FT.com / Reportage – The crisis of middle-class America
“Think of the American economy as a large apartment block,” says the
softly spoken professor. “A century ago – even 30 years ago – it was the
object of envy. But in the last generation its character has changed.
The penthouses at the top keep getting larger and larger. The apartments
in the middle are feeling more and more squeezed and the basement has
flooded. To round it off, the elevator is no longer working. That broken
elevator is what gets people down the most.”

Idealism is what precedes experience, cynicism is what follows.

Via Distressed Debt Investing: Seth Klarman from 1992

Don’t be a yield pig. (seeking high current rates in investments)

Seth A. Klarman

Brief
Summary: Some investors seek high yields with no thought of the risk.
In today’s stock market situation, it is better to use up some acquired
capital funds than to risk major loss.

I HAVE
THOROUGHLY reviewed the U.S. Constitution (and the Bill of Rights for
good measure) and, contrary to popular belief, there is no mention of a
right for savers to earn high rates of interest on government-guaranteed
principal. Nevertheless, it comes as a terrible shock to a lot of
people that some current short-term interest rates are only one-third of
early 1980s levels. The correct response to this shock can be crucial
to your financial health.

There is always a
tension in the financial markets between greed and fear. During the
1980s investor greed frequently got the better of fear, with the result
that yield-seeking investors, known among Wall Streeters as “yield
pigs,” were susceptible to any investment product that promised a high
current rate of return, the associated risk notwithstanding. Naturally,
Wall Street responded by introducing a variety of new instruments–junk
bonds, option-income mutual funds, international money market funds,
preferred equity return certificates (PERCS)–anything that promised
high current yields to investors.

Unless they
are deluding themselves, investors understand that to achieve
incremental yield above that available from U.S. government securities
(the “risk-free” rate), they must incur increasing levels of principal
risk. There is no risk-free yield enhancement on Wall Street. The
painful result: Higher risk investments often erose one’s capital and
produce lower returns–the worst of al investment worlds.
Higher-returns-for-higher risks only applies on average and over time.

Investors
must carefully examine alternative investments to assess when they are
being adequately compensated for bearing risk and when they are not.
When the yield differential between riskless and more risky securities
is sufficiently large, ven a conservative investor might reasonably
venture beyond U.S. government securities. Thus, for example, it made
sense to buy the Federated Department Stores senior secured bonds,
Harcourt Brace debentures and Manville preferred stock when panic hit
the junk bond market in late 1990 and early 1991.

These
days, however, I don’t believe investors are being compensated
sufficiently to venture beyond risk-free instruments. Yield spreads
between government bonds and corporate credits have contracted sharply
this year from levels a year ago. Some bonds of such highly leveraged
issuers are Burlington Industries and Unisys now trade above par. A year
ago the sold at substantial discounts from par.

Yield-starved
investors also have been bidding up the bonds of such deeply troubled
issuers as Chrysler, Stone Container and Marriott. The General Motors
PERCS–a newly created instrument that only a yield pig could
love–recently traded at a level so high that the common stock became a
better buy no matter where GM common traded and no matter what action
GM’s board took on its dividend.

Some
investors, desperate for better yield, have been reaching not for a new
Wall Street product but for a very old one–common stocks. Finding the
yield on cash unacceptably low, people who have invested conservatively
for years are beginning to throw money into stocks, despite the obvious
high valuation of the market, its historically low dividend yield and
the serious economic downturn currently under way.

How
many times have we heard in recent months that stocks have always
outperformed bonds in the long run? Funny, but we never hear that
argument at market bottoms.

In my view, it is
only a matter of time before today’s yield pigs are led to the
slaughterhouse. The shares of good companeis and bad companies alike are
vulnerable to sharp declines. Moreover, many junk bonds that have
rallied will tumble again, and a number of today’s investment-grade
issues will be downgraded to junk status if the economy doesn’t begin to
recover soon.

What if you depend on a higher
return on your money and can’t live on the income from 4% interest
rates? In that case, I would advise people to ignore conventional wisdom
and consumer some principal for a while, if necessary, rather than to
reach for yield and incur the risk of major capital loss.

