple net real estate market.  If you look at the last time we have repression in the US 1945 to 1980, it took 13 to 15 years before a bubble was formed and busted.  If the repression started in 2009, the analogy would be 2022 to 2024.  Another way to look at is how far are through deleveraging.  G. Schilling thinks we are about 50% done, so another 5 years.  If you look at the 1945 to the mid 1950s, you had poor equity sentiment like today and low interest rates. 

 

http://www.morningstar.com/cover/videocenter.aspx?id=603377

 

This is an interesting discussion but as Kraven has said I focus in "cheap" stock (aka the garbage man or bottom feeder) and my reflections on history do not effect my portfolio. 

 

Packer

[writser]

@Kraven: wise words  :) Lots of posts on this forum are being spent on macro-economics, interest rate forecasts, the sustainability of facebooks economic model, Apple vs. Microsoft, emerging market cooldowns, currency wars, etc. In the meantime, heroes like Packer and PlanMaestro (first two names that pop up) do the hard work and come up with some really good ideas, stocks that have doubled, tripled and quadrupled regardless of macro-economic forecasts. Salem Communications, Alliance Healthcare, Alaska Communications, Awilco Drilling, Air Transport Services, just to name a few.

 

While everybody was discussing the next market crash, the money was right there for the taking ..

[giofranchi]

I think these are fair points.  However, I think there is a lot of focus on the market as a whole being overvalued or at least fairly valued and not enough on individual undervalued securities.  While the market itself might return little to nothing over the next 7-10 years (I have no idea), that doesn't mean that one can't make money on individual securities. 

 

Gio, not directed at you, but I do find that for a board where many people pride themselves on their security analysis there is tremendous focus on the aggregate market.  Obviously a downturn will pull everything with it for some period of time at least, but an undervalued security will float up at some point.  And what is the alternative?  It would be to just stay in cash.

 

Just a further thought on this.  I find as well that people seem to confuse a pricing based market downturn with a decline caused by broader economic forces (such as a recession or something).  Often people will say the market is due for a downturn so best to hold BRK, FFH, MKL, etc.  That has never made sense to me.  If we get a downturn simply because the overall price of the market gets too high, those stocks will come down just as much as anything else.  There is no pricing safety in a BRK for example.  If the market falls 30% so will BRK most likely.  If it's a recession that's being predicted, then perhaps the alternative is to hold cash. 

 

Since I make no predictions about anything I just continue on my merry way.

 

Hi Kraven,

think just a second about my firm. The majority of its assets are concentrated in 4 businesses:

1) Engineering services

2) For profit higher education services

3) Fairfax Financial Holdings

4) Lancashire Holdings

Then, there is cash. You surely know many companies. Let me ask you a question: how many of them, percentage wise, hold just the minimum cash required to smoothly operate their businesses, and how many hold some cash also for safety? Just in case a rainy day comes? Even if that sad day might never come to pass? I want my firm to be in the second group. If I had to choose between 15% annual + a safety net and 20% annual with no safety net, I would go for the first one without hesitation. And for safety net I mean cash.

So, my question in not: do I have to hold cash? Instead, it is: how much cash do I have to hold?

 

Furthermore, it is something that is continuously changing. Both to always hold 5% of cash and to always hold 50% of cash doesn’t make any sense to me… Of course, I tend to decrease the cash level depending on how many opportunities to do business at high rates of return I see out there… But I also like to keep my eyes open and see what other people are doing. Anyone who manages a business know that, even if he does everything perfect and doesn’t commit any error, his results will still be influenced by external forces. More specifically, if everyone around you is going to suffer losses, you will experience some pain too… So, how are they behaving? Soundly or foolishly? If foolishly, I want to increase cash.

 

Finally, I don’t understand your view on FFH or LRE: in 2008, when the market fell (37%), FFH stock price increased from CAD$287 to CAD$390, +35.9%; while LRE stock price increased from 368 GBp to 425 GBp, +15.5%. Furthermore, it is very likely that LRE will go on paying huge dividends also in a downturn, dividends that could be used to scoop up great bargains.

