Thursday, May 25, 2017

Bubble Watch

Shiller said the other day that the market can go up 50% from here. OK, so I fell for it and clicked to watch the CNBC video. This was sort of a surprising comment coming from the creator of the CAPE ratio, one of the main indicators bears use to argue that the market is way overvalued.

Of course, this is not Shiller's forecast or expectation. In fact, he says that this is very unlikely, but it is possible. His point was simply that the CAPE ratio is 30x now, and in the 1990's it went up to 45x. So if that happened again, that's a 50% increase.

This is totally possible, especially now. I would not invest in the market with that expectation, of course. Actually, I would invest with the opposite expectation (when pressed, Shiller said the market is more likely to go up 50% than down 50%).

Trailing P/E
Let's put the CAPE aside for now and just look at regular trailing P/E's. Back in 1999, that went up to 30x, and in 1987, it went up to 21.4x (this is from the Shiller spreadsheet).

We keep hearing from the bears that the market is as expensive as it was during previous peaks, so we are in dangerous territory; they say we are in a bubble.

OK. That is possible.

But in previous posts, I argued that if 10 year rates stabilize at 4% over time (it's at 2.3% now), it is possible that the market P/E can average 25x during that period. Maybe the market fluctuates around that average, so the market can easily trade between 18x and 33x P/E without anything being out of whack. (Buffett also said at the recent annual meeting that if rates stay around this area, then the stock market could prove to be very undervalued at current levels.)

So we have a problem. This 18-33x P/E range puts the market in bubble territory according to the bubble experts. But we are saying here that if rates stay at 4%, that's the normal range the market should trade at.

So then, how can we tell when we are in bubble territory?

Since we are using interest rates to value the stock market, we will have to interest rate adjust our bubble levels too.

Interest Rate Adjusted Bubble P/E
So just looking back at 1999 and 1987, here are the indicators at the time:

               PE          EY       10yr
1987      21.4x      4.7%     8.8%
1999      30.0x,     3.3%     6.3%

Both 1987 and 1999 had the feel of a rubber band stretching and then snapping. You will see that the earnings yield was 4.1% lower than the 10 year rate in 1987 and 3% lower in 1999.

Right now, the P/E ratio is 23.4x, for an earnings yield of 4.3% versus the 10-year rate of 2.3%. So it's a full 2.0% higher, not lower. But even I think 2.3% on the 10 year is too low. I use 4.0% these days for what I think is a non-bubbled up, unmanipulated-by-the-Fed, sustainable, normalized rate.

Using this spread, long term rates would have to go up to 7-8% for me to worry about an overstretched rubber band snapping.

How about the stock market? How high would it have to go before I think we are really in bubble territory?

With interest rates at 2.3%, we can't deduct 3% or 4% from it to get a bubble-level earnings yield.
So we'll look at it as a ratio.  In 1987, earnings yield got to as low as 0.53x the bond rate (4.7%/8.8%) and in 1999 it got to 0.52x (3.3%/6.3%)

Using the current 2.3% 10-year rate, earnings yield would have to get to 1.2% for me to really think that maybe we are in a stock market bubble.  That comes to 83x P/E!  At that level, trust me, even I won't be talking much about long term investing, and would probably be net short with a bunch of put options too.

But wait, let's not use 2.3% because we all know that's too low. Let's use my normalized 4%.  Even with a 4% bond yield, earnings yield would have to get to 2% to be considered really bubble level.  That is a P/E ratio of 50x.   That's more than a double from here.

So for me, the market would have to actually more than double from here before I see it as really bubbly. (If you want to see what a real bubble is like, look at Bitcoin!)

Narrow Market
The other thing I hear a lot is that the market is up only because of the very few hot tech stocks like the FANG stocks. They make it sound like the market would be doing nothing without them. Maybe.

But just as a quick check, I compared the S&P 500 index (ETF: SPY) to the S&P 500 equal-weighted index (ETF: RSP); the super-large caps would have no more impact than the smallest S&P 500 companies.

Check this out:
  (The blue line is the RSP, green is SPY)

SPY versus RSP Long Term

SPY versus RSP 10 Years

SPY versus RSP 5 Years


In all of the above time periods, the RSP outperforms SPY, which I don't think would be the case if it was only a few of the super-large caps that is pulling the S&P 500 index up.

Just for fun, I looked at the S&P 500 index versus the Russell 2000 index too. If only a few super-large caps were pulling up the averages, then obviously, the S&P 500 index should be outperforming the Russell 2000 too.  The blue line is the Russell 2000, and the green line is the S&P 500 index.


S&P 500 Index versus Russell 2000 - 5 Years

S&P 500 Index versus Russell 2000 - 10 Year


Here too, I don't see the S&P 500 outperforming in a big way lead by the supers.  To the contrary, the S&P 500 index is behind the Russell in the 10 year period.

I had no idea what I would see when I put up these comparisons. Looking at them now, I am a little disappointed in active managers who claim that they are underperforming because they don't own the FANG stocks; the above shows that maybe that's not the issue.

Anyway, that's another ongoing topic here.

Conclusion
All of this stuff, I just do sometimes to satisfy my own curiosity; not to make any claims either way. I have no idea what the market will do, but I don't believe we are in a stock market bubble at all. OK, if interest rates got up to 7-8% and valuations are still here in the 23-24x P/E area (trailing basis), then yes, I would agree we have a valuation problem.

