Saturday, January 10, 2015

Bank of America & Citigroup

This is a follow up on my last post Top Investments for 2015.

I was asked the following question in the comment section.  This answer is a little more than a comment so I decided to post it here.


Anonymous January 10, 2015 at 7:15 AM

Hi Kevin,

Could you please share with us your thoughts on the current tangible book value of C and BAC and why you still see a discount on their current price?



Hi Anonymous.

Thanks for your question. The price to tangible book value for C and BAC as can be calculated to be 0.9 and 1.2, respectively. Whether or not that is cheap enough for you, is something you will need to decide. 

Let me offer some additional thoughts on BAC and then on C. BAC has paid out around $100 billion in legal expenses over the past 5 years. Their tangible book value has risen slightly over that same time. Given the fact the company has close to $150 billion in tangible book value, legal expenses of this magnitude are not insignificant.

The next fact I would point out is that in Q3 2014, the company earned $5.0 billion in profits excluding the consumer real estate services (CRES) division. Annualized this works out to just about $20 billion per year or $1.88/share. Let me be clear, Bank of America earns this amount of profits already today.  They are earning this amount in a sub-optimal economy, a low interest rate environment, and with many regulatory headwinds.  All you have to do is wait for the dust to settle and the earnings power of the company will come shining through.

Now this $20 billion in profits works out to be approximately a 0.9% return on assets (ROA).  On a comparable basis Wells Fargo (WFC) is earning 1.3% on their assets.  I believe that with strong management BAC can earn above 1% on their assets, just like WFC does.  The reason for this is that BAC, just like WFC, has a large, low cost deposit base supporting their assets.  Including non-interest bearing liabilities, both companies have access to over a trillion dollars in deposits at a cost of 0.1% (10 basis points).

Coming back to the returns on tangible common equity, we have already established that BAC has a number of businesses that together are earning 13.4% on tangible common equity (TCE).  This is interesting because WFC is earnings 13.8% on TCE, and JPM is earning 13.5% on TCE and C is earning 6.5% on TCE.  If BAC was valued on the same P/TBV multiple as WFC or JPM, the stock would sell for between $19-25/share. 

So nothing has to happen and the value of BAC's stock will rise somewhere between 15-50% as the underlying earnings emerge.  Any help from a rise in interest rates and it will have real liftoff potential.  Oh and perhaps the CRES division will turn a profit and the company will be able to utilize their deferred tax assets (>$30 billion).  If the company earns $80 billion over the next 4 year, it isn't hard to make the case that the common shares will sell for between $35-40/share.  Of course a large portion of these returns will likely be dividends and share repurchases but the net result is the same, the common shareholders will realize over 20% annually over that time period.

Turning to Citigroup (C), they are selling at a much lower price to TBV.  As noted above that is warranted because of they are earning only 6.5% on TCE.  Their ROA is only 0.6%, lower than BAC (ex CRES) and JPM at 0.9% and WFC at 1.3%.  Don't let this fool you, they have higher earnings potential just like BAC.  As the real earnings power of the company emerges, they will earn around 1% on assets.  If you apply a 1% ROA to C, the net result is an EPS of $6.21/share.  First Call analyst estimates are for $5.41/share in 2015 and $6.52 in 2016, so we are right in the ballpark.  Citi also has over $50 billion in deferred tax assets.

In today's markets there are few companies that can be purchased at less than 10x normal earnings and C is one of them.  In the future the shares will sell more in line with BAC and JPM at 1.3 P/TBV, or around $75/share.  So the upside is easily 50% and all shareholders have to do is be patient and watch the earnings rise.

Hope this helps.   


Best Regards,
Kevin

Disclosure: I own BAC common, BAC Class A Warrants, JPM & WFC. 

Saturday, January 3, 2015

Top Investments for 2015

2014 Year in Review

Well 2013 turned out to be another interesting year.  It was a strong year for investment returns despite numerous issues going on around the world.  China is clearly slowing down, Europe is facing deflation, and Russia annexed Crimea.   As I said last year, uncertainties always abound but capitalism continues to unleashing human potential. 

Commodities and oil & gas in particular got slammed again in 2014, following up on steep losses in 2013.  I have been recommending that investors avoid commodities for a couple years now (Canada - Headed for a Crash & Canada: A Storm Brewing in China).  Also I have commented numerous times on how the high oil prices don't make sense (Saudi America & US Oil and Gas Drilling). 

Before discussing what oil did in 2014 and last years market returns, I want to remind readers of what I said last year at this time (Top Investments for 2014).

I find it remarkable how oil prices have held up in 2013.  US oil production has been off the charts, going up in a parabolic curve.  US dependence on foreign oil fell to a 27 year low (Click Here).  In 2005 the US imported 60.5% of their oil requirements and last year that fell to only 34%.  This is a result of the shale oil revolution in the US where oil production is up 46.5% or 2.36 million barrels a day since 2007.  If oil prices fall in 2014 that will be another significant headwind for the Canadian economy.