So, I sincerely don’t see how anyone could time these things…

 

giofranchi

 

[giofranchi]

@Kraven: wise words  :) Lots of posts on this forum are being spent on macro-economics, interest rate forecasts, the sustainability of facebooks economic model, Apple vs. Microsoft, emerging market cooldowns, currency wars, etc. In the meantime, heroes like Packer and PlanMaestro (first two names that pop up) do the hard work and come up with some really good ideas, stocks that have doubled, tripled and quadrupled regardless of macro-economic forecasts. Salem Communications, Alliance Healthcare, Alaska Communications, Awilco Drilling, Air Transport Services, just to name a few.

 

While everybody was discussing the next market crash, the money was right there for the taking ..

 

writser,

what can I say? As you have suggested, Packer, PlanMaestro, Kraven, and others are heroes! And they will go on doubling, tripling, and quadrupling their money!

If there is something I am completely immune to, that something is envy. Therefore, I am sincerely happy for them, but won’t try to emulate them. Instead, I will stick to what I know, understand, and judge the most sensible course of action. I am quite positive I also will create some wealth…

Though, of course, much less than Packer, PlanMaestro, Kraven, and all your other heroes! ;)

 

giofranchi

 

[Kraven]

I think these are fair points.  However, I think there is a lot of focus on the market as a whole being overvalued or at least fairly valued and not enough on individual undervalued securities.  While the market itself might return little to nothing over the next 7-10 years (I have no idea), that doesn't mean that one can't make money on individual securities. 

 

Gio, not directed at you, but I do find that for a board where many people pride themselves on their security analysis there is tremendous focus on the aggregate market.  Obviously a downturn will pull everything with it for some period of time at least, but an undervalued security will float up at some point.  And what is the alternative?  It would be to just stay in cash.

 

Just a further thought on this.  I find as well that people seem to confuse a pricing based market downturn with a decline caused by broader economic forces (such as a recession or something).  Often people will say the market is due for a downturn so best to hold BRK, FFH, MKL, etc.  That has never made sense to me.  If we get a downturn simply because the overall price of the market gets too high, those stocks will come down just as much as anything else.  There is no pricing safety in a BRK for example.  If the market falls 30% so will BRK most likely.  If it's a recession that's being predicted, then perhaps the alternative is to hold cash. 

 

Since I make no predictions about anything I just continue on my merry way.

 

Hi Kraven,

think just a second about my firm. The majority of its assets are concentrated in 4 businesses:

1) Engineering services

2) For profit higher education services

3) Fairfax Financial Holdings

4) Lancashire Holdings

Then, there is cash. You surely know many companies. Let me ask you a question: how many of them, percentage wise, hold just the minimum cash required to smoothly operate their businesses, and how many hold some cash also for safety? Just in case a rainy day comes? Even if that sad day might never come to pass? I want my firm to be in the second group. If I had to choose between 15% annual + a safety net and 20% annual with no safety net, I would go for the first one without hesitation. And for safety net I mean cash.

So, my question in not: do I have to hold cash? Instead, it is: how much cash do I have to hold?

 

Furthermore, it is something that is continuously changing. Both to always hold 5% of cash and to always hold 50% of cash doesn’t make any sense to me… Of course, I tend to decrease the cash level depending on how many opportunities to do business at high rates of return I see out there… But I also like to keep my eyes open and see what other people are doing. Anyone who manages a business know that, even if he does everything perfect and doesn’t commit any error, his results will still be influenced by external forces. More specifically, if everyone around you is going to suffer losses, you will experience some pain too… So, how are they behaving? Soundly or foolishly? If foolishly, I want to increase cash.

 

Finally, I don’t understand your view on FFH or LRE: in 2008, when the market fell (37%), FFH stock price increased from CAD$287 to CAD$390, +35.9%; while LRE stock price increased from 368 GBp to 425 GBp, +15.5%. Furthermore, it is very likely that LRE will go on paying huge dividends also in a downturn, dividends that could be used to scoop up great bargains.

