“There’s Always Something to Do” by Christopher Risso-Gill

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I just finished “There’s Always Something To Do” and enjoyed the book. It is a quick read about one of the greatest investors of all time, Peter Cundill. Peter was a fascinating and wise individual. In addition to successfully navigating the markets, Peter also valued fitness and regularly ran marathons in under 3 hours.

Sadly, Peter passed away at the age of 72 after a struggle with a rare neurological disorder, ActiveX.

Peter Cundill’s Epiphany

Peter Cundill was a Canadian investor who began investing in the late 1950s and 1960s. He had value instincts, but never took a true value-oriented approach during that period and was disappointed by his results.

In 1973 at the age of 35, Cundill read “Super Money” by Adam Smith on a plane ride. “Supermoney” took a close look at the insane money culture of the 1960s (not dissimilar from the insane money culture that rears its ugly head during every bull market) and found one group of people who stuck out as different: the disciples of Benjamin Graham. Featured prominently were a young Warren Buffett and Walter Schloss.

Reading the book was an epiphany for Cundill. He absorbed all of Graham and Dodd’s work. Of particular interest to him was Chapter 41 of Security Analysis, “The Asset Value Factor in Common Stock Valuation”. After a careful evaluation of Graham and Dodd’s work, Cundill decided to launch his value-oriented strategy. He explained the shift in strategy in a letter to his investors in which he said:

“The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favorable investment opportunities.”

The Peter Cundill Stock Screen

In addition to explaining the overall strategy, Cundill also set strict quantitative criteria for his fund. The criteria included:

  • The price must be less than book value, preferably less than net working capital.
  • The price must be less than one half of the former high and preferably at or near its all-time low.
  • The price-earnings multiple must be less than 10 or the inverse of the long-term corporate bond rate, whichever is the less.
  • Over the last five years, the company was profitable each year and increased its earnings over the five year period.
  • The company must pay dividends
  • Low levels of long-term debt.

Peter also set sell rules for his fund, agreeing to sell at last half of any given position after its price had doubled. Peter looked throughout the world for bargain stocks. He didn’t restrict himself to North American markets and scoured the world for bargains. Every year, he visited the worst performing market in the world while searching for investment opportunities.

He launched his fund at an opportune moment for value investing in 1974, after the calamitous bear market of 1973-74 when everything was crushed.

To give some perspective on how many bargains were available on the market in 1974, here is a great exchange between Forbes magazine and Warren Buffet. Forbes: “How do you feel?” Buffett: “Like an oversexed guy in a whorehouse. Now is the time to invest and get rich.”

Peter’s first decade of deep value investing was extraordinarily successful: from 1974 to 1984, his fund delivered a 26% rate of return.

International Cigar Butts

Peter pursued investment opportunities of the “cigar butt” variety. He didn’t adhere to the Buffett style of buying wonderful companies and holding for the long term. Cundill bought deeply undervalued securities and sold when they reached fair value.

He also didn’t restrict himself to stocks and he took up large positions in distressed debt.

Peter was called the “Canadian Buffett,” but I think his approach shares more similarities with the investment style of Seth Klarman.

Peter’s Wisdom

The book is a short, quick read and covers Peter’s investment career and his unfortunate illness. I wish the book covered Peter’s personal life a bit more in depth, but it was still a good read and filled with bits of Peter’s wisdom. Some of my favorite Peter Cundill quotes are below:

  • “The most important attribute for success in value investing is patience, patience, and more patience. The majority of investors do not possess this characteristic.”
  • “The value method of investing will tend to give better results in slightly down to indifferent markets and less relatively sparkling results in a raging bull market. What matters, however, is that the method will provide a consistent compound rate of return in the middle teens over very long periods of time.”
  • “I’m buying your stock because it’s cheap and for no other reason.” – Peter’s response to the management of J. Walter Thompson, who didn’t understand why Peter was buying their stock!
  • “I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market behavior using a disparate, and almost certainly incomplete, set of statistical variables.”
  • Particularly relevant: “Computers actually don’t do much more than making it quicker for investors to react to information. The problem is that having the information in its raw state on a second by second basis is not all the same thing as interpreting and understanding its implications, and this applies in rising markets as well as falling ones. Spur of the moment reactions to partially digested information are, more often than not, disastrous.”
  • “If it is cheap enough, we don’t care what it is.”
  • “Curiosity is the engine of civilization. If I were to elaborate it would be to say read, read, read and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts. Keep the reading broad, beyond just the professional. This helps to develop one’s sense of perspective on all matters.”
  • “I think it is very useful to develop a contrarian cast of mind combined with a keen sense of what I would call “the natural order of things.” If you can cultivate these two attributes you are unlikely to become infected by dogma and you will begin to have a predisposition towards lateral thinking – making important connections intuitively.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“The Fourth Turning” by William Strauss and Neil Howe

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A Lucky Trip to the Bookstore

When I was a kid, I went with my family to Wildwood, NJ every summer.

