Tuesday, July 20, 2010

Thoughts on Historical Multiples and Value Investing



These two are somewhat connected, and let me explain how. Every once in a while, especially around sharper market moves up or down, the TV channels would parade numerous experts who argue if the stock market is overvalued or undervalued. One of the experts' favorite tools is looking at the 30-40-50-60-70 year average/median P/E ratios. Then the expert would inevitably make a pronouncement about the current state.

Here's something that goes a bit underappreciated in my view. Before the computers and the internet, collecting corporate data was a really labor-intensive exercise: I doubt many people active in the market now have gone "down to the library" of their institution to get the filings of Company X, and then proceeded to manually fill ledgers with numbers. I doubt anyone thought it would be possible to get all of this data (some vendors even adjust for non-recurring items), plug away a few numbers, press F9, and, voila, we "know" to the cent how much Company X is worth because "this is what the model says." The end result is that in the computer/internet era, financial information is much more democratic. So is corporate transparency: one can check if company X has that many stores, even ogle the storefronts with Streetview, or snoop on company Y's Peruvian open pit mine in 3D. If the management team seems fishy, one can check them out on LinkedIn or the federal prison bureau, lexis/nexis, facebook, basic searches, real estate records and so on. If you don't know much about the product, check the pricepoints online, see the vendors, read the reviews, order it for yourself to test. The drastically increased transparency reduces risks. Reduced risks increase multiples, and I think we have seen some of that: so that a 1920's P/E incorporates a lot more unknowns than does a 2010 P/E.

So, how is this linked to value investing? In its classic sense, value investing is about buying $1 for 50 cents. One of the most popular approaches is Ben Graham's "net-net". But here is the problem: back when Graham came up with the formula (or when Buffett did his famous cocoa liquidation trade), just trying to do a net-net calculation had been very laborious, as I describe above. And the people who did the work got rewarded. What is the situation now? One can screen thousands of companies just with the click of a button. What is the end result? Much, much fewer bargains (in my view, I have not validated at it statistically). Most of Graham's net-nets are usually small cap, illiquid stocks of companies in the middle of some reorganization: these might be fine for a smart individual investor, but difficult for anyone running more serious money. The greater transparency has resulted in making the screaming bargains nearly extinct. Even Buffett himself rarely makes substantial open market purchases any more (substantial vs. the size of BRK). Outside of the railroad acquisition, his other recent investments (GS, GE, etc.) were effectively private transactions.

"This time, it's different" is a dangerous statement, but maybe, this time it really is different: higher transparency and easy information flows might be warranting higher average multiples.

Sunday, July 4, 2010

Unstructured Thoughts on Structural Problems



Here are some unstructured thoughts on structural problems and malinvestments that I see. As long-time reader know, I belong to the Garage Logic University school of economics.


The whole housing "boom" was a malinvestment. Detached single-family homes are a malinvestment (vs. denser solutions) and lead to built-in dependency on oil, malinvested commuting times, too many furnaces, ACs, washers, dryers, roofs, siding, lawns, garage doors, automobiles, etc. Pushing homeownership is another malinvestment (even without the credit risks) as it reduces labor mobility, a US characteristic that has served us well. A big part of the euro-zone problems is the lack of intercountry mobility, while here people move for jobs from state to state quite often.

There is a structural problem (connected to the real estate industry kidnapping the American Dream and making it a single-family house). We are structurally short oil. This has translated to (1) permanent trade deficits with a number of hostile countries and (2) enormous military expenses to secure the flow of oil (please have no illusions about Iraq and the ~stan countries). I do not know what the solution would be here: Manhattan project, market forces, managed market approach (ie communicating that the excise taxes on gasoline will go up by 20% every year for the next X years).

College education is a malinvestment for many of the students (and the taxpayers who subsidize them). The generous (6-year) graduation rate is 56% as of 2008. This means that 44% of the enrollees possibly waste years and thousands of dollars (I say possibly to account for people who enrolled just for a class or non-traditionals). Of the 56% that graduate, there are plenty that majored in practically useless subjects, from Art History to Medieval Lit to Photography to "Interdisciplinary Studies", whatever that is. Sadly, the government policies will only increase malinvestment there: subsidies for college education are only going up and the government policies are based on the assumption that more people need to "go to college". This is pure malinvestment, as the likelihood of actual benefits accruing to the new marginal student is very low. The system is failing both the students and society as a whole. We really should face up to the fact that a "degree" does not ensure real world success, and, in some case, might actually impede it. Success in highly structured predictable environments, such as colleges or doctoral programs, can lead to both false confidence and inability to think independently.

We have other massive malinvestments, too: large federal bureaucracies that run large federal programs (for example, why do we have HUD or Dept of Education? Solve any issues in these areas at the local level.) There are too many others to list. On the other hand, we have the SEC and the DOJ completely asleep at the wheel with the frauds, including C-level, that became apparent with the crisis.

There are other structural problems besides malinvestments. There is a demographic tidal wave that is starting to hit now. As noted management guru Peter Drucker had once said, demographics is the future that has already happened. Ours is not pretty. The current crisis has only sped up the day of reckoning for the endless promises made by our election-cycle driven politicians. Now is the time to make decisive, drastic steps (raising the retirement age to 75-80 and truly reforming healthcare, for example): of course, the failure of leadership is astounding, but not surprising.

The demographic tidal wave can be offset some by immigration. The structural problem with the current system is that it does NOT favor skilled immigration. Many other "first world" countries have independent professional immigration programs, while our system creates disincentives for educated, law-abiding people to stay around, while, through lack of enforcement and promises of amnesty, keeps the low skilled people here as they have nothing to lose (even Obama's aunt ignored deportation orders). Between the crisis and the work visa quotas and kinks, many highly educated friends that were employed in brand-name places had to move (for some, 10 years after coming to the US for undergrad): this is not the sort of out-migration we want.

We also have a structural problem with healthcare at all levels (privately purchased coverage, employer-provided, government-provided). The upcoming reform does nothing to lower the cost of care: it neither reduces demand, nor does it increase supply. Healthcare is the millstone around the neck of small businesses (both for starting one up, and for attracting talent), and instead of moving away from the employer-based system (that originated by "great" government policies in the 40s), the current disastrous bill is expanding it. Also, when looking at real incomes, one sees that the increases in productivity have not resulted in increases in incomes: but employers have been absorbing higher and higher HC costs. So one can infer, non-scientifically, that the increases in productivity over the last 20 years have been expropriated by the HC complex. Then there is the problem of % dollars spent on actual care vs. % dollars spent on paperwork, administrators, and trial lawyers. There is also the unresolved basic fairness problem of paying for the care of the irresponsible (including the "clusters" of acute and chronic diseases associated with smoking and obesity, both largely "lifestyle choices").

And, happy Fourth, it's a holiday after all.