Otherwise, it would take a market P/E of 50-80x for me to think we are in a stock market bubble (and I would put on shorts and load up on puts! But even then, I wouldn't expect an immediate payoff. If the market took off like that, it would be very hard to pick the top).

Otherwise, we are just, in terms of stock market valuation, in the "zone of reasonableness", to borrow Buffett's phrase from a few years ago.

Also, keep in mind, this 50-80x P/E ratio range is not a target, of course. That's where it has to go before you convince me we are in a stock market bubble.

Also, this doesn't mean the market can't enter a bear market at any time. There was no interest rate / earnings yield rubber band in 1929 and 2007.

Friday, May 19, 2017

High Fees

So, I was taking to a friend who has a million dollars in a large cap stock fund. The fund happens to be the Fidelity Magellan fund. The fund is very famous for being the ship that Peter Lynch navigated. But years later, it's just another generic, closet-index/large cap fund.  I don't follow mutual funds too closely, but my initial thought was that there is basically no chance of Magellan outperforming the S&P 500 index over time.

And, of course, the expense was almost 1%.  That is kind of shocking.

When you read gambling and trading books, they always tell you not to think of money as real money. When you are betting in poker and you see the $70,000 of cash in the pot as a BMW,  you will make really bad decisions and will play poorly. If you see the loss on your portfolio as two years of your kid's college education, you will freak out and make irrational moves. (Actually, if you really need that cash for your kid's education in the near future, then maybe you should freak out, and maybe you shouldn't have that cash in risk assets!)

But let's do the opposite now.  I said to the friend, gee, well, do you have a reason to believe that the Magellan fund will outperform the S&P 500 index over time? Not really. OK, then why are you basically writing a check for $10,000 per year? That's almost $1,000/month.  That's a lot of money for a retired person. Why would you write a $1,000 check every single month for nothing?

In ten years, that's $100,000 gone. Poof.  For absolutely no reason at all. That's more than most people have in their IRA's.

It's hard to notice these things as they are just deducted from the account so you don't actually write a check every month. If you did, you would probably think about it a lot harder.

1% Too High?
Mutual fund fees are too high for most funds. There are some funds that may be worth the fee, especially some of the value funds with long term track records.

But with expected equity returns of around 5-6% going forward, we have to wonder about 1% fees. It's one thing charging 1% fees in a 10% equity return world, but it's a whole different world now. Maybe fees should be restructured so that the fee is minimized to cover overhead and bulk of fee comes from outperforming a benchmark index.  I don't know. I actually don't own any funds so it's not really an issue for me, but something interesting to think about.

Speaking of high fees and having watched the Berkshire Annual Meeting video, it reminded me of a fund with really high fees.

Wintergreen
Some people believe that there is no bad publicity, but in this case, maybe it was bad publicity. David Winters of the Wintergreen Fund criticized Coke for their egregious stock compensation plan and even criticized Warren Buffett for not speaking out against the plan and even went so far as to sell Berkshire Hathaway stock in a huff saying that Warren Buffett no longer looks out for his shareholders.

This was kind of shocking for a few reasons.  First of all, when Winters talked about the massive wealth transfer, his number was totally off. I talked about it here, and Buffett said the numbers were also way off. So it means either that Winters is not a very good analyst, or is simply dishonest and threw out a huge number deliberately to get attention. I don't know which is worse, but either way is not very encouraging for his shareholders (take your pick: incompetence or dishonesty). He also sold off Berkshire Hathaway because of this. This seemed to me he was taking all of this personally and getting too emotionally involved. I don't know. But that's what it seemed like.

This lead Buffett to mention at an annual meeting that Winters charges very high fees for bad performance. Ouch. A lot of people love to go on CNBC because it's free advertising. But sometimes it backfires, particularly when you criticize a giant with no track record to back it up (and charge fees much higher than anyone else!).

First of all, this all happened in 2014. Winters sold his BRK in the 1Q of 2014. His fund is in red, BRK is blue and the S&P 500 index is the green line.


The Wintergreen Fund had assets of $1.6 billion in Dec 2007, but still had more than $1.2 billion as recently as the end of 2013. But as of the end of 2016, AUM was down to $300 million.  There is some AUM in the institutional class too but that is down a lot too.

Here is the performance of the fund:



That's a pretty huge underperformance no matter how you slice it.

OK, that's not so uncommon these days with active managers underperforming.

But here's the shocker. Look at the fees charged on this fund:


That's 2%! First of all, the fund underperforms in all long term time periods. In a 5-6% return equity world, the fund is basically charging 33%-40% of expected return!  But that's assuming the fund keeps up with the index, which historically hasn't been the case. If the fund lagged 1%/year on a gross basis that comes to more like 40-50% of expected returns going to the manager. That's truly insane.

And looking at this on a real cash basis, if you had $1 million in this fund, you would be writing a check for almost $20,000 per year! That's some real money.  Over 10 years, that's $200,000!?  You had better be sure someone will outperform the index if you are going to be writing checks that big every year.

One may argue that the benchmark is wrong; Wintergreen owns non-U.S. stocks. Actually, as an investor, that shouldn't matter. The fund doesn't have an explicit mandate that they must invest internationally or anything like that. If they invest in non-U.S. stocks, it has to be because they think non-U.S. stocks are more attractive; that they will outperform U.S. stocks. Or else why bother, right? So in that sense, benchmarking against a completely neutral S&P 500 is fine.

It's kind of crazy what people get away with.

I know people will immediately respond by saying, yeah, but you like all those alternative managers with even higher fees!  Well, most alternative guys charge too much too, but the ones I tend to like do have really good long term records.

