The Trouble With Indexing, A Reader Comments

Reader CP had this succinct analysis of the trouble with indexing as an investment strategy:

I think that, in practice, index investing means:
“Treat cash like it’s toxic and buy a little bit of everything at the asking price.”

It’s an idea which has happened to enter a positive feedback loop and thereby generated attractive retrospective returns since 2009. (Although the price appreciation of the S&P since 2007 has only been about 4% a year not counting dividends!)

Buying everything at the asking price would not work or be considered a valid strategy in any type of wholly owned and operated business. Imagine if you just bought every [retail operation] at the asking price.

Actually, people do this from time to time, it’s called a roll up and the stock price chart looks like the market chart now – a parabola followed by a huge crash. Dendreon’s problem was that they levered up and bought every pharma company they could for asking price.

So I don’t see why or how buying pieces of businesses at asking price will do anything except transfer value to the sellers, i.e. result in losses, which will be crystallized someday, for the buyers.

Advertisements

A Summary Of Horizon Kinetics’ Arguments Against Indexation

Murray Stahl and Steven Bregman of Horizon Kinetics have written an ongoing series examining the theoretical and practical flaws of indexation as an investment strategy. As the series is long and the arguments are many, I’ve decided to try to summarize each of their major essays into a single summary sentence to make the argument easier to follow. All links below come from the “Under the Hood: What’s In Your Index? series:

  1. International Diversification – Bet You Don’t Know How Much You’ve Got, investors seeking diversification with their indexing strategies are ignorant of the fact that almost 30% of the revenues of S&P 500 companies come from outside the US, and many international companies in non-US indexes derive substantial parts of their revenue from the US; therefore political diversification of economic risk is illusory in index allocation strategies
  2. Not Your Grandfather’s S&P, the calculation of the S&P 500 was adjusted for available float (non-inside held shares) beginning in 2005, meaning that much of expectations about its return built on past price performance is no longer analagous because earlier index returns were purely market cap-weighted and thus the index got the full benefit of great, insider-owned growth stories such as Wal-Mart and Microsoft
  3. Your Bond Index – Part of the ETF Bubble; valuation-agnostic institutional investors following a “diversified” asset allocation model use tools such as international bond ETFs to gain exposure, and the liquidity constraints of the underlying issuance create perverse results wherein war-torn, criminally fraudulent and economically unstable foreign regime debt ends up with lower yields than stable, profitable US corporate debt
  4. How to NOT Invest in the Dynamism of Emerging Markets: Through Your Emerging Markets ETF; using India ETFs as an example, it is shown that the concentration of market caps, lack of trading liquidity and concentration of the largest firm’s revenue sources outside the home market imply that one can not reliably get exposure to an emerging market by buying emerging market ETFs, meaning that the “diversification” available with such tools is illusory
  5. How Liquid is YOUR ETF, or What Does This Have to Do With Me?; in a “virtuous circle”, the liquidity of index ETFs has attracted long-term asset allocators whose allocation decisions have created even greater liquidity in the ETF, but the events of August 24th, 2015, show that it’s possible for this circle to operate in reverse, creating sharply-divergent share price performance between an ETF itself and its underlying holdings
  6. The Beta Game – Part I; allocation models favor low-beta strategies (historical price risk relative to broader market) over high-beta strategies, such that high-beta strategies are being allocated out of existence and low-beta strategies are being allocated into a bubble, even when the underlying strategy itself seems to imply higher risk and volatility than the broad market
  7. A New Bubble Indicator; Is One of Your Stocks In a Momentum ETF?; “the appearance of billion-dollar momentum ETFs means that the most expensive stocks are being bid higher, and those that have not done well – that is, their relative momentum has abated, as it ultimately must – are being sold short, so the cheap are being sold cheaper”, “The index universe has become, simply, a big momentum trade. It is the most crowded trade in the history of investing.”
  8. The Beta Game – Part II; when the beta-trade goes in reverse because peak beta-driven demand is reached, index ETFs which are primarily purchased because of their beta will fall in value and funds will flow into contrarian, non-indexed securities which will also have constrained supply (illiquid) resulting in sharper price increases
  9. The Robo-Adviser, Part I: What Does Rebalancing Mean to You?; asset allocation patterns, especially the robo advisor-driven variety, create a structural need for outsize turnover volumes of ETFs versus the turnover of their underlying stocks as portfolios are more aggressively rebalanced, in the future a cascading rebalancing effect could create dramatic selloffs in underlying securities just as cascading demand seems to drive price increases on the way up
  10. The Robo-Adviser, Part II: What’s in Your Asset Allocation Program?; robo-advisor portfolio recommendations seem to make similar investment allocations despite different inputs, creating a herd momentum in index ETFs
  11. How Indexation is Creating New Opportunities for Short-Sellers, And Why This Should Alarm Ordinary Buyers of Stock and Bond ETFs; historically low interest rates and growth of indexing as a strategy have made short-selling a punishing exercise, but sudden and unpredictable price volatility will force low-beta ETFs to dump their holdings in favor of other securities, opening up opportunities for short-sellers to profit
  12. Why Utility Stocks Should Concern Income-Oriented Investors; qualitative analysis reveals a worrisome risk picture for the utility industry, yet ETF flows and the search for yield have combined to create high P/Es for the industry as a whole
  13. The Exxon Conundrum; despite a massive decrease in the price of oil and thus $XOM’s per share earnings, its share price was relatively unimpacted and it remains an overweight position of numerous ETFs, suggesting it is $XOMs pre-existing size and liquidity which generates its (over-)valuation, and not the other way around
  14. 5000 Years of Interest Rates (Part I); interest rates in 5,000 years of recorded human history across the globe have never been near zero or negative as they predominantly are in Western economies at present, meaning equity valuations are built on truly unprecedented circumstances while most financial logic involves historical pricing as a basis constructing behavioral models
  15. 5000 Years of Interest Rates (Part II); interest rate increases would result in painful adjustments to the value of fixed-income (bonds) and fixed income-like ETFs (REITs, utilities), and a safer bet would be in non-indexed securities whose prices are already somewhat depressed and whose underlying businesses represent idiosyncratic risks versus the broad market
  16. What’s in Your Index? The Value of Cash; cash is deemed to be a liability in a low interest rate environment, creating a drive to acquire assets regardless of valuation, when in reality cash might be the very thing investors need to survive the coming tide of rising rate-induced market crashes
  17. What’s in Your Index? Gold Miner ETFs; leveraged ETFs in the gold miner space seem to be creating price movements divorced from the underlying fundamentals of gold itself, indicating this is not an efficient market despite the fact that it is being indexed (or rather, because it is being indexed)
  18. The Indexation That Is, Versus The Indexation That Should Be; the commodity nature of index strategies implies that most fund providers who face the same profit motives as active managers of the past will promote diversification strategies to “index investors” that will cause them to underperform the broad market for the same reasons active managers did

The Argument (So Far), Summarized:

  •  Modern indexation is primarily practiced via allocation to various thematic ETFs
  • The construction of the thematic ETFs is often inconsistent with their stated theme and therefore unable to provide the sought after diversification, due to liquidity constraints
  • The price behavior and valuation of the holdings within these ETFs seem divorced from underlying economic reality and are largely explainable through the feedback mechanism of high inflows to indexation/ETF-based strategies themselves
  • Myopic focus on beta (a measure of relative volatility) and momentum (tendency for price trend to continue, a characteristic which shouldn’t exist in an efficient market) have created herd mentalities and currently dominate index-driven strategies
  • Indexation as a strategy requires and logically replies upon historical price data, but the data being relied upon was gathered in an interest rate environment that was historically normal but entirely dissimilar to recent interest rate paradigms, bringing into question the validity of this data to present strategies
  • Indexation relies upon the existence of an efficient market to operate, but the indexation phenomenon itself seems to be driving persistent inefficiencies in the market, bringing into question the stability of the indexation phenomenon
  • Most current index investors do not follow the historic and academic recommendations for executing an index strategy, nor can they given the profit motives of investment marketers offering ETFs outside of the broad market index theme, ensuring underperformance relative to the index benchmark for the same reasons active managers underperformed in the past