Fellow Canadians could have benefited from the fall in commodities by not owning Canadian Dollars.  Canadians who invested in the US not only realized out sized gains this year, they also realized foreign currency gains that contributed an additional 7% to their returns.

I figured it was only a matter of time before oil fell and boy did it in fall off a cliff in 2014.  Similarly, the falling Canadian dollar was another theme that continued in 2014.  As I have said before this is a great way to be short commodities since the Canadian dollar is very closely tied to commodity prices.

I will be returning to both of these themes throughout this post.

2014 Market Returns


Market returns were strong again, making it the six straight year of solid gains.  Just like 2013, Canadian investors could have benefited from the drop in commodity prices by owning US companies, realizing over a 9% gain from the falling Canadian Dollar.  I would still recommend avoiding Canadian dollars as the loonie will likely fall further in 2015 as our economy stalls. 

Last year I included this chart from JP Morgan that puts market returns into context.



Commodities

As already mentioned commodities got slammed this year.  Below is a list of the damage.


Oil and natural gas were both down significantly in 2014.  Metals also fell as well as agricultural commodities.  The only bright spots were the 3C's - Cattle, Cocoa, and Coffee.

For those wondering why oil was down, the answer is shown below.

Source: Carpe Diem Blog

Now if anyone would have said back in 2005 to 2008 that US oil production would rise by over 4 million barrels per day by the end of 2014, everyone would have considered them crazy.  Look at that graph again, US oil production has almost doubled in 4 years.  Let me say that again, oil production went up 4 million barrels per day in 4 years.  That is an economic miracle and we should be thankful for the entrepreneurs who made this happen.  To me this is the fantastic part of capitalism, as we all enjoy the benefits of what these entrepreneurs have created.

For investors, the above graph shows 4 million reasons to avoid oil investments going forward.  Don't get me wrong there is money to be made in the oil, but just like airlines it is hard to pick the winners from the losers.  We are in the top of the first inning of the shale oil revolution and if you don't think this isn't a paradigm shift, you need to look at that graph again.

In the words of Henry David Thoreau, "It's not what you look at that matters, it's what you see."


2014 Stock Recommendations

So how did the stock recommendations for 2014 turn out?  Total returns include dividends and I also included what the total returns were in Canadian dollars (CAD).  Overall the results were decent with the exception of Lightstream Resources.  I have more to say about Lightstream more below.


Here is what those yearly returns looked like throughout the year.  


Looking at the graph, Lightstream was up over 40% in May before going on an epic slide erasing nearly all of the equity value of the company.  Of course I pick these stocks for fun and use the year end as arbitrary start and end points but much higher gains can be had for those who sell once the facts change or when the company approaches its intrinsic value. 

As I said last year, Bank of America has been like shooting fish in a barrel.  After being up 110% in 2012, it returned 34% in 2013, and returned a respectable 15% in 2014 (with dividends).  Like last year, Bank of America is recommended once again for 2015.  It is still selling below its intrinsic value.

The same can be said for Citigroup.  Citigroup's poor returns in 2014 are mostly attributable to failing the Federal reserve's stress test.  That likely won't happen again this year.  Like Bank of America, Citigroup is once again recommended for 2015.

POSCO and Ezcorp are both very cheap and again recommended for 2015.  POSCO, a steel producer, is still profitable but struggling to earn decent returns.  The steel industry is over-capitalized, iron ore prices have plummeted and the outlook is uncertain.  With a book value of $140/share and the current quote of $63.81/share, the stock is cheap.  They are a low cost producer so they will be fine.

Comments on Lightsteam

Lightstream was recommended last year but as some readers know I subsequently changed my mind on the company after reading the year end reserve report released in late March (I have made comments elsewhere on an internet investment forum).  At the time when I recommended LTS, it was selling for $5.88/share.  Looking back at 2012 (the most recent reserve report) they had spent just over $320 million in capital, added 27 million barrels of reserves, and the cost looked very reasonable at around $12 per barrel.

I also did a quick and dirty analysis of the companies proved reserve value and came up with a rough Net Asset Value (NAV) of about $9/share.  This has been their NAV for a while, ever since I said it was a poor company back in 2010.  (There are several other posts on there about PBN & PBG, If you want some fun reading... do a search on my blog as I had some interesting debates on the company in the past.  Click here for an example.)

Anyway, once the reserve report and annual financial statements were released in late March it became clear LTS had deteriorated significantly.  First of all they spent $719 million in capital in 2013 and added 12.3 million barrels in reserves, This gave them a finding and development cost of over $70 per barrel.  That was only the beginning.  Obviously they spent a pile of cash and generated NO value.  This can clearly be seen in the annual report where they wrote off the $1.4 billion in goodwill they were carrying.  The annual report also revealed to investors how they justified the carrying amount of their assets on their balance sheet.  A careful read would have found this comment buried in the details.