Mutual Funds Sticky
Here's the thing about mutual funds versus alternative funds. I think a lot of mutual fund assets are really sticky due to the indifference of many investors. They just leave it and don't think about it, which is the correct approach to investing, generally. But the downside is that many don't realize how much is being sucked out of their net worth from these fees for no return.

Hedge funds, private equity funds, on the other hand, have investors who are more active in tracking performance etc. If you perform poorly, you will lose assets more quickly and go out of business as many hedge funds have seen in the last few years. Mutual funds can last forever on dreadful performance.

KO
And speaking of KO, it was also in 2014, I think, that Kent (KO CEO back then) started talking about zero-based budgeting. I was skeptical about this at the time; a lot of CEO's would just grab the latest buzzword and throw it in their presentations just to show how hip they are to the current state of the world (Now it seems to be AI, machine learning, big data etc... Well, that's all over Dimon's letter too, but financials have been big into these areas for a while...).

Anyway, KO is too big for most to make a run at it so there is no real sense of urgency there so you know nothing is going to happen, not to mention the arrogance there from a century of dominance. I have made the case that for anything to change at KO, it's going to have to come from the outside. Internal people will not be able to make big changes; they can't pull off the band-aid as it would hurt too many 'friends'.

Look at margin trends since they claimed they started using zero-based budgeting:

Analysis of Consolidated Statements of Income
Percent Change  
Year Ended December 31,
2016

2015

2014

2016 vs. 2015
2015 vs. 2014
(In millions except percentages and per share data)
NET OPERATING REVENUES
$
41,863

$
44,294

$
45,998

(5
)%
(4
)%
Cost of goods sold
16,465

17,482

17,889

(6
)
(2
)
GROSS PROFIT
25,398

26,812

28,109

(5
)
(5
)
GROSS PROFIT MARGIN
60.7
%
60.5
%
61.1
%

Selling, general and administrative expenses
15,262

16,427

17,218

(7
)
(5
)
Other operating charges
1,510

1,657

1,183

(9
)
40

OPERATING INCOME
8,626

8,728

9,708

(1
)
(10
)
OPERATING MARGIN
20.6
%
19.7
%
21.1
%


Operating margins are actually down from 2014.  So much for zero-based budgeting!

Munger indicated that a $150 billion deal would be huge for Berkshire Hathaway, so it is unlikely that BRK could make a run for KO on it's own. But in some sort of combination with BUD, KHC or some other 3G entity, who knows what will happen.


Berkshire Hathaway Annual Meeting Last Question
By the way, the last question on the Yahoo video was about CEO's social responsibility; should companies move jobs overseas to increase profits at the expense of local communities, domestic jobs etc.?

This was really a good question and I think about that sort of thing all the time. Do we always have to be the most efficient and lowest cost at all times? Do we really need to be increasing productivity all the time? Why can't we come to some stable status quo and not keep trying to grow or increase profits all the time?

And I always seem to go back to Japan. Japan is a country where companies usually do act responsibly and really doesn't want to fire people. And Japan is in terrible shape, I think, large due to that. Long time Canon CEO, Fujio Mitarai, explained that Japan can't compete well in many industries because they operate under the system of corporate socialism. The Japanese government won't provide unemployment and other social safety nets; Japanese corporations are expected to take care of redundant workers (by not firing them) etc.

You can protect people for a while like that, but at some point, the burden gets too big and the corporation will collapse.

Panasonic was one of those intensely socially responsible companies; Konnosuke Matsushita, the founder, strongly believed that it was the responsibility of the company to take care of their employees. He never wanted to fire anyone. It's a great concept and noble, but I don't believe it works.

McIlhenny Company (Tabasco sauce) was like that early on; they had an island they wanted to be self-sustaining. They wanted their employees to live there, they built schools, stores etc. But over time it just doesn't work. I think Henry Ford, Hershey and others tried similar things too when it was believed that if they created a company town with everything necessary for employees to raise a family and live comfortably, they can create a sort of self-sustaining utopia.

It just doesn't work. It also reminds me of the pre-Thatcher Britain; it didn't work at the national level either.

And besides, more of a threat to the domestic work force than globalization is technology. I haven't done much research in the area, but technology is probably more responsible for job losses than globalization (moving production to low wage countries).

And do we really want to limit or stop technology? Japan will make large advances in that area due to their shrinking population. They need nurses and other workers to take care of the increasingly aging (and dwindling) population.

If the U.S. slows technological progress for the sake of maintaining low unemployment, then the Japanese will ultimately rule the future and we will have a large, unemployed (and unemployable) population.

Related to all this, just by chance, I happen to be reading the new Kasparov book. I'm not done with it yet, but it is really fascinating. True, he's a former chess world champion so what does he really know? He is a voracious reader and runs around meeting and talking to interesting people all over the world so he has interesting insights into many things.

He points out that every time we have technological advancement, people fear this or that.  For example, the elevator operators union had 17,000+ members in 1920. The technology existed in 1900 but wasn't widely used (automatic elevators) until 1930 due to people's fear of riding operator-less elevators (similar to fear of driverless cars today; but people's fear is not what is holding back driverless cars today...).

Anyway, I am not a believer in holding anything back for the sake of maintaining employment; it will only delay the day of reckoning, and at that point the negative impact might be much worse.

Since technology is advancing so quickly, retraining won't be able to keep up, so something like a universal basic income is probably the only way to go at some point. I know I sound like a communist when I say that, but I can't think of any other way.