BONUS, Horizon Kinetics Q4 2016 Market Commentary, summarized:

  • When the total available pool of index-driven funds reaches its limit, index strategies which are valuation-neutral will no longer set the marginal price for the underlying securities they own, and that price will be set by value-conscious active managers, implying a sharp correction downward for indexed security prices in general
  • Indexation as a strategy has a place in certain portfolios in a “normal market”, but this is not that market and therefore indexation seems to carry undue risk
  • There is no such thing as an “inadequate index return”, so index investors have no logical basis for being unhappy with the returns they get
  • If index investors did try to pull their money all at once, there is no logical alternative to active asset managers because bonds are priced too high to offer a greater return and there is not enough money in money market funds to change places with the index fund outflows at current prices
  • Returns to large cap equities from 1926-2015 have averaged between 9% and 10% a year; returns to equities from 1824-1924 averaged 7% a year, but most of that return came in the form of dividends, not price appreciation
  • In an age of indexation, true diversification comes from analyzing individual securities and finding the one’s whose share price performance is not dictated by broader market trends, as indexed ETF securities are
  • The age of analyst-driven active management may again be upon us

Notes – The Intelligent Investor Commentary By Jason Zweig

The Intelligent Investor: A Book of Practical Counsel

by Benjamin Graham, Jason Zweig, published 1949, 2003

The Modern Day Intelligent Investor

The following note outline was rescued from my personal document archive. The outline consists of a summary of the end-chapter commentary written by Jason Zweig. Zweig did such a good job of reviewing Graham’s lessons in each chapter and practically applying them that I find you can get most of the major principles of The Intelligent Investor by reading the combined commentary chapters as if they were a standalone investment book.

Of course, Graham’s original work is a classic in the value investing tradition and it should be read and savored on its own, as well.

Chapter 1, JZ commentary

  1. What is investing?
    1. You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock
    2. You must deliberately protect yourself against serious losses
    3. You must aspire to “adequate”, not extraordinary, performance
  2. How to invest
    1. An investor calculates what a stock is worth, based on the value of the underlying business
    2. A speculator gambles that a stock will go up in price because somebody will pay even more for it
    3. You should be comfortable owning the underlying business even if you couldn’t get timely, regular quotes of its market price
    4. Price is what the business is selling for, not what it’s worth. Value is what the business is worth. Money is sometimes made in the arbitraging of the two, but price does not dictate value; in the long-term, value dictates price
  3. Limit your risk
    1. Never mingle speculative accounts and investment accounts
    2. Never allow your speculative thinking to spill over into your investing activities
    3. Never put more than 10% of your assets into your “mad money” account

Chapter 2, JZ commentary

  1. Stocks have not had a perfect record of keeping up with inflation, as measured by the CPI
  2. 20% of the 5year periods from 50s today in which inflation dominated saw falling stocks
  3. Two strategies for branching out beyond stocks during inflation:
    1. REITs (Real Estate Investment Trusts)
    2. TIPS (Treasury Inflation Protected Securities)
      1. IRS considers an increase in TIPS value to be taxable income

Chapter 3, JZ commentary

  1. “By the rule of opposites, the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run.”
  2. The stock market’s performance depends on three factors:
    1. real growth in earnings and dividends
    2. inflation(-expectations) within the general economy
    3. speculative appetite for stocks/risk (increase/decrease)
  3. In the long run, you can reasonably expect stocks to average a 6% nominal return, 4% real return (with inflation calculated at 2% historical rate)
  4. Be humble about your ability to forecast future stock returns– don’t risk too much on a forecast that could turn out to be wrong.