"In addition to discounted cash flows, the Company also considered a range of market metrics in assessing fair value less cost to sell for certain CGUs. Market metric information was obtained from recent transactions involving similar assets."

Ok, so they used "market metrics" to justify the fair value, not the reserve report which is as close to reality as you can get given the assumptions.  Anybody looking to acquire a property would use the reserve analysis and also adjust for drilling opportunities.  Market metrics is exactly what most of the people who invest in oil and gas do to justify their overvalued holdings.  The problem is every property has different costs and netbacks, so blanket metrics do not work well. 

Going back to their reserve report, they had a pile of technical revisions and it really makes you question if management was being candid with shareholders.  I would also add that the NAV got a 5% boost due to higher commodity prices.  They won't be getting that boost this year.  Given the fact that LTS has a very short reserve life, the reserve value will take a huge hit.  I have calculated this for LTS and I estimate a 50% haircut to their reserve value.

The last thing I determined from the reserve report was that the NAV was less than $2/share after taking into account other assets and all liabilities.  This result was based on the over $90 per barrel oil price used in the reserve report.  So basically the company destroyed 60-70% of their value with a terrible return on a huge amount of capital.  The capital is gone and the equity investors have lost their capital.

Anyways, that is what happened to LTS this year.  I actually spent a decent amount of time this year analyzing the reserves and asset values for 68 of the 108 oil and gas companies listed on the Toronto Stock Exchange.  I didn't find a single company to invest in.

2014 Other Recommendations

For 2014 I also recommended IBM in the Safe & Very Cheap category.  Here is the results.


Clearly the market is still worried about future of IBM.  Most of what I have read is concern over IBM's falling revenue.  I really don't understand all the fuss is about.  IBM has had flat revenue for 10 years.  Revenue per share is up 6.5% over the past 10 years and as an owner that is what counts.

Also, IBM has been shedding divisions that generate billions in revenue and generate little to no profits.  That right, some lose money.  IBM is currently selling one division that generates $7 billion in revenue but loses $500 million per year.  I'm looking forward to the higher earnings when that earnings drag isn't getting in the way.  This is a common situation at many companies when you dig into the details.

IBM falling 11% does bother me in the least.  Revenue and earnings were higher on a per share basis in 2014.  It now offers outstanding value.

Top Investments for 2015 


IBM (NYSE – IBM, $160.44)

Ezcorp (NASDAQ - EZPW, $11.75)

Bank of America (NYSE – BAC, $17.89)

Citigroup (NYSE – C, $54.11)

POSCO (NYSE - PKX (ADR), $63.81)

If you want investment commentary on these stocks, see what I wrote last year (Click Here).  For Canadian investors, I believe owning US dollars will once again be advantageous in 2015.  I'll likely discuss a few interested tidbits from the Ezcorp annual report next year.  I'll leave them for you to find.  

As mentioned last year, be sure to do your homework on any investment.  The markets are at all time highs and while that shouldn't alarm you, it should invite caution.  All of these companies have wide appreciation potential but anything can happen in the short term.  All of the recommended companies have short term headwinds that will clear over time.  . 

Cheers to another great year!


Best Regards,

Kevin


Disclosure – I own BAC common, BAC Class A warrants, EZPW, & IBM. 

Monday, December 8, 2014

AutoCanada - ACQ - An update

Below is an update to the ACQ article I wrote a few months ago.  It was selected for an award at seekingalpha.com.  Please note the article will be open to the public for the next 48 hours. 

The article also explains why I haven't written much in the past few months.  I am currently pursuing my MBA. 

http://seekingalpha.com/article/2736635-announcing-this-weeks-outstanding-performance-awards-brian-grosso-and-kevin-graham


Best Regards,
Kevin

Sunday, August 24, 2014

The Value Proposition by Kim Shannon

One of the perks of having a blog like this is that you get contacted by a wide variety of people.  Most people want to discuss investment ideas, some discuss startups, and some are company executives or directors.  A few months back, I was contacted to do a book review on a home grown Canadian value investor.  Since I love to read I could never turn down a book, particularly one related to value investing.
  
The book is called The Value Proposition – Sionna’s Common Sense Path to Investment Success written by Kim Shannon (CFA, MBA).  Kim has over 25 years of investment experience as a value investor and since 2002 has served as chief investment officer and president of the firm she founded, Sionna Investment Managers Inc. 
Overall ,I would recommend the book to those who want to understand the fundamentals of the value investing framework.  The book caters to a wide audience and I feel both investors and non-investors will learn something from the book.  One thing I found particularly interesting was the reasons why they talk to the management of the firms they invest in, while most value investors don’t (more below)
The book is divided into three sections.  The first section is an introduction to Kim Shannon and the firm she founded.  The second is about Sionna’s philosophy and the last section is about the how Sionna implements its own take on value investing.
In this article I will describe my key takeaways from the book and a few principles that I found interesting or disagreed with.   