Anyway, this veers far away from the topic of this blog, so let's get back on topic.

Conclusion
If you are one of those people who have a bunch of mutual funds in your IRA/401K or whatever, I would actually go in and do the work to calculate how much you are actually paying in real dollars. Is it really worth it? Same with financial advisors. When fees are just deducted from your account, you may not realize how much you are paying. Calculate what your are paying. Is it really worth it?

Let's say you have $5 million and most of it is in tax-free money market funds and the S&P 500 index funds. With a 2% fee, that's $100,000 per year! Why would anyone pay that? Is it really worth it? Can your advisor really pick stocks and funds better than some simple passive portfolio?

I don't know. When you look at it in real dollars like that, it is really insane.




Wednesday, May 3, 2017

Fairfax India Holdings (FFXDF)

This is one of those things that I looked at before and never posted, so here it is. Actually, I didn't write much about it, it was just sitting in my queue.

I know Munger likes China more than India, but I think India is very interesting. I don't think I have to say much about it as it is not a new idea. And yes, India has problems that China doesn't have (democracy that can actually hold back progress unlike in the authoritarian China where the government can just basically do what it wants). But India is still fascinating, especially with all the things going on over there now (pro-business government for the first time etc).

Anyway, as usual, before that, check this out from the Fairfax 2016 Letter to Shareholders.

Here's the long term investment performance of Fairfax (not the India entity):


And what happened in 2016:


...and the summary overall for the period 2010-2016:



Their equity hedge has been very costly, basically a total disaster.  Their hedges cost them $4.4 billion since 2010. Since it was a hedge, you have to look at it on a net basis with the longs; that's a $1.7 billion loss.  Still pretty awful. This is during a period the S&P 500 index went up 12.5%/year. In 2010, they had $4.5 billion in stocks. If this was unhedged and their stocks kept up with the market, it would have added $4.5 billion to their net value instead of losing $1.7 billion; that's a swing of $6.2 billion!  That's huge given their common equity in 2010 of around $8 billion ($8.5 billion at end of 2016).

It's fair to say, though, that if the portfolio wasn't hedged, it might have been smaller than $4.5 billion; the portfolio might have been sold down for risk management purposes.

Since 2007, Fairfax has still outperformed (price basis) the S&P 500 index and all of the so-called Berk-a-likes:


This chart (and other charts), by the way, are updated every day at the Brooklyn Investor website.

Anyway, over the long term, they have done well, so it's not fair to focus just on this one mistake (even though it's a huge one). Many CEO errors cause their companies to go bust, and that hasn't happened here, or anything even close to that.

Here is the other 'bet' Fairfax has on:


This bet doesn't look so interesting these days, but the important point is that the downside in these bets are known and small. It's one of those "if you're wrong you don't lose too much but if you're right you can make a ton" deals. Needless to say, the equity portfolio hedge was not that kind of bet!

Expensive Market
Anyway, I still have conversations about this sort of thing and hear all the time about the markets being expensive, people being confused as to what's going on.

One hedge fund executive (wasn't clear what position was; not sure if he had investment experience/responsibilities) was on CNBC the other day and it was stunning because the comments were based on such extraordinarily static analysis, talking about the uncertainties in the market, how things were expensive etc.

Reflexivity
And it reminds me of a book that I plan to reread (if I can find it!). When I read it years ago, it was incredibly eye-opening, and it feels like a lot of people have forgotten about this sort of thinking. The book is by George Soros, one of the greatest of all time:

   The Alchemy of Finance

He talks about reflexivity, and it sort of differentiates the traditional economists viewpoint based on static analysis versus his more dynamic view of the world based on reflexivity. (This book is more of interest to traders than long term investors).

For example, if the market goes up, most people assume it must go down because it is overvalued. Economists base their views on supply/demand balance so they think things must trend towards equilibrium. Most comments I hear these days tend to be in this camp.

Soros' view is that in fact, an expensive market can make a market even more expensive.  Why? Because if markets go up and gets overvalued, then financing costs go down and can encourage more profit-making and increased earnings, which can drive prices even higher. Economists wouldn't consider this factor. This is in fact what happened in Japan too in the late 1980's.

I think Soros talks about the REIT boom/bust of the 1970's in this book; maybe it was somewhere else. But the above is exactly what happened.

Anyway, I am going to dig up a copy of this; it must be somewhere around here in one of these boxes or piles of books.

Mean Reversion
Sort of related to the above, here's another thing I hear all the time: mean reversion. I too believe in mean reversion. But there are tradable/investable mean reversions and untradable/uninvestable mean reversions.

Values mean revert, usually. As a value investor, we can buy undervalued stocks and assume mean reversion will enhance our returns. This is investable mean reversion. As long as you are not leveraged, you can just wait for the market to prove you right.

Shorting overvalued stocks is also a mean-reversion trade, but it is untradable.  Ask anyone who was or is short Tesla, Amazon, Netflix. Oh, remember L.A. Gear? Or U.S. Surgical? Anything in 1997-2000? Those are untradable because you will get killed trying to short that stuff even if mean-reversion will eventually kick in. Nobody has that kind of staying power.

So what kind of mean reversion do you want? You want mean reversion that happens OFTEN. You want mean-reversion that is tradable.