Chapter 4, JZ commentary

  1. Two kinds of intelligent investors:
    1. active/enterprising – continual research, selection and monitoring of a dynamic mix of stocks, bonds or mutual funds (intellectually/physically demanding)
    2. passive/defensive – create a permanent portfolio that runs on autopilot and requires no further effort but generates very little excitement (emotionally demanding)
  2. How to allocate amongst stocks and bonds for defensive investors?
    1. “Age” is arbitrary and pointless
    2. Instead, consider the fundamental circumstances of your life and the financial needs you’ll have for the foreseeable future
    3. For the aggressive investor, 25% in bonds and cash, 75% in stocks
    4. For the defensive investor, 25% in stocks and 75% in bonds and cash
    5. Rebalancing should be done on a predictable, disciplined basis– not when the market dictates, but when the “calendar” or schedule does
  3. Income investing (bond choices)
    1. Taxable or tax free? Choose tax free (municipal) unless you are in the lowest income bracket
    2. Short-term or long-term? Intermediate term bonds of 5-10yrs allow you to avoid the guessing game and see-saw risks of short and long-term bonds
    3. Bonds or bond funds? Unless you have a lot of capital to make minimum purchases, probably more cost effective to buy a bond fund
    4. Watch out for preferred stock, the worst of both worlds
      1. Secondary claim on assets in bankruptcies (junior to bonds)
      2. Offer less potential profit than common equity because they are often forcibly called by businesses when interest rates drop or credit ratings improve
      3. Companies can not deduct the interest payments like they can with bond issuance, ask yourself, “Why would a company that is healthy issue preferred rather than bonds?” Answer is, probably because they aren’t healthy
    5. Sometimes, stocks can offer competitive yields with Treasuries, which can increase income yield while raising potential return (as well as increasing potential risk of loss)

Chapter 5, JZ commentary

  1. Markets are least risky after a crash, most risky at the top
  2. Should you buy what you know? Psychological studies say that we tend to discount risk inappropriately when we feel we are experts on something due to familiarity
  3. Dollar-cost averaging can be a disciplined way to force oneself to invest through bear and bull markets

Chapter 6, JZ commentary

  1. Junk bonds
    1. Graham warned against them because they were difficult to diversify away the risks of default; today, many junk bond funds exist which allow an investor to diversify
    2. While junk bonds have outperformed 10yr UST even with historical default rates factored in, many junk bond funds charge high fees which reduces their appeal
  2. Emerging market bonds
    1. Typically not correlated with US equity markets
    2. Restrict holdings in bond portfolio to 10% (published 2003)
  3. Day trading
    1. The increased transaction costs of day trading is a surefire way to bomb a portfolio
    2. Day trading raises transaction costs to the point where returns must be beyond what one could reasonably expect to make with a conservative estimation of returns, just to break even
  4. IPOs
    1. Most people who have bought-and-held IPOs have been decimated over time
    2. Hard to find value in the mania buying of an IPO
    3. The public excitement of an IPO often leads investors to forget about valuing the underlying business; many investors have paid ridiculous sums for businesses that were not profitable and never had a chance of being profitable
    4. “It’s Probably Overpriced”