As a geek, instead of spending time in the sun like a normal kid, I was mainly drawn to the shore for the pizza and arcades. I would spend most of my time either in an arcade or reading a book.

I’d also make a habit of taking my lawn mowing earnings and buying a book on the boardwalk that I would read back in the motel.

In the summer of 1998, I came across a book that grabbed my attention. It was called Generations: A History of America’s Future from 1584 to 2069. The book (published in 1991) told the story of America’s history as a series of generational biographies. It also informed me that those born during 1982 and after were part of a new generation, called Millennials. (Yes, they coined the term.)

The authors, William Strauss and Neil Howe, were trying to find out if the generation gap that existed between the baby boomers and the G.I. generation during the 1960s was a unique event. They found out that not only was it not a unique event, but there is a rhythm to history caused by different generations interacting with each other.

I finished Generations in that weekend, and I was transfixed by the story. It was a unique way to look at history. Most history books are simply a recounting of events. It never captured what people actually experienced and thought during those times. I went home to my dial-up internet connection and found that they just came out with another book, The Fourth TurningI found that one at a local bookstore and quickly devoured it.

I then found out that Strauss and Howe were active in an online forum hosted on their website for The Fourth Turning. I signed up for an account and interacted with a brilliant community of people who were quite accepting and tolerant of me, a 16-year-old kid who knew very little about anything. I learned a lot interacting with them.

Eventually, I went with my parents and traveled to Washington, D.C. to meet the authors. They were kind and wonderful people. I was very sad to hear years later that William Strauss passed away after a struggle with pancreatic cancer.

I was very fortunate to meet them and become familiar with their unique ideas.

Strauss & Howe’s Theory

Strauss & Howe noticed a rhythm to history. They discovered that there is a cycle of generations that persists throughout history. The generational cycle fuels a sequence of historical moods, defined below. These 4 distinct moods last for roughly 20 years and form an 80-year sequence.

Cycles of History

High – The most recent high was the “American High” that lasted from the end of World War II through the assassination of John F. Kennedy. A high takes place after a civilization-defining crisis. The last crisis was the Great Depression & World War II. After the Crisis is over, everyone wants to get back to normal. Pragmatic civic solutions are embraced and the culture has a long-term orientation. Think of the Presidency of Dwight Eisenhower: interstate highway systems, the establishment of NASA, reductions in public debt. It is an era of strong public institutions and public cohesiveness. Critics would say that highs are also eras of stifling conformity and a lack of creativity. During a high, the outer world is doing well, while the inner world is neglected.

Awakening – The most recent Awakening was the “Consciousness Revolution”. Young people rebelled against the conformity and strong institutions created during the Crisis and strengthened during the High. This is an era during which the established institutions are criticized. A new generation of young people emerges with their own take on morality and culture. It is an era of the challenge to the status quo and a focus on new ideas about values and morality. Cultural creativity surges. While institutions were strong and conformity was reinforced during the high, during an awakening the emphasis of society begins to shift to individualism and new ideas. An awakening is an era in which culture undergoes a renaissance and is fundamentally changed.

I think that Awakenings are the most enlightening and thought-provoking eras in history.

Unraveling – The most recent Unravelling was defined as the “Culture Wars” by Strauss and Howe. In retrospect, I think “The Great Moderation” (coined by economists) is a tremendous alternative term for it. After society has gone through a consciousness-altering and culture shattering awakening, the values of the Awakening begin to become ingrained in our culture. People want to move on and focus on their own lives. This was very much the attitude of the mid-1980s. After the Generation Gap, Vietnam, Watergate, and cultural upheaval, people wanted to settle down and focus on their own lives. The attitude is “after all that, let’s have a good time.”

The culture becomes fragmented and individualistic, with everyone free to pursue their own interests and passions. From the perspective of some, this is an isolating force. Meanwhile, distrust in institutions is high, and they began to show signs of stress. Problems start to brew but are ignored (slavery before the Civil War, the sovereignty of the colonies before the American Revolution, the lack of an international order due to the decline of the British Empire before World War II).