Not exactly a mean reversion trade, but take index arbitrage. You go long stocks and short future against it (or vice versa). You know from history that the premium/discount fluctuates over time. But you also know that this spread will not diverge too far apart, and you know that at expiration, your long and short will offset and you can realize the spread perfectly with very little risk. That's a spread you can trade safely. (In fact, one of Soros' early strategies was to arb gold prices between New York and London. I think a long distance phone connection was that era's version of a direct optical fiber connection to exchanges today)

How about options volatility? For shorter dated options, trading volatility works too. You may or may not make money, but volatility cycles are often not that long so you can capture volatility by trading options. You may need some staying power, though, because sometimes you sell volatility at 30% and it goes to 40% or 50%. But you know that eventually, these panic levels will subside at some point for much lower volatility.

What about stat arbs?  These guys too, especially the high-frequency guys, are trading mean-reversion. The one mentioned in the Thorp book, I think, was based on 2-week returns in stocks. Stat arbs these days turn over their portfolios multiple times in a day (I am guessing, but we had high turnover a long time ago; I am assuming it's much faster now), which implies a high level of mean-reversion; each trade is not expected to last very long. Things diverge and revert very quickly.

This has two big advantages (well, probably more but let's keep it simple); first, with so much frequency you have that many more data points. With that many trades, you are that much more likely to make money. With time span so short, the risk of divergence, or spreads widening out even more, is minimal.

Imagine trying to trade inefficiencies in the stock market based on tick data where trades last for minutes. What is the risk?  Hint: tiny on each trade, and since you do so many trades, you are well-diversified and if your data is correct, you are more likely to realize the 'edge'.

Now imagine trying to trade inefficiencies in the stock market where people misprice P/E ratios on individual stocks. The expected duration of a trade can be years (the P/E ratio inefficiency probably will not correct within the next week or even month. Unlikely even in the next year; how many years have TSLA, NFLX and AMZN been overvalued?). Now think of the range of stock prices that a mispriced stock can trade at over that time span.  Now you see how huge the risk is.

Of course, sometimes you can see some sort of deterioration in a company, some manic blowoff or some other 'timing' device that might help you nail a short of an overvalued company. But you see how trading just on valuation on the short side is going to be tough game.

The Market
Let's take all of the above thoughts and apply it to the overall market. People always talk about mean reversion of the market P/E ratio, profit margins and things like that.

Are these factors tradable? If the stock market went to 20-30x P/E and then went down to 8-10x and then went up to 20-30x and kept doing that many times over the years (averaging out at 14-15x), then it turns into a tradable idea. You can set ranges too and calculate probable outcomes and manage risk accordingly.

But looking at long term data, that's not really the case. It's more like these things happen very rarely and over long periods of time. Most people talk about what happened in 1929, 1968, 1987, 2000 or whatever. I think it was Buffett (but may have been Munger) who said that to bet on something that happened just a few times over the last 100 years does not sound like a good idea.

Again, the same questions apply: when is the expected reversion? What is the risk? If the reversion is not expected in the short term (next week, next month, within the year etc...), then what is adverse move against you going to cost?

Interest rates mean revert too, but look at the rates in the past 100, 200 years. If you want to realize any 'edge' in the long term mean-reversion of interest rates, you have to play for decades, and the reversion may not even occur within a single generation.

Back to Fairfax India
Emerging markets haven't been so hot in recent years, but I don't think there is any doubt that that is where a lot of growth is going to come from over the next few years. Much of that growth will be captured by global firms to be sure, so owning global companies will give you exposure without having to invest in emerging markets.

But it's fun to have some direct investment overseas when there is an interesting opportunity. I don't think FFDXF is a unique opportunity right now in terms of value/pricing, but it is an interesting opportunity in that you can co-invest with a successful manager in an investment vehicle focused on India that combines listed stocks and private investments. There are not too many of those ideas.

The option to invest in private deals expands the universe of potential investments so increases the odds of finding winners. The closed nature of this vehicle (not an ETF, mutual fund or hedge fund/partnership) allows them to focus on the long term and not worry about liquidity and short term performance.

With these advantages and with a management that we understand that agrees with out own views on investing makes this an interesting opportunity.

Of course, the value approach to investing is not universally accepted, and Fairfax has its own fair share of long-time critics.  So this is only interesting to those who appreciate the Fairfax track record and what they are trying to do in India.

India Macro
Here are some charts from the FFXDF marketing slides from a couple of years ago. You can get all of this at the SEDAR website:  


Nothing really new here, but just to refresh: 

One huge headwind in the global economy is demographics; this is a problem everywhere, Japan, China, Europe and even the U.S. to a lesser extent than the others. 

And this is India:



A lot of potential for growth in India, and recently trending well:






Singapore II?
Watsa compares what can happen in India going forward to Lee Kuan Yew's Singapore starting in the 1960's. Singapore is a great example of a successful nation, and Munger brings it up all the time too. But we have to remember that Singapore was a tiny island city-state with a population of less than 2 million (in the early 1960's), and a current population of less than 6 million. The area of Singapore is smaller than New York City.

It's one thing to rebuild and lead a nation of 2 million, but it's an entirely different matter to try to do the same with a country with a population that exceeds a billion. Try banning chewing gum in a huge country like India with a 1 billion+ population!

But OK, we get the analogy. Maybe India can't repeat Singapore's performance, but with the right policies, they can still do really well.

Past Performance
These things may not be as indicative of future performance as we'd like to think, but here is the track record of Watsa's India investment management team. They have done really well, but we have to keep in mind that the results are very volatile. We are talking about an emerging market, and a highly concentrated portfolio. Plus not much has happened since 2007 (a lot of volatility!).