Introduction and History

This section discusses Kim’s unconventional upbringing in a military family.  Which had its positives but also had it's negatives.  The most positive lasting impacts were that she developed independent thinking abilities and wasn’t afraid to stand alone (pg. 11).  These attributes will help any value investor as you must be able to trust your own judgment.  Kim also had a passion for reading and learning.  Those are both cornerstones for personal development and are critical for investment success. 

Sionna’s Philosophy

Sionna is based on a value philosophy and they strive to be client centered.  Although most investment firms say they are client centered, I definitely took away from the book that they have more integrity than most investment firms in this regard.  One of the most important keys to a successful investment management firm is to have clients who both understand and share the investing mindset of the firm.  For value firms, this means underperformance when bull markets are raging and outperformance often comes when markets turn down.  The reason this happens is that value investors have a belief in the rationality of the markets over the long term, but definitely not in the short term. 

When you think about it clearly, companies can’t alter their underlying values to a large degree over the short term, but their share price can fluctuate dramatically.  Companies simply don’t have the capacity to double or triple in a matter of months, but the prices of their shares can.”  (pg. 27)

I couldn’t have agreed more when I read this quote.  People don’t get quotes on land, houses, or other assets they own every hour, but they do get quotes on price of businesses on the stock market every second.  These values can and do rise and fall quite dramatically over short periods of time.  This is what makes value investing successful because if you can successfully value a company and buy at a discount you have much better odds at outperforming those who don’t have a clue as to what they are doing.  And that includes more investment professionals than you realize.   
One key difference from Sionna to other investment firms is that they use a relative value approach.  This means they select stocks from all sectors and also stay invested in bull or bear markets.  They are always looking for the cheapest companies in each sector at all times.  This is particularly important in Canada where resource and financial firms dominate your investment choices. 
The benefits of the relative value approach listed in the book were better diversification and a smoother ride.  The smoother ride is definitely helpful to keep clients from selling out at the wrong times.
While the relative value approach has some benefits I couldn’t help but ask myself, what are the downsides?  This is where I found the book lacked because it didn’t discuss the downside. 
I feel there are a few downsides to this approach.  First of all, a relative value approach may take you into a sector where all companies are overvalued.  Just because a stock is the cheapest in a sector doesn’t mean it is cheap.  It could also be overvalued, so why risk the capital for the sake of diversification?  Secondly, the smoother ride is nice but you can't do this without sacrificing the highest attainable total return.  Personally, I prefer to go where the value is and not be constrained by any sector or requirement to be diversified. 
Some of the other foundations to their approach are reversion to the mean and the sources of total equity returns.  What I found interesting is that in range bound markets (see GDP & Stock Market Returns ) 90% of equity returns comes from dividends.  This makes total sense when you look at a company like Microsoft that has been range bound for more than a decade.  While the company has experienced very strong earnings growth, it has been masked by shrinking multiples (P/E ratio).  In Microsoft’s case the P/E ratio fell from over 40x to under 10x during the last 14 years.  The only return investors in MSFT’s stock have seen (until very recently) was in the form of dividends. 
The book briefly talks about other philosophies such as growth, momentum, speculators and Growth at a Reasonable Price (GARP).  I find GARP to be self-deception at its finest.  I constantly see lots of wannabe value investors turn to “GARP” to justify the purchase of their stocks.  Once you start to talk about “growth” you are now turning from what you know to trying to predict what you don’t know.  Being able to differentiate between what you know and what you don’t know is critical to investing.
On a whole I must say I was greatly drawn to the firm and the principles on which they stand.  I wouldn’t hesitate to send potential clients there way as they appear to have more integrity than most investment managers. 

Implementing Investing at Sionna

This is where the book does a really good job and opened my eyes to help me improve my investing ability.  First of all, the book describes their Intrinsic Value Model (IVM).  You will have to read the book for the details; I can’t give it all to you here.  What I will say is that it involves three major quantitative factors: book value, historical ROE, and relative P/E ratio.  Those are all foundational to my own philosophy, so I almost felt I was reading my own approach to investing. 
I tend to think in terms of slightly different factors, those being: book value, normalized ROE, and relative P/BV.  These are only slightly different ways of thinking about the same quantitative factors they use at Sionna.  
From the three quantitative factors they calculate a rough intrinsic value and expected return.  After it passes this preliminary test they do more fundamental research into the company’s financial position.  I especially liked how they approach financial statements very skeptically.
Another key difference to Sionna’s approach is that they attempt to meet with the management of the firms they invest in.  The reason why they do this isn’t to find out more information, although they usually do, but it is to determine whether management is honest and trustworthy. 
Most value investors don’t bother meeting with management because they don’t find it worthwhile and it may even lead to a bad decision.  The reason is that most CEO's are typically quite charismatic and are able to sell ice to an Eskimo. 