I think that Unravellings are probably the most fun of all the historical eras. Of course, all of that fun comes at a dire cost.

Crisis – We are currently in a Crisis. When the current crisis began is subject to debate. I would argue that it started on 9/11, while I believe Neil Howe says it started in 2008. I prefer 9/11 . . . because I’m an optimist and I would like the Crisis to be resolved sooner rather than later!

The last Crisis was the Great Depression & World War II. This is when the problems that were brewing during the Unravelling come to a head. The institutions that were weakened during the Unravelling, now fall apart and are replaced.

During a Crisis, problems that were mounting during an Unravelling become too big to ignore any longer. Old institutions are torn down and new ones are created. Unfortunately, this unique mood tends to create wars and financial crises.

On the positive side, while Crises throw everything into turmoil, they make the world a stronger place. They create institutions and leadership that beget a stabler and stronger world.

The cycle of historical moods creates a cycle of generations that are shaped by the events. The generations at different life stages create the unique cultural mood of each turning in the cycle. The two drive each other in a kind of historical ecosystem. The generational cycle is below:

Prophets – These are the children of a High. The current example of this is the baby boom generation. Their parents went through hell in the Crisis, and they are determined to create a good life for their children. They are indulged as children. They are encouraged to be inquisitive and to think about the weightier issues facing their civilization. They grow up with a distinctly ideological, moralistic, crusading attitude that carries them through into adulthood. Growing up in a stifling and conformist world that values the technical over the spiritual, they want to create the opposite of that.

Prophets produce intensely ideological leaders and some of the most creative people in history. There is a reason that this generation produced people like Steve Jobs and Steven Spielberg. Creativity and expression are a part of the baby boomer DNA.

Nomads – Nomads are the children of an Awakening. While adults focus on their inner world and challenge cultural conventions, Nomads are left with a mostly unsupervised childhood in which they are encouraged to find themselves and learn about the world on their own. Their parents, the “artist” archetype, grew up with a stifling and strict childhood during the Crisis. They want to give their children more freedom and less structure. This childhood causes Nomads to get into a lot of trouble, but it also creates a generation of richly individualistic and rugged people. Think about ’80s teen movies. There are no parents in sight and if they are around, they’re clueless about what’s going on. They don’t make movies like that anymore because the dynamic wouldn’t resonate with modern audiences.

Parents in modern movies tend to be deeply involved in their child’s lives (for good or bad) because that’s the current dynamic.

Pathologies increase during Nomad youth (drugs, crime, teen pregnancy, etc.), but so does entrepreneurialism. The current example of this is Generation X. It includes some of the greatest entrepreneurs of all time, people like Jeff Bezos. Before them, the last example was the Lost Generation — veterans of World War I, participants in the roaring 20s, and people like Dwight Eisenhower who led society through the Crisis. Growing up in a world that has its head in the clouds, they want to return the world to pragmatic reality.

Heroes – Heroes are the children of an Unravelling. Their parents are predominantly Prophets who want to instill their ideas and values into their children. They are fiercely devoted to raising their children and maximizing their future. They are nurtured as children but given more structure and attention from society than Nomads. The current example is the Millennial generation.

While Generation X was growing up, for instance, Disney ceased making animated films, and the culture became somewhat indifferent towards young children. All of that changed with the arrival of Millennials, with a society entirely focused on preparing children for the future. Pathologies get better — Millennials actually improved crime rates, SAT scores, and have lower rates of teen pregnancy than their Xer peers. They are conformist and prone to groupthink, far less individualistic than their Xer and Boomer elders. They also tend to be more optimistic than Prophets and Nomads.

The last hero generation was the G.I. Generation, Tom Brokaw’s “Greatest Generation”. This was the generation that was young adults during the Great Depression and World War II, who rose to the occasion and acted as a group to save the country. It’s yet to be seen if Millennials will live up to the last Hero generation. I think they will rise to the occasion if challenged. If they don’t . . . well, then I guess I’ll have to focus more on my low Shiller PE international strategy. (I’m biased.)

Growing up during a complacent Unravelling with weakening institutions, Heroes want to see a world that is the opposite of that. Instead of weak institutions, they want healthy institutions, and they want to see those institutions do big things. Big things can be good or bad – think of the Moon landing and the Vietnam War. They are two sides to the same coin. Instead of rampant individualism, they want to create a cohesive conformist culture.

Hero generations are marked by their positive and optimistic attitude. You can see this in modern Millennials. This is in sharp contrast to the youthful attitudes of the 1980s and 1990s, for instance, when it was “cool” to be cynical. It’s not anymore.