One thing that Fairfax fans may not like is the management fee structure. This seems kind of normal in the investment world; 1.5% management fee and 20% incentive fee (but only after 5% hurdle). In this day and age, it might sound a little steep. Maybe it's not so bad when you consider that it is partially a private equity fund.



Why not ETF?
Well, if India is so interesting (and I don't mean in the timing sense, by the way. I don't follow India closely enough to tell you even what the sentiment is like, but I think emerging markets overall here has been out of favor), and the fees are too high, why not go with and indexed ETF?

That may be a good idea. I haven't looked in detail at any of the India ETF's, but emerging market ETF's tend to be packed with large, inefficient, formerly state-run enterprises. Plus who knows when the government dumps (IPO's) a large, stodgy, bureaucratic, inefficient state-run organization onto the market for non-differentiating index funds to blindly buy into (this could be one of your funds!).

I think the inefficiencies in these markets tends to favor the active investor.

Plus, here, you are betting on the continued success of the Fairfax/Watsa investment approach. You don't get that in an index.

Speaking of emerging market funds, it seems like emerging markets have grown at a higher pace than mature economies for decades, and yet how come there aren't really any good emerging market funds with good long term track records? Mark Mobius was a big star back in the 1990's. Last time I looked, his funds' performance was not very good. I wonder about that.  Maybe it's something I should look at in another post. I am always intrigued by the idea of emerging markets, but am almost never sure what to do about it!  (uh oh... reading too many Watsa reports... the exclamation point is contagious!).

There was a time in the late 1980's and early 1990's when all you had to do was to own the telephone companies in each of the emerging markets and you could earn hedge fund-like returns (any ADR with a 'com' (not '.com') in the name would have worked).

Conclusion
Anyway, this may not be for everybody, and it will probably be pretty volatile but it's an interesting thing to keep an eye on, or tuck into your portfolio somewhere and just forget about it and check back in a few years.


Friday, April 7, 2017

JP Morgan 2016 Annual Report (JPM)

I haven't posted much about JPM recently as it's still basically the same story. Great CEO building an awesome company performing really well etc.  After even a couple of posts, they are basically the same.

But since I haven't been too active here recently, I figured why not? Let's take a look at this. There is a lot to learn here, not just about banking and the economy, but about markets and investing too.

So first of all, let's look at how well JPM has done in recent years. And it's not just because of the huge bull market since 2008. If you look at the performance figures below, they go back to 2004, and the performance chart in the proxy is from 2007, which is the benchmark I use to get 'through-the-cycle' returns.

Anyway, Dimon's Letter to Shareholders is really good so go read it if you haven't done so already. I sort of look forward to this one even more than Buffett's lately.

Check out the total return of JPM stock over various time periods:



This is really crazy given what has happened since 2000 and particularly after 2007. Back in 2000, I don't think anyone would have guessed JPM stock would outperform the S&P 500 index over the next 16 years. People were bearish the financials after the collapse of the 1999/2000 internet bubble, especially JPM which had a large investment bank attached to it with trillions in notional derivatives outstanding. For years, JPM has been considered the first domino in the coming financial collapse.

And yet, look at that! Yes, bears will argue that JPM got bailed out during the crisis etc. I've talked about that a lot here so won't go into it too much, but I disagree. I agree that the government bailed out the whole system, which is what it should do (that's what the Fed is for, and that's what the government has the power to do in extraordinary situations).  But I don't think JPM was in any danger unless the whole system itself collapsed, in which case nothing would matter anyway. 

So let's look at the performance of the company itself:


This is just totally insane. TBPS has increased even more than the stock (total return).

Here's a chart from the proxy that is indexed to 2007:


That's a 10.5%/year return since 2007.  That's crazy. Let's say you knew that the worst financial crisis would come and almost destroy the country. People would have called you an idiot if you said, "Fine. I don't care. My stock will return 10.5%/year over the next 9 years!".  In fact, I did own JPM and didn't sell in front of it, even when cracks appeared. I didn't sell any during or immediately after either. 



Investment Lessons
And here's sort of the lesson on investing. It was widely known that Dimon was a super-competent manager when he took over Bank One. I think he was already considered at the time one of the best managers in finance. When he left Citigroup, many thought C would collapse because Dimon was the detail guy that made sure everything was OK.  Sandy was a big picture guy while Dimon chased after the details. No Dimon == noone looking at the details => eventual blowup. (I heard this from someone that was there at the time and watched how they worked up close too.)

But a lot of people didn't invest in JPM because it was a large money-center bank and banking cycles tended to be severe. Everyone remembers the banking crisis of the 1970's and the late 80's/early 90's.
So the thought was 'thanks, but no thanks'.  I confess I was one of those. I've owned Bank One since forever and JPM too, but never allowed it to become a huge position because of that. (On the other hand, I would not mind being 100% in Berkshire Hathaway, even though BRK has gone down 50% on a number of occasions).

In 2007, bank stocks were expensive and we were at the tail end of a very long credit cycle. Contrary to the claims of some best-selling books, the leverage built upon shrinking credit spreads was pretty well-known within the industry. It would have been wise to not be too exposed to financials at this point.

But, when you own a great business run by great people, it is often better off to ride out the cycles than to try to time them.  And that's another lesson here with JPM stock. This is not really hindsight trading either, as I would have told you back in 2007 (and I think I did even though this blog was not in existence back then) that JPM and GS would be the survivors in any crisis, and they would come out the other end bigger and stronger (as Charlie Munger says about how great companies grow; they grow in bad times, just like Rockefeller, Carnegie and everyone else did).