Conclusion

If you are looking for a decent book to explain the value investing approach, I would recommend this book.  It provides enough information on both the quantitative and qualitative approaches to solid investing and doesn't waste pages with useless drivel.  As I like to say, most books could be written as a pamphlet and very few authors actually provide new material, chapter after chapter. 
While I understand why they use a relative value approach, I personally could never take such an approach.  I just can’t invest in something only because it is relatively cheap. 
If you are interested in learning how to determine the intrinsic value of a business, the model discussed in this book gives a solid framework on which to do that.  From there you have to dig deeper and look at other quantitative and qualitative measures that are discussed in the book. 

 
Best Regards,

Kevin
 
P.S. I am currently reading Stress Test by Tim Geithner, and it is a fantastic book about the financial crisis.  I'm about half way through and so far I am fascinated at how the various government officials felt like they had to act during the crisis.   
Disclosure: Long MSFT

Monday, June 30, 2014

AutoCanada: CEO sell Millions

Summary
  • The CEO is selling between $115 and $150 million of AutoCanada stock.
  • The company is selling $200 million in equity, doubling its equity capital.
  • These actions confirm the overvaluation of AutoCanada.
In my recent article AutoCanada: An Easy Short, I demonstrated the overvaluation of AutoCanada (OTC:AOCIF) (TSE:ACQ). This thesis was recently validated when AutoCanada announced it was raising $200 million in equity. Beyond this, Canada One Auto Group (CAG) is selling $150-200 million of ACQ shares in a secondary offering. Both of these offerings are quite intriguing for different reasons, and will be investigated separately.

Click here to read the press release.

You can read the rest of the article here:

http://seekingalpha.com/article/2292655-autocanada-ceo-sells-millions


I sold the company, the CEO is selling the company, and senior management is selling the company.

That leaves the question, who would buy the company at the current price?


Best Regards,
Kevin

Disclosure:  I am short ACQ

Saturday, June 14, 2014

Short Idea - AutoCanada (ACQ)

Summary

  • AutoCanada's market cap has exploded from $350 million to $2 billion in a year and a half.
  • AutoCanada's valuation is 3-4x higher than its US peers on a P/E, P/S, P/B, and P/CF basis.
  • The strong auto sales market over the past 4 years has been a huge tailwind. It will no longer have this tailwind going forward.
  • AutoCanada doesn't have voting control over some of its dealerships.
  • Analysts present the illusion of a huge number of acquisitions targets and unlimited growth in Canada. They truth is it only has 3x upside in Canada.

I don't typically share my stock purchases, but this is a unique situation in that I am shorting a stock and I am seeking to bring about a more rational price in the shortest time frame possible.

The stock is AutoCanada (OTC:AOCIF, TSE: ACQ), listed on the Toronto stock exchange. Simply put, the company owns and operates around 34 car dealerships in Canada. The reasons why I am short the stock are explained in the graph below.



 
To read the rest of this article click on link below:

http://seekingalpha.com/article/2267263-autocanada-an-easy-short


Best Regards,
Kevin Graham

Disclosure:  Short ACQ

Saturday, May 24, 2014

EconTalk - Marc Andreessen

Every Monday morning I listen to EconTalk, a weekly podcast where Russ Roberts interviews various people of different backgrounds to discuss relevant economics issues.  Russ is a research fellow at Stanford University's Hoover Institute.  He is a fantastic interviewer, makes you think, and often discusses the "unintended" economic consequences of various economic ideas or policies. 

This past week Russ interviewed technology venture capitalist Marc Andreessen.  Mark is best known for co-creating the early web browser Mosaic, and later co-founded Netscape. 

The interview this past week between Russ and Marc was absolutely fantastic.  It is not very common for me to discuss these podcasts with friends/fellow investors but I couldn't resist after listening to this one.  They discussed the challenges of being a venture capitalist (predicting future trends in tech), how smartphones are causing a technology revolution around the world, how Bitcoin is so much more than a digital currency, and how technology has and will affect areas such as newspapers, healthcare, and education. 

The entire interview is great but I found the second half of the podcast to be outstanding.  As many investors understand, the newspaper industry has come under heavy pressure from the internet starting around 2007.  Newspapers, once fantastic businesses are now losing money and have lost their monopolistic dominance over local markets.  The internet now allows people to access news much faster and from different cities.  Marc discusses how the internet has fragmented newspapers and how competition is forcing them to change.  The local monopoly's they once enjoyed are over.  He also discusses the one gift that the internet has given to the newspaper industry.  Myself, like Russ and Marc believe there is still a market for good journalism and news but the future will look different than the past. 