Artists – Artists are the children of a Crisis. They are raised primarily by Nomads. Nomads become strict and structured parents after seeing all the trouble that they got into with free reign in their youth. Artists are raised during a civilization-threatening Crisis and this also impacts their outlook. They grow up to be largely conformist young adults, with a deep yearning to break free of that. Entering midlife during an Awakening, they lead the charge into breaking free of conformity and rules. Think of Martin Luther King Jr.

The last Artist generation is the Silent Generation, born between roughly 1930 and 1945. Growing up with strong conformist institutions, they want to see society break free of that and create a more individualistic world. The most prominent member of the Silent Generation in the investing world is the one and only Warren Buffett.

Side note: I love to think of the dynamic between Benjamin Graham (a Nomad  member of the Lost Generation) and Warren (an Artist member of the Silent Generation). Graham was focused in an almost cynical way on intrinsic value to eliminate losses (i.e., the cigar butt approach) after experiencing the speculative fervor of the Unravelling (the 1920s). Graham’s focus was always on how much he could lose and not how much he could make. Warren, while he internalized Graham’s lessons about margin of safety and intrinsic value, took a much more optimistic view of the world (as Artists tend to do) and instead pursued the purchase of “wonderful companies at good prices” and holding for the long term. That right there shows a dynamic between a Nomad view of the world and an Artist perspective.

Criticisms

On the surface, the theory of generational archetypes coming in sequence and seasons of history sounds a bit new-agey and mystical. It’s really not. Strauss and Howe’s observation is simply that different generations raise their children in unique ways (usually in critical ways that are different from the way they were raised). Those children then grow up and raise their children differently than the way their parents raised them. They think they are doing something “unique,” but most of it was already done before.

The cycle of different generations raising their children in different ways creates unique personalities to generations.

These personalities align at different life stages create unique cultural moods. A society in which Artists are calling the shots (i.e., the ’80s and ’90s) will be uniquely individualistic to a point where younger generations will find it isolating (think Bowling Alone). A society in which Nomads are calling the shots (the late 1940s and 1950s) will be pragmatic to the point where younger people find it soul-deadening (think The Man in the Grey Flannel Suit).  A nation run by Prophets (the 2000s and today) will seem overrun with overblown ideology. A society run by Heroes (the 1960s and 1970s) will seem capable of achieving anything, but spiritually empty.

Another criticism is the claim that the generational theory is a vain attempt to predict events. This is not the case. Good and bad events happen throughout each stage of history. Strauss and Howe are quick to point out that they are not anticipating specific events, they are predicting a general cultural mood that will react to events in unique ways.

A Crisis era generational alignment (Prophets are in power, Nomads are in Midlife, Heroes are young adults) will react to events differently than an Unravelling era generational alignment (Artists are in power, Prophets are in Midlife, Nomads are young adults). In an Unravelling, after a foreign attack, the country will try to find a quick solution. In a Crisis, after a foreign attack, the Prophet instinct will be to use this as an opportunity to enact sweeping changes and mobilize. Think of George W. Bush’s declaration of an “Axis of Evil” after 9/11.

A crisis is merely an era in which institutions are run by Prophets. Prophets tend to have itchy trigger fingers to impose their moral will, and they will have a compliant cohort of young Heroes who can help them make that happen. This doesn’t mean a war must be the way that the crisis is resolved, but the unique assembly of generations at different lifecycles raises the probability of it.

That’s the key to generational theory. It’s not the events themselves that drive history, it is the reaction of civilization to those unique events.

Similarly, an Unravelling is an era in which Artists are running the show and want society to fully embrace individualism. With crumbling institutions and an individualistic entrepreneurial “kill what you eat” young cohort of Nomads, it’s natural for a society to become financially reckless.

Another criticism is that this theory ignores the unique personality of people within a generation, who may not ascribe to these stereotypes. This is valid, but I think it’s hard to deny that each generation has a unique personality. There are people within the generation who defy generational stereotypes, but on the whole, they do have a distinct character, and there are commonalities.

The Bad News & The Good News

The next 10 years will likely see this era resolve itself. 2025 is exactly 80 years after 1945, the year that the last crisis ended. This means that we are entering a dangerous time in history in which we will need to rise to the occasion. We will face a challenge of history on par with the American Revolution, the Civil War, and World War II. New institutions will likely be created, and old ones will be torn down.

I hope this era doesn’t end the United State’s position are the world’s preeminent superpower, but that is indeed a possibility. It might very well set the stage for another country’s emergence as a superpower. It may also result in better global institutions and cooperation.