The argument back in 2007 really focused a lot on the notional derivatives outstanding at JPM. This was one of the major red flags that kept some investors away. I have managed derivatives before so understood that notional amounts outstanding is not a measure of risk. When you are a big banker and dealer, you end up with huge amounts of notionals outstanding because, for example, if you issue bonds for an issuer, you sometimes do interest rate swaps to accommodate the client's cash flow needs. Same with FX. As a major FX dealer, you often use swaps as a tool to help risk-manage clients' risk exposure.  Those 'straight' swaps often have very little risk.

Cyclical or Secular?
The other lesson is that markets have cycles. After the financial crisis and after JPM has shown its resilience and management competence, it traded cheaply for a long time. Even the most prominent bank analysts would say things like, "Yes, it's cheap, but there is no reason to own it as regulations make it hard for them to make money...". I've heard that argument over and over again post-crisis.

But these folks held a linear, static model in their heads. They didn't realize, or underestimated how the industry would adjust to new regulations and requirements. If the regulatory capital burden got too heavy in a line of business, they would drop it. They can cut expenses. They can reprice products as new regulations apply across the industry.  Sure, they may not get back to bubble-era returns, but banks don't need to to be good investments.

Maybe this was due to the short-term nature of Wall Street; with regulatory headwinds and low interest rates, bank stocks were simply not recommendable.

Either way, long term value investors look to invest in great businesses at reasonable (or cheap if available) prices.

And interestingly, now, hedge funds and others seem to be piling into banks.  Nobody wanted JPM at $20 or even $40, and now they are piling in at over $80!  And people say the market is efficient, picked over etc.?

I think all of this sort of just illustrates the cyclical nature of markets. The key in successful investing is being able to see the difference between cyclical and secular. It's true that this is very hard a lot of the time. But I never thought banking itself was in secular decline. Every year, Dimon has shown how much business needed to be done over the long term in banking.

Regulations tend to be cyclical too as the pendulum can swing wildly from one extreme to the other. We are now seeing the pendulum start to swing back the other way. As Dimon says, a lot of this can be done (simplify regulations) without congressional action.

By the way, I have a lot to say about this, maybe in future posts, but I do believe that this max exodus out of hedge funds too is cyclical, as is the move towards machines (vs. people) / indexing. I do believe that most hedge funds probably don't deserve to exist, and machines will more and more take over money management, but I think it will still be very cyclical.  We have seen this before in the past; move to quantitative money management, indexing vs. active, hedge funds vs. index etc...

Buffett and WFC
And this sort of thing explains why Buffett has been buying WFC for all these years, even right before the crisis. I always heard comments like, "doesn't Buffett see this big trouble brewing? This huge storm?  Doesn't he understand that the era of big banks is over?". He has been buying before, during and after the crisis at 'high' prices.

He focuses on what a business can earn on a normalized basis over time, so he doesn't care about the short term outlook. He doesn't care about what other people say. He doesn't worry about downturns as strong institutions should be managed to survive and grow in such situations. Trading in and out to avoid such dips is a loser's game.





2x Tangible Book
Dimon says it was a no-brainer to buy back stock at 1x tangible book, but says this year that it still makes sense to buy back stock at 2x TBPS. That would be over $100/share!

That sounds insane. Who would have even guessed JPM would be closing in on $100 just a couple of year ago? 

Assuming a 50% payout ratio on $6.00 or so in EPS, that would be $3.00/share in dividends.  Using a $100/share price, that's a 3% dividend yield.  Assuming JPM grows along with the economy (4% nominal), that's an expected total return of 7%/year against what I would assume a normalized long term rate of 4% (actual is 2.3%).  As a sanity check, EPS grew around 4%/year from 2007 to 2016. 

OK, students will immediately jump on me and argue that earnings growth should be 6.5%/year for a 9.5%/year return (50% retention at 13%). Well, JPM is a big bank so it may not be able to grow that much more than GDP over time, so let's just say earnings grow at nominal GDP.  That would just mean that payouts would be higher as capital can't be invested at a 6.5% growth rate.  

In that case, payouts may be 70%.  On a $6/share EPS, a 70% payout is a $4.20/share dividend for a yield of 4.2% (again, at a $100 stock price).  4.2% dividend yield plus 4% growth is 8.2% expected return. 

This reminds me of Buffett talking about how he bought a stock yielding more than the financial products the company was selling. 

Of course, as we wait for things to normalize, bad debt may normalize too; JPM is sort of over-earning in the sense that credit trends are really good now. This has probably bottomed out and should head higher. I don't think there are any time bombs at JPM, but it will sort of be a race on the economy picking up steam and interest rates normalizing versus credit trends bottoming out. 

But of course, stocks never trade at what they are supposed to trade at. Which leads to my next digression.

Models and Odds: Ed Thorp Book
I was actually going to make this a whole separate post; maybe I still will.  But writing the above got me back to thinking about models, odds and things like that.

This goes back to the argument about stocks being expensive or not, wondering about being short because the market is overpriced and losing money for years on end etc.

I just finished this book by Ed Thorp:  A Man for All Markets

And I have to say it's one of the best books I've read in a long time. It's not a manual like Securities Analysis or the Greenblatt books, but an autobiography.  But it is a fascinating read. Some may be disappointed by the lack of mathematical details, but this is not meant to be that sort of book. In any case, the math involved in what he talks about is widely available now anyway. But the thinking that went behind figuring all this out is fascinating.