Stick
to short-term U.S. government securities, federally insured bank CDs,
or money market funds that hold only U.S. government securities. Better
to end the year with 98% of your principal intact than to risk your
capital rooting around for incremental yield that is simply not
attainable.

I would also counsel conservative
income-oriented investors to get out of most stocks and bonds now, while
the getting is good. Caution has not been a profitable investment
tactic for a long time now. I strongly believe it is about to make a
comeback.

Via The Epicurean Dealmaker
Never forget: every wise man started out a simple fool like you or me.
He learned wisdom by questioning, by learning, and by doing.

…..age is no guarantee of wisdom

…so many of them have risen to ranks of position, power, influence, and
reputation on an uncommon mix of luck, skill, and patronage, if not
downright nepotism. (Never underestimate the potency of the Lucky Sperm
Club.)

….The size of a man’s bank account, and the number of hits of his name on
Google, are no measure of his intelligence, much less an indication of
the quality of his wisdom.

….no-one in the world outside of your mother will give you unconditional
love (and even she is no certainty); that most people alive couldn’t
care less whether you live or die; and that naked power, selfishness,
fear, aggression, and hate are deep and puissant elements of human
society in any age, and that you cannot ignore them or wish them away.

….It is an old saying, but true nonetheless, that the wise person is
certain of little but his or her ignorance. A wise man is wise enough
to know what he does not know. He believes the world is too
mulitfarious, changeable, and miraculous a place to put much trust in
feeble humanity’s ability to comprehend and control it as we would wish.
Therefore, a wise man counsels caution, and encourages us to pay
attention to our ignorance—what we do not and cannot know—as we make our
way through life. A wise man does not provide answers. A wise
man asks questions, and encourages us to ask questions of
ourselves.

…cultivating the path of wisdom does not lead to the answers to life—if
any such childish fantasies exist. It merely allows us to test and
practice our courage in the face of the ineluctable Unknown.

The M score was created by Professor Messod Beneish. In many ways it is similar to the Altman Z score, but optimized to detect earnings manipulation rather than bankruptcy. 

Beneish used all the companies in the Compustat database between 1982-1992.

The M score is based on a combination of the following eight different indices:

DSRI = Days’ Sales in Receivables Index

* Measured as the ratio of days’ sales in receivables in year t to year t-1. A large increase in DSR could be indicative of revenue inflation.

GMI = Gross Margin Index

* Measured as the ratio of gross margin in year t-1 to gross margin in year t.
* Gross margin has deteriorated when this index is above 1. A firm with poorer prospects is more likely to manipulate earnings.

AQI = Asset Quality Index

* Asset quality is measured as the ratio of non-current assets other than plant, property and equipment to total assets.
* AQI is the ratio of asset quality in year t to year t-1.

SGI = Sales Growth Index

* Ratio of sales in year t to sales in year t-1.
* Sales growth is not itself a measure of manipulation. However, growth companies are likely to find themselves under pressure to manipulate in order to keep up appearances.

DEPI = Depreciation Index

* Measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in year t.
* DEPI greater than 1 indicates that assets are being depreciated at a slower rate. This suggests that the firm might be revising useful asset life assumptions upwards, or adopting a new method that is income friendly.

SGAI = Sales, General and Administrative expenses Index

* The ratio of SGA expenses in year t relative to year t -1.

LVGI = Leverage Index

* The ratio of total debt to total assets in year t relative to yeat t-1.
* An LVGI >1 indicates an increase in leverage

TATA – Total Accruals to Total Assets

* Total accruals calculated as the change in working capital accounts other than cash less depreciation.

The eight variables are then weighted together according to the following:

M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI

A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator. In his out of sample tests, Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.

The five variable version excludes SGAI, DEPI and LEVI which were not significant in the original Beneish model.

M = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI

In 2008, Beneish goes into more detail in another paper that he published titled “Identifying Overvalued Equity” which seeks to use the M score to select stocks.

Beneish examines portfolio deciles based around his M score over the period 1993-2003 with annual rebalancing done four months after the financial year end.