The excellent news is that regardless of how this crisis shakes out, it’s eventually going to be over and we will enter the First Turning in the next decade. The First Turning will be rigid, conformist and corporatist — but the economy will likely do very well, and I’ll take that over a Crisis.

Investing & Economics

In terms of investing ideas, I was struck by how Strauss and Howe’s ideas align with Ray Dalio’s thoughts about the long-term debt cycle. Dalio identified an 80-year debt cycle (the last one culminated in 2008, the one before that in 1929) that strongly aligns with Strauss and Howe’s theories.

Dalio has a mammoth paper about this, that is well worth your time. He also has an excellent short video explaining this that I’ve mentioned before on this blog.

Another interesting parallel is the work of Hyman Minsky. Minsky described a financial cycle which I think fits into the larger 80-year cycle. Minsky’s idea (similar to Dalio’s) is that debt drives the long-term economic cycle. After a financial crisis (the Great Depression or the 2008 financial crisis), firms avoid debt. This reduces the risks to the financial system. Over time, the reduced financial risk will ultimately spur more lending and borrowing. Increasing debt levels increases the risks to the financial system, which ultimately turn into a Crisis moment. The Crisis moment changes attitudes towards debt, and the cycle repeats.

(Disclaimer: As I wrote earlier, while Macro is a lot of fun to think and theorize about, it is in most investor’s interest to avoid it. Even though I know this, I simply can’t help myself!)

Conclusion

I think you should read this book. This book changed the way I look at the world and I think it will change your perspective, too. You’ll not only gain unique insights into history, you will begin to see people of different generations in a new light. Current events will also make a lot of sense through a generational lens.

Even if you don’t buy into Strauss and Howe’s theory, you will enjoy looking at history through the perspective of culture and people instead of a simple recounting of events.

Low CAPE Indexing: EPOL, EWS, EWZ, ERUS, TUR

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After deliberating the issue for the last month, I decided to go ahead and deploy my cash balance and place 10% of my portfolio into global indexes boasting a low CAPE ratio. Today I executed the below trades, which places 10% of my portfolio into the five country indexes boasting the lowest CAPE ratios in the world:

Poland – EPOL – 36 Shares @ $27.245

Singapore – EWS – 39 shares @ $25.215

Brazil – EWZ – 23 shares @ $42.625

Russia – ERUS – 29 shares @ $34.0795

Turkey – TUR – 23 shares @ $41.935

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Growth doesn’t bring much to the party

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Counterintuitive Findings

Prior to reading Deep Value by Tobias Carlisle, I always thought that the key in value investing was to find cheap companies that could grow fast.

Buffett even discussed the merits of combining growth and value in his 1992 letter:

Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

A key point of Tobias’ book is that growth is not how value delivers returns. The discount from intrinsic value and the closing of that gap is the key driver of return in a value portfolio.

De Bont & Thaler

He cites two studies in the book that are compelling because of how counterintuitive they are. They were both conducted by Werner De Bondt and Richard Thaler. The first study looked at the best-performing stocks and compared them to the worst performing stocks in terms of price performance. They found that the worst performers go on to outperform the best by a substantial margin.

They also looked at this in terms of fundamental earnings growth. They reached the same conclusion: the worst companies outperform the best.

A Simple Backtest

I decided to backtest more recent data myself to see if this still holds true. In an S&P 500 universe, I performed a backtest going back to 1999. I compared the performance of the 30 companies with the fastest growth in earnings per share to a portfolio of the 30 worst stocks, rebalanced annually.

Just as De Bont & Thaler determined before, the 30 worst companies continue to outperform the 30 best.

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Keep in mind: there is no other factor involved here except for 1-year earnings growth. We’re not even looking at these stocks in a value universe: it’s simply the 30 fastest growers vs. the 30 worst.

Value Drives Returns

The evidence suggests that value alone is the best determinant of future returns. Growth isn’t nearly as powerful.

For instance, I also tested the performance of a universe of stocks with a P/E less than 10. This universe of stocks delivered an 11.69% rate of return since 1999. Within this winning universe, if you bought the 20 stocks with the best earnings per share growth then the return actually declined to 9.77%. Fast growing value stocks actually underperform the overall value universe.

The same is also true from a macro standpoint. Looking at the performance of the S&P 500 since the 1950s, the greater determinant of future returns is starting valuation, not actual business performance.

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As you can see, the valuation of the market at the start of the decade (Shiller CAPE and the average investor allocation to equities – both valuation metrics are discussed in this blog post) are far more predictive of future returns than actual business performance.