So, I sincerely don’t see how anyone could time these things…

 

giofranchi

 

Gio, your points are well taken. In your case you focus more on the macro and your own operating business than individual security selection. You walk the talk. That's fine. What I find interesting is the people who spend their time looking for undervalued securities but then fret over Grantham or Hussman or something. If a stock is undervalued its undervalued. What should it matter if the broader market does nothing over the next 10 years?

 

My point on FFH, etc is different than yours. I see why you want to hold and continue to hold FFH, LRE, etc. What I was trying to say is that for those involved in selecting individual securities it makes no sense to me why someone would hold any of these stocks if they "know" a downturn is coming. Either certain securities are undervalued and will do fine or they won't. The world of securities that will do fine in the next 10 years isn't limited to BRK, FFH, etc.

 

Finally, personally I put very little weight on the FFH macro bet from 2008. Sure, they called it right and others did too, but there was a lot of luck involved in that call. It was not preordained that the financial crisis hit the way it did. There was a tipping point. If Lehman had not been allowed to go under things may have turned out much differently. If the Fed had backstopped them for a couple days to allow Barclays to buy them we might have been looking at things differently. If that had happened it may have been that Fairfax's macro bet was similar to that of today's - I.e. a mistake, not prudence in my view. There were many variables at play. Skill it recognizing it for sure, but plenty of luck too.

[Packer16]

Gio,

 

I think you have to be careful in comparing LRE and FFH in 2007 to toady and how much better they can whether a downturn.  For LRE, in 2007 they were selling at a nice discount to book (20% at the low price you quoted) and now it trades a 50% premium to book.  Quite a difference.  This does not mean LRE is not a good company.  It is probably the best but the market has realized this and its incorporated into the price today versus in 2007.  For FFH, they had the CDS options doing their thing.  I don't see a similar counter cyclical bet that can payoff in the same way.  You have the same issue with FFH.  In 2007, the market was not giving them credit for the CDS bet, thus the increase.  I think both will do well in a storm but the I think the out performance will be nothing like 2008.

 

Packer

[giofranchi]

Either certain securities are undervalued and will do fine or they won't.

 

Kraven,

I think we live in a much more uncertain world… Sometime I look back at the file in attachment… either those folks at Value Line were complete fool and wholly incompetent, or we live in a much more uncertain world!

 

giofranchi

BAC_-_Value_Line_-_23_nov_2007.pdf

[giofranchi]

Gio,

 

I think you have to be careful in comparing LRE and FFH in 2007 to toady and how much better they can whether a downturn.  For LRE, in 2007 they were selling at a nice discount to book (20% at the low price you quoted) and now it trades a 50% premium to book.  Quite a difference.  This does not mean LRE is not a good company.  It is probably the best but the market has realized this and its incorporated into the price today versus in 2007.  For FFH, they had the CDS options doing their thing.  I don't see a similar counter cyclical bet that can payoff in the same way.  You have the same issue with FFH.  In 2007, the market was not giving them credit for the CDS bet, thus the increase.  I think both will do well in a storm but the I think the out performance will be nothing like 2008.

 

Packer

 

Packer,

I agree. But I always look only at business results. I don’t care about anything else. And I think LRE operations will be practically undisturbed by any market downturn: it will keep generating a lot of cash, exactly when cash will be needed the most. Second, I don’t know of any other company better positioned than FFH to capitalize on the foolishness of others.

 

And I want to be clear: I don’t think FFH defensiveness is a mistake at all. We have embarked on a lot of never attempted before things… and, just because the outcome is unpredictable, no one should be excused for not seeing or acknowledging the risks involved. Imo we must turn things around: if everything will finally be solved for the better, that would be good luck… instead, the risks of wall-street (financial economy) diverging too much from main-street (real economy) should be evident to everyone… A company like FFH has the duty to protect itself from those risks… even if at the end we all get lucky and the consequences of those risks are averted… and its defensiveness turns out to be nothing more than wasted time and resources.