The results produce 14% for the 8 variable model and 14.8% for the 5 variable M score version where the top M score stocks were held long while the lowest M score stocks were shorted.

Via The Economist

Agricultural Bank of China’s IPO may be the biggest in history. The
initial public offering of Agricultural Bank of China, the country’s
third-largest bank, looks set to become the biggest IPO on record. On
July 6th and 7th the bank raised a reported $19.3 billion in a dual
listing on the Shanghai and Hong Kong stock exchanges. If the bank takes
up a further 15% allotment of shares, that would value the deal at a
total of $22 billion, slightly more than the offering in another Chinese
bank, ICBC, in 2006.

Via James Montier
Modern day economics is much like these poor animals. Many economists have learnt to become helpless. They would rather lay down and whimper and whine about how unfair the world is, and mutter that everything would be alright if only people behaved like their models, than seek to look outside the narrow confines of their obsession with rationality and mathematics to see if others might just have some useful insight.

The age of the specialist (people who learn more and more about less and less, until they know absolutely everything about nothing) has proved to have some fundamental flaws. Three cheers for the generalists!

Via Bronte Capital
Credit risk you “manage” – which is a euphemism for “accept”.  Fraud
risk however you avoid – and you avoid it by doing due diligence.

Via Reuters:
There were six ways to dig oneself out of a debt hole.

• The first, growth, does not seem to be happening, at least in part
  because of the dead weight of debt and the lousy way it was allocated.
• We are at the limits of the second, lower interest rates, so not
  much to hope for there.
• A transfer payment from outside, the third, might work for Greece if
  Germany obliges, but is not a scalable solution.
• Increasing taxes or cutting spending, Gundlach’s fourth option, are
  both politically difficult and could cause a downward spiral.
• We’ve already printed money, the fifth option, and in my opinion may
  well print a whole lot more.
• Option six is default, and Gundlach predicated some form of “polite
  default” from the United States either on entitlements or debts.

A 2004 study finds that United States senators outperformed the market by 12% per year versus the -1.4% underperformance of the average US household during the same period.  Even corporate insiders paled in comparison at a 6% out-performance per annum. You can read the whole study here.

Via Farnam
Street: Jamie Dimon’s Summer Reading List
Business
The World is Flat
Competitive Strategy: Techniques for Analyzing Industries and Competitors
Security Analysis – Classic 1940 Edition
The Intelligent Investor
Execution – The Discipline of Getting Things Done
Jack: Straight From the Gut
Sam Walton – Made in America
Double your Profits in 6 Months or Less
Built from Scratch
Only the Paranoid Survive
Built to Last

History Bio
Founding Brothers: The Revolutionary Generation
Autobiography of Ben Franklin
Lincoln at Gettysburg: The Words that Remade America
Undaunted Courage: Meriwether Lewis, Thomas Jefferson, and the Opening of the American West
Eisenhower: Soldier and President
The Rise of Theodore Roosevelt
Washington: The Indispensable Man
Lincoln
Personal Memoirs of U.S. Grand
Jefferson
Team of Rivals: The Political Genius of Abraham Lincoln

History Other
A Short History of Nearly Everything
Guns, Germs, and Steel: The Fates of Human Societies
Complexity: The Emerging Science at the Edge of Order and Chaos
A History of Knowledge: Past, Present, and Future
The Clash of Civilization and the Remaking of World Order
The Wealth and Poverty of Nations: Why Some are so Rich and Some so Poor