Also, the discussions about Bitcoin, healthcare and education are all well worth the free price of this podcast.

You can stream or download the podcast here:

http://www.econtalk.org/archives/2014/05/marc_andreessen.html



Enjoy!

Kevin Graham

Monday, May 19, 2014

GDP & Stock Market Returns (DJIA)

Today I want to examine the relationship between Gross Domestic Product (GDP) and stock market returns.  The purpose will be to determine if periods of strong economic growth correlate to strong stock market returns.  Does looking at the macro economic data help or hinder you as an investor?

Let's look at the data for the 20th century.  To begin we will examine stock market returns from 1900-2000.  For our purposes we will use the Dow Jones Industrial Average (DJIA), a common market index, as our proxy for overall market returns*.  It is one of the only indexes that has data going back that far. 


The first thing we notice from the graph is that stock markets over this 100 year period can be divided into six distinct periods of time.  The red highlighted periods indicate flat or down markets.  The green highlighted periods indicate upward or bull markets. 

The periods 1900-1921, 1929-1948, & 1966-1981 all saw flat or declining stock prices.  These were fairly long periods of time ranging from 15-21 year in length.  These flat markets accounted for 54.25 years. 

The periods 1921-Fall 1929, 1948-1966, & 1981-2000 all saw huge bull markets for the stock market.  These periods ranged in length from 8.75 years to 19 years.  The stock market gained between 9.8% to 21% annually over these periods.  These bull markets accounted for 45.75 years. 

Let's breakdown and look at the economic growth for each period of the above periods highlighted both red and green in the graph above. 

1900-1921

The first time period was from 1900 until 1921.  So what did GDP do during this period**?


It wasn't exactly smooth growth but for the entire period real GDP grew from $457 billion to $726 billion (all figures in 2009 dollars).  For this period GDP increased 59% or 2.2% annually.  Stock market increased by only 9% or 0.4% annually. 

1921 - Fall 1929

The second period was from 1921 to the fall of 1929, shown below.


During this time period the growth was consistently up with no down years.  Real GDP increased from $726 billion to $966 billion (end of period data used).  During this 9 year period GDP increase 33% or 3.2% annually.  In contrast, the stock market was on fire, increasing 430% or 21.0% annually.

Fall 1929 - 1948

The third period began with the Great Depression in the fall of 1929 lasted until 1948, shown below. 


This period began with a serious decline in real GDP (the Great Depression), but then growth rebounded.  Real GDP increased from $966 billion to $2,018 billion.  During this 18.25 year period real GDP increased 109% or 4.2% annually.  In contrast, the stock market went into a deep slump losing just over half if its value (-52%) or -4.0% annually.

1948 - 1966

The fourth period was from 1948 and lasted until 1966, shown below.


This period saw solid growth, once again, with a few down years.  For the entire period real GDP increased from $2,018 billion to $4,235 billion.  During this 18 year period real GDP increased 110% or 4.2% annually, almost exactly the same as the previous period.  The stock market finally woke up to the strong growth.  The DJIA increased from 181 to 969, increasing 435% or 9.8% annually.

1966 - 1981

The fifth period was from 1966 and lasted until 1981.  This period was marked by high inflation and other worries and is shown below.


This period again saw solid growth again with a few down years.  For the entire period real GDP increased from $4,235 billion to $6,611 billion.  During this 15 year period real GDP increased 56% or 3.0% annually.  The stock market however went into hibernation during this time.  The DJIA was essentially flat with the DJIA falling slightly from 969 to 964.  This equates to a 0.5% decrease for the entire period, or -0.0% annually. 

1981 - 2000

The sixth period was from 1981 and lasted until 2000, shown below.



This period began with a slight recession but once again saw solid growth.  For the entire period real GDP increased from $6,611 billion to $12,565 billion.  During this 19 year period real GDP increased 90% or 3.4% annually.  The stock market once again resumed it's upward march.  The DJIA increased from 964 to 11,497 during this time.  This was the longest bull market during the 20th century with the index increasing 1093% or 13.9% annually. 

To summarize the data, here are the results for the DJIA for each of the six periods. 


Taken as a whole, the DJIA increased from 66 to 11497 from 1900-2000.  During that time the DJIA rose 173 fold or 5.3% annually. 

The DJIA saw a total of 54.25 years of flat or declining values.  Remarkably the DJIA recorded all if its gains over a period of 45.75 years, or less than half of the time.  While economic growth was fairly constantly upward, the returns of the stock market were anything but steady. 

Here is a summary of the data for both real GDP (top table) and real GDP per capita (bottom table) for all six time periods. 