Look at where the divergence is widest — the 1980s versus the 2000s.

The 2000s was a much better decade than the 1980s in terms of actual business performance. During the 2000s, earnings grew by 191%. In the 1980s, earnings only grew by 16.40%.

However, the 1980s witnessed a 409% total return for the S&P 500, while the 2000s actually clocked in a net decline of 9%.

Of course, there were macro events driving both markets. In the 1980s, returns were bolstered by interest rates declining from all-time highs once inflation was brought under control. At the end of the 2000s, we suffered the worst financial crisis since the Great Depression and the worst recession since the early 1980s, which negatively impacted stocks at the end of the decade.

With that said, the key factor behind the returns was the overall valuation of the market, not macro events or even business performance.

The undervaluation of the US market in the early 1980s was the true force that propelled the bull market forward.  In 1980, the Shiller CAPE for the US market was 8.85 and the average investor allocation to equities was only 23%.

In contrast, the overvaluation of the US market in 2000 was the key force that drove down returns over the next decade. In 2000, the Shiller CAPE was 43.77 and the average investor allocation to equities was 50.84%. Actual corporate results were impressive but that wasn’t enough. Valuation mattered more.

Conclusion

The conclusion is both simple and radically counterintuitive: valuation matters more than growth in predicting future returns for a single company stock or an entire market.

In the long run, growth simply doesn’t bring much to the party.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

A financial health check up for the S&P 500

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Debt: The Best Measure of Risk

One of my core beliefs as an investor is that debt is the best measure of risk.

Academic attempts to define risk as the volatility of a stock price are ridiculous. Risk is the possibility of a permanent loss of capital. The risk that a company will go out of business is heightened through the use of leverage.

There is no perfect measure of risk, but I think that debt levels give the clearest signals about the risk of an investment. A company without debt can withstand incredible business problems, while a company in deep debt won’t be able to survive the slightest shake-up.

Debt levels are one of my chief concerns when I purchase a stock.

As a deep value investor, I focus on firms that are going through a tough time in their business or sector. Because they are going through difficulty, it is paramount that balance sheet risk is low. If they have a healthy balance sheet, then they will be able to survive whatever trouble they are mired in.

I try to find the firms that are still profitable and are still in a strong financial position so they can survive the temporary business setback.

Corporate debt at all-time highs!

Due to my views on the subject, I was alarmed when I read several articles indicating that debt is rising to all-time highs within the S&P 500. High leverage levels were one of the driving forces behind the crisis of 2008.

The narrative of the corporate debt scare articles goes like this: (1) the Fed made debt too cheap after the crisis, (2) companies are taking advantage of it and spending it on frivolous activities like buying back shares, (3) corporate debt is now at all-time highs and will trigger a severe credit contraction in the future.

The headlines are usually along the lines of “corporate debt is at all-time highs!”

Well . . . based on inflation alone, corporate debt should regularly hit all-time highs in raw dollar terms. Looking at the total dollar volume of debt issuance doesn’t make a lot of sense.

The Real Story

What, then, is the best way to measure the debt risks to corporate America? Many like interest coverage ratios . . . but I don’t like this, as interest rates can change on a dime for the better or the worse. I look at total debt relative to earnings and assets.

When I assembled the data, I was pleasantly surprised to see that the situation is actually not that bad. Corporate America is financially healthy. Despite record low interest rates, corporate America hasn’t gone on a debt binge. Quite the opposite. They have been deleveraging since the crisis.

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This suggests that if we do fall into a recession, it won’t be the painful credit crunch we endured in 2008. Even though interest rates are at historic lows, corporate America is not taking the bait.

This also explains why the Fed has been able to keep interest rates near all-time lows. Few companies are actually taking advantage of the low rates.

Financial journalism is in the business of creating sensational click-bait headlines. They aren’t particularly useful. This is why individual investors need to do their own homework and think independently.

I think low corporate debt is also is a major reason that the economy isn’t growing more than 2% even though interest rates are rock bottom.

While it means less growth for the economy, it also means less risk for corporate America. That’s a good thing.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Macro is hard and probably a waste of time

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Macro is probably a waste of time, but I can’t help myself

Everywhere I turn in discussions of the stock market, everyone seems to have made a similar conclusion: (1) The stock market is in a bubble, (2) the Federal Reserve created the bubble, (3) When the bubble bursts, we will be faced with financial Armageddon.