Via Institutional Investor: Hedge Fund Rising Stars

Marc Andersen & Eliav Assouline, Axial Capital Management
Timothy Babich, Fortelus Capital Management
Julien Balkany, Nanes Balkany Partners
Joshua Berkowitz, Woodbine Capital Advisors
Keith Black, Ennis, Knupp & Associates
Jason Bonanca, MKP Capital Management
Todd Builione, Highbridge Capital Management
Scott Carter, Deutsche Bank
Daniel Celeghin, Casey, Quirk & Associates
Neil Chriss, Hutchin Hill Capital
Patrick Degorce, Thélème Partners
Matthew DesChamps, Kepos Capital
Stuart Feldman, Jefferies & Co.
Matthew Grossman, Plural Investments
Kevin Lenaghan, Cliffwater
Robert Mazurek, New York State Common Retirement Fund
Youlia Miteva, Proxima Capital Management
Jason Mudrick, Mudrick Capital Management
Ralph Nacey, WestSpring Advisors
Anita Nassar, Citadel Investment Group
John Novogratz, Millennium Management
Edward O’Reilly, Capula Investment Management
Laetitia Pichot de Cayeux, Ajna Partners
Arvind Raghunathan, Roc Capital Management
Tomer Seifan, BNP Paribas
Mal Serure, Arrow Capital Management
Daniel Sundheim, Viking Global Investors
Peter Tarrant, BTIG
James Treanor, Florida State Board of Administration
Boaz Weinstein, Saba Capital Management

Hilarious!

NCAV - Net current asset value. Stocks trading at a 33% discount to NCAV.
NNWC - Net Net Working Capital. Stocks trading below NNWC. Commonly referred to as net nets.
NNWC Increasing - Stocks that have increased their NNWC from the previous quarter. Signs of a potential turnaround.
Magic Formula - Screen based on Greenblatt Magic formula.
CROIC - Cash Return on Invested Capital. Stocks able to generate cash off their investments.
FCF – Cows Stocks that generate plenty of FCF. Very strong cash generators.
Negative Enterprise Value - Stocks that trade below their enterprise value. Another method to find cheap stocks and net net stocks.
Share Buy Back - Stocks where stocks have been bought back. Number of shares outstanding has been decreasing.
Insider Buying - Stocks where insiders have been buying.
Altman Z - Stocks with an Altman Z score of above 3. These companies are fundamentally healthy with no chance of bankruptcy.
Piotroski Score - Stocks with strong fundamentals. Healthy stocks that also help to filter out bad investments.

1. Adequate size of the enterprise: Graham’s idea here is to exclude small companies, which may be subject to more than average volatility (or illiquidity, or neglect). He does note that there will often be good opportunities in smaller stocks, but this is probably not for the “defensive” investor. In 1973, he recommended not buying stocks with less than US $100 million in sales and $50 million in assets.
2. A sufficiently strong financial condition: For industrial companies, Graham looked for current assets to be at least twice the current liabilities (current ration > 2). Also, long-term debt should not exceed the net current assets (or “working capital”).
3. Earnings stability: The company must have positive earnings in each of the last 10 years.
4. Dividend record: The company must have paid dividends without interruption over the previous 20 years.
5. Earnings growth: The company must have experienced a minimum increase of at least one-third (33%) in per share earnings (EPS) in the past 10 years using 3-year averages at the beginning and end.
6. Moderate price/earnings ratio: The prevailing stock price should not be more than 15 times average earnings of the past 3 years (historical PE < 15).
7. Moderate ratio of price to assets: Current price should not be more than 1.5 times book value. However, a PE < 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, Graham suggests that the product of the PE and (ratio of price to book) should be less than or equal to 22.5 (which again corresponds to a stock price that is 15 times earnings and 1.5 times book value).

These screens are designed to eliminate most stocks from an investor’s radar screen by excluding companies that are (1) too small, (2) in relatively weak financial condition, (3) with a deficit stigma in their 10-year record, and (4) not having a long history of continuous dividends. Obviously, looking at 10- to 20-year track record is easier in the mature markets of the United States and Europe, but probably too restrictive in young markets of Asia. Nonetheless, the concept remains sound.

Via Initiative Blog
CAPM is CRAP, or, The Dead Parrot lives!
By James Montier

See Tom Brakke’s posting in his blog The research puzzle on what analysts do. Very informative and addresses the difficulty of an analyst’s job.

Via Aswath Damodaran
Valuation is not rocket science. Valuing companies may not be easy but the challenges we face are not in valuation theory but in estimation practice. Put another way, we know exactly how to value companies. What we do not have a handle on is how best to estimate growth, risk and cash flows. So, let’s stop concocting new models and theories and start thinking more seriously about how best to estimate cash flows for a cyclical firm, risk for a regulated company and growth for young start-up firm.