Other than his adventures in Las Vegas, I've been involved in just about every area he talks about in the book, from options, warrants, convertible bonds, closed-end funds, even the Palm stub trade, statistical arbitrage etc. (One thing he fails to mention about the Palm trade is that even though it looks like the market is inefficient, in some cases, there is no stock to borrow to implement the trade; rebates go through the roof and reduces or takes away potential profit etc... The stock lending side is often not as visible).

For Buffett fans, there is a whole chapter on Warren Buffett, which is fun to read. They knew each other and Buffett even checked him out over dinner long ago.  Thorp also invested in Berkshire Hathaway but moved his money elsewhere as returns went down as BRK got larger.

One interesting fact that Thorp mentions is that the Buffett partnership returned 29.5%/year, gross, in the 12 years from 1956-1968 versus 19%/year for small caps stocks and 10% for large caps. I knew Buffett made his money buying small/microcaps back then, but it was surprising that a good half of the outperformance came from the small cap bias.  Maybe I should not have been surprised.  But anyway, I did take note of that as I read the book.

OK. Back to models. Early in my career, I spent a lot of time creating models; economic models, stock market valuation models, statistical models, single stock valuation models, technical trading systems, mean-reversion trading models (early stat-arb) etc...

And what struck me while reading the Thorp book was the difference between the typical economist who creates models and the traders that write models.

Economists plug in all these numbers and tell you that the economy should do this or that, and that the market should be valued here or there. And sometimes, they get all caught up in their models and think they are absolutely right and get their head handed to them.  I've seen this happen time and again. One benefit of working at a large firm was that I sat through many presentations (people pitching big banks to fund their proprietary trading models/ideas).  And a lot of the ideas lacked real world common sense.

And then you read what Thorp did. For example, he created the option model before or at the same time as Black-Scholes etc. This model told you what an option or warrant was theoretically worth. But the model would have been useless if there wasn't a way to capture the price difference. You can hedge the option by trading the stock and capture any mispricing.

All of the strategies that Thorp was involved in had very specific odds attached to them, including the possibility of adverse outcomes. What are the odds of this or that? What happens when you are on an expected, normal losing streak? You have to have enough capital to be able to stay in the game. Traders' models usually have a "what if this happens, or what if that happens? what are the odds of this or that happening?".  Economist models are like, "This is what will happen and all the back-testing proves it will happen... we have calculated to the seventh decimal places using 30 models and they all confirm we are right". If you ask them, but what if reality deviates from the model? They say, "it won't because we are right".

Even some investors I respect had a huge hedge on their equity book that lost them tons of money. It made sense on the surface; stocks are expensive so we must hedge our equity exposure. The problem is that, as I have shown in previous posts, overvaluation is a very poor reason to go short the market or put on hedges (well, it might make sense to do some hedging).

I've seen the bubble in Japan in 1989 and the U.S. bubble in 1999 and I would guess that most people who correctly identified those as bubbles didn't make money when the markets collapsed. It was stunning how many funds were hurt during the late stages of the bubble and weren't around to capitalize when they were proven correct.

The problem with overvalued markets is that the odds of a blow-off are pretty high, and when things blow off, the more expensive things are, the higher they go. So, if you own a bunch of value stocks and hedge using the S&P 500 index or some other market cap-weighted index, you will probably be destroyed as the expensive large caps will go up the most.  (This reminds me of something I did long ago; I owned some value stocks that went up 20-30% so was proud of myself, but was short Starbucks against it and that doubled... Oops.  So much for hedging a value portfolio with a growth/mo-mo stock).

There was an interesting article recently that said that a bubble isn't a bubble unless the market has gone up 100% over a period of two or three years or something like that.

This is why people like Thorp would not make directional bets on the market. One can easily observe that markets are expensive, but what is the edge that that specific observation brings to you?  I remember Buffett telling someone, when shown a chart of how overvalued the stock market is, that it's just a squiggly line and it can go this way or that way, who knows which way it would go? That seemingly 'clueless' response is much wiser than it seems on the surface.

If you hedge using market-cap weighted indices or go net short, can you survive a real bubble-like blow-off? What are the odds of such an event occuring?  Is it really zero? I bet that this is not even incorporated in most models or the thinking of most investors. Of course, most of the quant funds would have this worked out (or hedged out); quants don't like to take risks that they can't hedge.

On the other hand, if you are a long manager, do you need to care about the odds of a correction? No, because if you own solid stocks that won't go bust (like owning JPM from 2007-2016), then corrections don't really matter. You just ride it out. The only way the market can break you is if the companies you own actually go out of business.  Otherwise, you may just have to wait longer to realize value. But otherwise, there is not that much risk.  This is not true when you are short, of course; it is much easier and probability of survival higher for a long to live through a bear market than the other way around.

Cheap Labor
Back to JPM. The great thing about JPM is that we get all of this for so cheap. OK, 'cheap' may be offensive to average folks out there earning normal salaries. So I shouldn't say that too much. But still, cheap is cheap. We paid Dimon 0.1% of profits. Compare that to other financials! (from the proxy).  Let's not get into hedge fund fees here.



...also from the proxy:



And for the Berk-heads here, a familiar new face on the board:



OK, this is getting way too long.  There is a lot more in Dimon's Letter to Shareholders so go read it. I may post more about it later (but maybe not), but let me just get this post out before more time goes by without a post!