The mood among value investors looking at a historically high CAPE ratio is something like this:

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I love talking and thinking about Macro, but I suspect it is mostly a fun waste of time and not entirely useful. Peter Lynch offered the following advice about these matters:

Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.

Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

I think living through 2008 might have polluted everyone’s minds, the same way 1929 poisoned the minds of a generation of investors and made them stay out of the market for life to their own detriment.

Unlike the 2000-02 meltdown, in 2008 there was nowhere to hide. This is because the 2000 collapse was driven by an overvalued stock market falling apart. 2008 was different because it was an economy-wide credit contraction that caused everything to decline.

This left investors with a kind of financial PTSD. As for myself, I had hardly any money at the time, so I wasn’t concerned about my financial assets going down, but I was still consumed by fear.

By day I am an operations nerd for a bank, so I was acutely aware of what was going on. I had very little savings (I was in my mid-20’s and had just started making decent money), a pile of debt and I was mostly worried about basic survival if I lost my job and faced a Depression job market. My main personal lesson from the crisis was about the dangers of being in too much debt and not having sufficient savings. Today I have zero debt and an emergency fund if I lose my job. I sleep better at night.

If anything, this is why the simple low-PE low-debt Graham strategy intuitively appeals to me. Financial problems facing a company or a person are always manageable . . . Unless you’re in heavy debt.

Post-crisis, everyone is consumed with trying to predict the next meltdown after getting burned so badly.

We look at investors who made the right call — people like John Paulson — and are in awe that they made the right call. They knew what was going to happen. We want to be able to predict what is going to happen. We become obsessed with finding tools that will help us prevent losing money.

Post-crisis hindsight also puts the permanent bears in a positive light. They are lauded for getting it right in 2008, but how much money has been lost listening to them since then?

Prediction is Hard

As small investors, I think we may have to just accept the fact that if we want equity-sized returns, we need to take equity-sized risks. A 25% drawdown a couple times a decade is pretty standard. A 50%+ drawdown 3 or 4 times a century is also typical. The average person lives about 80 years, so when they see these events happen a couple of times it looks extraordinary in the context of our lives and permanently affects our thinking. In the grand scheme of things, these events are not uncommon and we should expect them.

Charlie Munger gave this great advice about the subject:

This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%.  I think it’s in the nature of long-term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%.  In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

We can’t invest like 1929 or 2008 are going to occur tomorrow. It’s not a useful long-term strategy for building wealth. We need to accept the fact that we will face those kinds of drawdowns and face the fact that there will be more minor drawdowns frequently (or the 20-25% variety) and don’t give into our emotional need to panic. If we constantly live in fear that a big drawdown is imminent, then we should stay out of the market and won’t earn equity sized returns.

Using valuation tools to time to the market

There are tools to predict future market returns (like the CAPE ratio, the average equity allocation, market-cap-to-GDP, etc.) that give us clues as to where we stand in the cycle, but timing the market using those tools isn’t particularly effective either. I’ve talked about them on this blog.

You can use these tools to predict market returns 10 years out, but it doesn’t tell you if a correction is going to happen tomorrow and they are not particularly useful for timing the market.

The 10-year S&P returns predicted by valuation tools don’t happen in a straight line. My favorite indicator (the average equity allocation), suggests a 10-year rate of return for the S&P 500 of 3.34%. With the 10-year treasury yielding only 2.361%, that actually makes sense. We are likely in store for a decade of low returns across all asset classes. “Low returns over 10 years” does not mean “We are facing Old Testament biblical meltdown.”

(Hell, if we were facing an Old Testament Mad Max kind of situation, what good is your 401(k) going to do you anyway?)

You can use market valuation tools to get a fair understanding of what returns will look like, but it is not a crystal ball. It doesn’t predict if a crash will happen tomorrow or what the road to those returns will look like.

Current valuations are basically where we were around 1973 and 1998. The 10 years after ’73 and ’98 were not particularly good for the indexes . . .  but they were great for value investors, the indexes still delivered a small return, and the world didn’t end. Value stocks had an excellent bull market from 2000-2003 and 1975-1978.

The difference between the two eras is that in 1973-74, value stocks went down with everything else before their bull market in 1975 and in 2000-03 value experienced a bull market during the decline of everything else.

This happened because the 1973-74 event was caused by a real economic shock, while the 2000-03 meltdown was the stock market coming back down from crazy valuations. The 2000-03 collapse was unique in that the market caused the economy to contract, while most meltdowns (like ’73-’74 and ’07-’09) are the economy causing the market to contract. The stock market wasn’t overvalued in 2008, the real estate market was. The decline in real estate caused the economic contraction, which ultimately impacted stocks.