I invest in FFH, because they are doing precisely what I would be doing, if I were in their stead.

 

giofranchi

 

[Packer16]

Over the LT, the business results will drive returns.  My approach is to combine both business results and sentiment via valuation.  I think both Ben Graham and Phillip Fisher have stated the largest gains come from changes in sentiment.  That is why I don't hold LRE now.  If it approached BV, I would.  Based upon historical RoE, BV and recent dividend distribution (BV of $7.19 per share), my estimated return on LRE is closer to 11%.  If we get to BV, the return approaches 20% (closer to my interest level).  I am just more price sensitive and that drives my approach. 

 

Packer

[giofranchi]

I dont think the world was certain anytime in the past and it won't be anytime in the near future. Kraven and Packer have made very valid points.

 

shalab,

you surely remember what Mr. Twain used to saying, right?

All generalizations are wrong, this one included.

Every time is different and each of us is called to use his/her own judgment. I don’t believe in things on auto-pilot.

From time to time, we are also asked how we can discuss macroeconomics yet profess to largely ignore the topic when selecting investments. It’s a good question. First, we do not think we are particularly good fortune tellers, nor do we think many such gifted people exist. However, with fiscal deficits exceeding a trillion dollars in recent years, an extended period of zero interest rate policy (ZIRP), and quantitative easing at the rate of roughly $1 trillion per annum, the size of Federal economic intervention is impossible to ignore. The breathtaking scale of these programs has forced us to consider macro risks – especially in the context of how a potential or existing investment can be hurt by shifts in policies.

--GoodHeaven 2013 Semi-Annual

 

giofranchi

 

[Kraven]

Either certain securities are undervalued and will do fine or they won't.

 

Kraven,

I think we live in a much more uncertain world… Sometime I look back at the file in attachment… either those folks at Value Line were complete fool and wholly incompetent, or we live in a much more uncertain world!

 

giofranchi

 

Gio, I agree that the world is uncertain. I always say we don't know what we don't know. So buy cheap and good things should happen. Of course what I think is cheap and what others do may be different. Thanks for attaching that BAC value line. Very interesting. I wouldn't have touched that (and didn't). It wasn't cheap at all to me.

[Guest ajc]

My 2 cents worth - I think it actually matters which country you're born and based in, what industry you work in and what type of job you have. Some of those are more easily influenced by you than others.

 

Say you're born in x country -  your family is there, friends, etc. What size country is it and what type of institutions (if any) does it have and how self-sufficient is it. In my opinion, living in a small country in a rough neighborhood means you're far more likely to grow up thinking about external factors and forming those types of mental habits. That's not to knock folks from places like that, because in many essential ways they'd be crazy not to pay attention to what was happening next door.

 

On the other hand, if you live in a huge, pretty homogenized territory that has massive scale and doesn't need to worry about outside military, social or economic shocks then I'd say it's easier to form habits in your development that allow you to not spend too much time focusing on outside factors. Again, not knocking anyone for being lucky in that way but I think there can be huge social pressures around how people should be thinking in a society which have alot to do with the geographical and natural aspects of the territory rather than their own choices (although clearly I'm not saying individual agency doesn't play any significant role, just that there are other important forces at work).

 

Anyway, that's one way to look at this I think. Same goes for industries, jobs, etc - how many of these things are swayed massively by where and to whom we're born instead of by our own selves? A substantial amount for the most part, in my opinion.

[giofranchi]

Over the LT, the business results will drive returns.  My approach is to combine both business results and sentiment via valuation.  I think both Ben Graham and Phillip Fisher have stated the largest gains come from changes in sentiment.  That is why I don't hold LRE now.  If it approached BV, I would.  Based upon historical RoE, BV and recent dividend distribution (BV of $7.19 per share), my estimated return on LRE is closer to 11%.  If we get to BV, the return approaches 20% (closer to my interest level).  I am just more price sensitive and that drives my approach. 