From the top table we can see that for the entire period real GDP grew 26.5 fold or 3.4% annually.  The first thing we can notice is that there was economic expansion during each of the six time periods.  While the growth was strong in some periods and weaker in others, overall it was fairly consistent in the 2-4% range. 

Out of curiosity I also calculated the numbers for real GDP per capita (the bottom table).  Due to population growth, real GDP per capita increased by 6.4 times during the 20th century or 2.0% annually. 

What I find ironic is that the highest level of real GDP per capita growth was during 1929 to 1948 where it increased by 3.2% annually.  This was a time when the stock market was cut in half but the standard of living increased immensely***. 

Conclusion

So what conclusions can be drawn from this?  Over the entire century, 1900-2000, real GDP grew at 3.4% annually and the stock market gained 5.3% annually.  As a whole, real GDP increased slowly and steadily between 2 to 4%.  The same can't be said for the stock market.  Over that same time period the stock market was flat or down 54.25% of the time, while the stock market was up only 45.75% of the time. 

Don't count on macro economic data to help you out in determining where the markets will head next year or next month. 

What about GDP and DJIA returns since 2000?

Here is the data here for your reference and amusement. 



Remarkably, the DJIA was flat for the first 12 years and has only started to rise since late 2012.  History seems to be repeating itself all over again. 

If the stock market rises 5.3% annually during the 21st century, the DJIA will reach 41,811 by 2025, 152,055 by 2050, and 2,011,044 by 2100. 

There will be a few new 52 week highs from the current DJIA level of 16,512.


Best Regards,

Kevin Graham



* DJIA Data Source: Samuel H. Williamson, "Daily Closing Values of the DJA in the United States, 1885 to Present," Measuring Worth, 2014

** US GDP Data Source:  Samuel H. Williamson, "What Was the U.S. GDP Then?" Measuring Worth, 2014.

***Standard of living is commonly measured by growth in real GDP.  While this may be one indicator of our standard of living, it is not a complete measure.  Today, many items we enjoy are free and some items have fallen in price yet have much higher quality and features than previous models and this is not reflected in standard GDP calculations. 

Sunday, April 20, 2014

Investment Risks - China and Market Valuations

The students of Columbia Business School publish an investment newsletter entitled Graham & Doddsville.  I was reading the winter issue on Saturday night and I came across an interesting comment by Jim Grant, publisher of Grant's Interest Rate Observer.  Grant has been commenting on the credit markets since 1983.  Here it is. 

Graham & Doddsville:  

Given the current state of the economy and the low interest rate environment, it sounds like you perceive risks that others do not. What facts, measures, or indications bother you most?

Jim Grant

Here’s a fact: China’s banking assets represent one-third of world GDP, whereas China’s economic output represents only 12% of world GDP. Never before has the world seen the likes of China’s credit bubble. It’s a clear and present danger for us all. 

And here’s a sign of the times: Amazon, with a trailing P/E multiple of more than 1,000, is preparing to build a new corporate headquarters in Seattle that may absorb more than 100% of cumulative net income since the company’s founding in 1994.   

Now, there are always things to worry about. Different today is the monetary policy backdrop. Which values are true? Which are inflated? In a time of zero percent interest rates, it’s not always easy to tell.


The risks in China have not gone away.  Here is an update on why.




As I have written before, defining risk is the most important aspect of investing.  Risk is not volatility, risk is permanent loss of capital.  The risks of the real estate bubble in China are huge and is a real reason to be defensive. 

Once this bubble in China bursts, Canada will not be spared.  We avoided the recession of 2007/2008 because of high commodity prices. 

To build 50 Manhattans between 2008-2012, a lot of commodities were used.  At the current pace in China, they could build 1 billion housing units in roughly 16 years.  I don't know how many housing units there are already in China but the math doesn't look real good.

Once commodity prices collapse, Canada will have its recession. 

Market Valuations


As Friday April 17th, the Price to Earnings (P/E) ratio of the Russell is now over 100x based on trailing earnings. 




To see current data, Click here: http://online.wsj.com/mdc/public/page/2_3021-peyield.html

I read elsewhere that nine companies in the Russell 2000 index have a P/E ratio of over 1000x.  Better yet, 1/4 of in companies in the Russell 2000 don't have any profits and so far this year they have outperformed the profitable companies by a three to one margin. 

I often wondered why Fairfax shorted the Russell back at the 661 level, roughly half the current level.  I don't wonder any more.  This market is completely irrational.   



Best Regards,

Kevin


Disclosure: Long FFH

Tuesday, March 25, 2014

Thoughts on Warren Buffett's 2013 Shareholder Letter

Below are my thoughts on portions of the 2013 Berkshire Hathaway Annual Shareholder Letter.

To read the entire letter CLICK HERE.

As I’ve long told you, Berkshire’s intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That’s why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount.