Whether the current situation is like the ’70s or the early 2000s is tough to predict. I suspect that it will be more like the ’70s (value will go down in the bear market with everything else, but then perform nicely). Hopefully I’m wrong and it pans out more like the 2000-03 event. This is discussed in depth in this blog post.

It’s also tempting to short stocks in this environment, but that’s not something I do. You shouldn’t do it, either (unless your name is David Einhorn). Shorting is a dangerous game. For instance, tech shorts in 1999 were correct in their analysis. Even though they were right, most were completely wiped out when tech stocks doubled in 1999. They were ultimately vindicated but, as Keynes warned us, markets can stay irrational longer than you can remain solvent.

It’s tempting to try to time the market with macro valuation tools. I found a great post at Tobias Carlisle’s blog exploring this issue of timing the market using CAPE ratios. You can read the post here and here.  The conclusion is simple: timing the market using valuation tools is a waste of time. He makes the following point:

The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns.

Japan

Japan in the 1980s is the common comparison among bears to today’s market. There was a similar sentiment among bears in the late ’90s.

In the 1980s, the success of Japanese firms combined with an easy monetary policy caused a massive asset bubble. There was a widespread perception that Japan was going to take over the world.

Easy monetary policy and rising asset prices are where the comparison ends, however. Valuations in late 1980s Japan were genuinely insane. In 1989, the real estate around Japan’s imperial palace was worth more than all the real estate in the entire state of California.

During the 1980s, the Nikkei rose from around 6,600 in 1980 to 38,000 by 1989. Everyone thought that Japan had figured it out: their management was superior, their workers were better, their processes were more efficient. The zeitgeist was captured in the Ron Howard movie “Gung Ho.”

Like all bubbles, the Japanese bubble collapsed. The Nikkei fell from its high of 38,000 in 1989 to 9,000 in 2003. This is the nightmare scenario that the bears fear will happen to the United States stock market.

Valuation puts this in context. Today’s investors fret of a Shiller PE around 30. In Japan circa 1989, the Shiller PE was three times that at 90. Indeed, there is no comparison between US stocks today and Japanese stocks in the 1980s. Valuations today suggest bad returns in the future for US stocks. Valuations in Japan indicated that a complete collapse was inevitable.

Lost from the typical talk of Japan’s lost decade is a discussion of its actual economy. The focus is solely on the markets. Japan’s economy continued to chug along despite the complete meltdown in markets. Its central bank scrambled to contain the collapse, but likely merely prolonged the pain as the market was destined to return to a normal CAPE. Their unemployment rate has never even gone above 6% during the meltdown!

It took nearly 20 years for Japan to go from a Shiller PE of 90 to a more normal Shiller PE of 15. Markets are worth what they’re worth and they will eventually fall to normal levels of valuation. That’s what happened in Japan. Very little changed in their real economy, it just took a long time to work off their crazy 1989 valuations.

Value in Japan

Even if the US is in a Japanese style asset bubble (even though it is nowhere near those levels), I was curious how a value strategy performed in Japan during their asset meltdown if this were the future for the United States.

It’s encouraging that value-oriented strategies actually performed very well during the Japanese market collapse. In James Montier’s epic The Little Note That Beats the Markethe observed that Joel Greenblatt’s magic formula returned 18.1% from 1993 to 2005 in Japan. EBIT/EV alone returned an excellent 14.5%.

This suggests that as long as you stick to a value framework, even in a market that is in long-term decline, a value strategy should hold up over a long stretch of time.

Conclusions

My apologies if this post is a bit of a mess, but it summarizes many of the things that have been on my mind lately.  To summarize my conclusions:

  • It is probably best for most investors to not obsess over macroeconomics. The smartest people in the world are playing that game . . . and they’re bad at it. We cannot do any better.
  • Market valuation tools are useful for predicting returns over the next decade but aren’t particularly helpful in predicting short-term market moves.
  • The United States is not in a Fed-induced, Japanese-style asset bubble. Our market is high, but a definite return is still likely over the next 10 years.
  • Even if we were in a Japanese style asset bubble (which we’re not), a disciplined value-oriented strategy should still perform very well in the United States.
  • 50% drawdowns 3-4 times a century and 25% corrections are standard. They’re the cost of earning equity returns. If equities went up by their historical 8% average every year in a straight line, they would eventually stop delivering those returns. If you can’t handle corrections of that magnitude, you shouldn’t invest in stocks.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.