 

Packer

 

Packer,

though I know LRE is not a trading opportunity, I firmly believe that the most impressive misjudgments the market commits are in pricing businesses that will go on compounding capital for many years into the future. The market simply ignores how to judge the prospects of a business beyond 2-3 years… That’s exactly why LRE is not a trading opportunity: because the market won’t recognize its error anytime soon… it will probably be a slow and gradual recognition year after year for a very long time to come. Imo in the end LRE shareholders will be handsomely rewarded.

 

The S&P500 is selling for 2.54 x BV with an average ROE of 13%; LRE is selling for 1.7 x BV with an average ROE of 20%. As you can see from the picture in attachment, LRE growth in fully converted book value per share plus dividend since inception, 7.5 years ago, is 270%. It means that $1 in BV at the beginning of 2006 now is worth $3.7. It has compounded value at 19% annual. If LRE goes on performing like it has done since inception for the next 20 years, then it literally disappears (no residual value here!), the present value of its future equity would be $35, using a discount rate of 10%. So, the market is pricing LRE for 1.7 x 7.19 = $12.3, or 35% what it would be really worth, if it succeeds in keeping its ROE at 20% for the next two decades. Of course, the market is absolutely incapable of making such long-term valuations. Generally, I am also not very good at it! But I look for those 5 to 10 investments, witch I have the confidence to invest in for the very long run. And, if I can find them, I am almost sure they will be deeply undervalued!

 

giofranchi

[giofranchi]

Gio, Buffett has been investing since he was ten or so. He hasnt changed his investing strategy much since his first partnership letter. No charts and macro predictions and reading the tea leaves. The world has done well inspite of world wars, Cold War, 9/11, Iraq/afghan wars, things are ok. There are people who have done better than Biglari, Ffh etc. in the last ten years. I am an optimist about the future and things will turn out ok...

 

shalab,

You surely are right! Yet, Mr. Buffett kept 28% of BRK Total Assets in Cash + Bonds at year end 2012… and he can count on $1.2 billion of new cash coming in every months… BRK is exactly the example of a company that always keeps much more cash at hand than what is strictly necessary to run smoothly its operations! ;)

 

giofranchi

 

[wisdom]

While, I generally would agree with Kraven and Packer, we must accept that the central banks are trying something that hasn't been tried before and the sheer size of liquidity being pumped in across the world is not the norm. Thus, I believe we must be flexible and accept that there could be risks that we might not have encountered in our recent history. This may or may not result in things playing out the way they normally do.

 

I believe Gio is showing that flexibility in his thinking and openness to things potentially playing out a bit different to the norm.

 

I am not saying that they have to play out differently - just that we don't know and thus, it is better to be open to that idea and take steps to cover for that eventuality.

 

On the other hand - nothing may happen and everything goes on as it has. But, it would not imply that Gio was wrong in his decision making process is correct.

 

The question to consider would be - how much is Gio being impacted in his thinking by the state of the Italian economy while we in Nth America seem to be more confident?

[merkhet]

Mr. Buffett once said that he believes part of his outperformance can be attributed to not having lived through the Great Depression. Specifically not having invested during that time. It changes a man.

 

I wonder how much of the macro tourism that we see currently from self-avowed value investors is attributed to the simple fact that living and investing through the 2008-2009 correction has a serious psychological effect on some people.

 

(Not directed at anyone in particular. Just an observation.)

[Packer16]

This may not be the norm but it has been done before.  From 1820 to 1858, in the US the money supply increased 5x but prices declined by 33%.  From 1875 to 1900, the money supply doubled but prices again declined by 33%.  From what I see price increases are caused by wars in the 1800's and early to mid 1900's and lack of productive capacity in the late 1900's via communism.

 

Packer

[wisdom]

I agree Packer - FFH deflation hedges and cash would be great assets if we rely on the 2 examples you have sighted.

 

Based on these cases, IMHO, Gio is making the correct decision whether we get deflation or not in the near to medium term.