The writing on the wall doesn't get any clearer than this. Buffett thinks that Berkshire (BRK) is worth much, much more than book value and he will be aggressive at buying back stock at the 120% level from any shareholder willing to sell.  This is interesting because BRK is selling at 131% of book value. It was selling for around 120% of book value earlier this year.  Do what you want with that but the implications are clear.

Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results.

This is an interesting comment because Buffett has laid out some guidelines in the back of the annual report on a 5 year yardstick that compares BRK's performance to that of the S&P 500.  It is true that BRK did not meet this test and that Buffett seems to have changed his yardstick to 6 years now.   

Over the past 5 years the per share book value of BRK has risen 91% while the S&P 500 index has gained 127%.  What I find interesting is that the per share book value of the S&P 500 has risen roughly only 50% over that same period.

Take from that what you want but to me the implications are clear.  Either BRK is cheap, the S&P 500 is overvalued, or some combination of the two.  My vote is BRK is cheap.

We completed two large acquisitions, spending almost $18 billion to purchase all of NV Energy and a major interest in H. J. Heinz. Both companies fit us well and will be prospering a century from now.

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

This is what I love about owning Berkshire.  They continually make good long term investments, which ensure good long term results.  BRK is a conglomerate that will be prospering a century from now... long after Buffett is dead and gone.  The market is currently willing to value the latest hot tech stock at absurd levels while BRK underperforms the broader market.  Let's be clear, BRK is built to last. 

Berkshire’s extensive insurance operation again operated at an underwriting profit in 2013 – that makes 11 years in a row – and increased its float. During that 11-year stretch, our float – money that doesn’t belong to us but that we can invest for Berkshire’s benefit – has grown from $41 billion to $77 billion. Concurrently, our underwriting profit has aggregated $22 billion pre-tax, including $3 billion realized in 2013. And all of this all began with our 1967 purchase of National Indemnity for $8.6 million.

So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund... 

If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. 

To put this is simple language, BRK has a $77 billion revolving fund (or loan).  I like to think of it as a loan but a loan that has a number of unique features.  First you never have to pay it back, so long as BRK's insurance companies are still operating.  Second, the loan has a negative interest rate.  In 2013 BRK was paid 3.9% to hold this loan.  Talk about having your cake and eating it too!

Now the lingering question in my mind is what is a loan like this worth, specifically one that has an indefinite term and a zero interest rate (assuming a long term combined ratio of 100%)? 

To give a simple answer this from a financial perspective you must turn to the perpetuity formula, where PV= C/d.  "PV" is the present value, "C" is the annual investment return, and "d" is the discount rate.  Assuming BRK can earn 10% on it's float and it doesn't grow from here, the annual investment return would be $7.7 billion. 

From here it is easy to see that choosing a discount rate of 10% gives a present value of $77 billion dollars for the float.  If we choose a 15% discount rate the present value is $51 billion.  Similarly if we choose a 5% discount rate the float is worth $154 billion. 

So what is the true value the float?  Make your own assumptions but Buffett makes it clear that the true value of this liability is dramatically less than the accounting liability.  I totally agree and in the past, given the investment returns it has generated for BRK, the liability was perhaps ZERO.

Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge.

In layman's terms, If BRK can earn 10% on that incremental invested capital beyond the depreciation charge, it will add approximately $550 million in annual earnings. 

In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They’ve earned it.

I must again confess that their investments outperformed mine. (Charlie says I should add “by a lot.”) If such humiliating comparisons continue, I’ll have no choice but to cease talking about them. 

Todd and Ted have also created significant value for you in several matters unrelated to their portfolio activities. Their contributions are just beginning: Both men have Berkshire blood in their veins. 

Looks like BRK has some top notch talent in line to take over the equity portfolio.  I find the comment in the last paragraph quite interesting.  To me it is foreshadowing a larger role in the company for either Todd or Ted.  Perhaps one will be the next CEO.

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

Buffett here is describing the "look through" earnings of the companies which BRK is a part owner of(common stock).  I wonder how many investors could actually tell you the "look through" earnings of their own portfolio?  That result might prove to be an interesting for many so called value investors. 

---

There is another fantastic portion of the BRK annual letter that I would highly recommend.  It is an essay entitled, "Some Thoughts About Investing".  In this essay Buffett compares buying a 400 acre farm north of Omaha and a commercial real estate investment to investing in common stocks.  The principles are exactly the same.

At the end of the annual report you will find the two page offer Buffett took over to purchase Nebraska Furniture Mart in 1983, the Financial Statement for Nebraska Furniture Mart for the yearend 1946, and a fantastic memo on the "Pitfalls of Pension Promises" by Buffett from 1975.  Click Here to read these sections.  They are located at the end of the annual report.   


Best Regards,

Kevin Graham


Disclosure - long BRK.b