Chapter 7, JZ commentary

  1. Market timing is essentially a fools errand: Life can only be understood looking backwards, but it is lived forwards.
  2. Growth stocks– the faster the companies grow, the higher goes their stock multiples
    1. A $1B company can double its business fairly easily, but how will a $50B company double itself?
    2. A great company is not a great investment if you pay too much for it
    3. When growth companies expand beyond 25-30 times earnings, they’re expensive and should not be bought
    4. One way growth companies could become temporarily attractive is when they suffer a setback or disclosure of upsetting information, creating “the relatively unpopular large company.”
  3. Most great fortunes in the world are made through concentration into one industry or business idea; similarly, most great fortunes are lost this way as well
    1. Because markets are sometimes cyclical, people who got rich in one industry as it boomed will likely lose their fortunes in that same industry when it busts
  4. Bargain hunting for stocks can be a winning strategy; consider stocks that are selling at or for less than their net working capital (Current Assets – Total Liabilities, including preferred stock and long-term debt)
    1. One way to quickly find these stocks can be to search for companies that have recently hit new lows for the past 52 weeks
  5. Diversifying outside the US (or home market) is adviseable because national economies suffer booms and busts as well as specific industries do
    1. If you had been Japanese in 1989, you would probably think it foolish to invest in America; however, you would lose 2/3 of your equity value over the ensuing decade as a result
    2. The country that you live and work in is already a multilayered bet on the economic prospects of that country’s economy; buying foreign stocks (including emerging markets) provides insurance against the possibility that your home market might be a laggard

Chapter 8, JZ commentary

  1. Do not let the movement of Mr. Market, up or down, affect your decision on whether to buy or sell a particular company or stock at a particular time
    1. Don’t buy just because the market is going up
    2. Don’t sell just because the market is going down
  2. Graham: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.”
  3. Investing intelligently is about controlling the uncontrollable
    1. your brokerage costs
    2. your ownership costs (mutual fund fees)
    3. your expectations (keep them reasonable)
    4. your risk (how much of your total assets do you put into each investment)
    5. your tax bills (short vs. long term cap gains)
    6. your own behavior
  4. “To be an intelligent investor, you must also refuse to judge your financial success by how a bunch of total strangers are doing”
    1. You haven’t lost if everyone else has won
    2. You haven’t won if everyone else has lost
    3. Focus on your own absolute performance
  5. Remember: market quotations are what other people think the value of a stock is– not what the true value of the stock is in relation to underlying intrinsic value
  6. Selling into a bear market can occasionally make sense in relation to taking a realized loss for tax purposes; consult a tax professional before doing so

Chapter 9, JZ commentary

  1. The pitfalls of mutual funds:
    1. avg fund does not pick stocks well enough to overcome the costs of researching and trading them
    2. the higher a fund’s expenses, the lower its returns
    3. the more frequently a fund trades, the less it tends to earn
    4. highly volatile funds tends to stay volatile
    5. funds with high past returns are unlikely to remain winners for long
  2. Why don’t more winning funds stay winners?
    1. migrating managers; top mgrs get picked off by higher paying companies or go on to start their own funds
    2. asset elephantitis; when a fund is too large, it reduces the types and size of investments it can possibly make, reducing its nimbleness
    3. no more fancy footwork; many fund “incubate” before going public and whatever advantages they had during incubation are generally lost afterward, yet they use the incubation period performance to promote the fund
    4. rising expenses; it often costs more to trade in size than to trade smaller because markets become illiquid when trading in size
    5. sheepishness/herding; fund mgrs who have been successful and attract higher fees grow accustomed to these fees and their reputation and don’t want to take any risks that might jeopardize either one, so they trade like other fund mgrs
  3. The solution for the individual investor is boring, low cost index funds– they won’t beat the market, but they won’t get beaten by it either
  4. How to pick good mutual funds?
    1. managers should be the biggest shareholders
    2. they should be cheap/low fee; high returns are temporary, high fees are permanent
    3. they should be run creatively and “dare to be different”
    4. they shut the door before they get too big
    5. they don’t advertise much if at all
  5. Expense fee guidelines:
    1. taxable and muni bonds, .75%
    2. US equities, 1%
    3. high-yield bonds, 1%
    4. US equities (small stocks), 1.25%
    5. foreign equities, 1.5%
  6. When to sell a mutual fund?
    1. a sharp and unexpected change in strategy
    2. an increase in expenses
    3. large and frequent tax bills (caused by excessive trading)
    4. suddenly erratic returns (big gains or big losses)

Chapter 11, JZ commentary

  1. Five decisive elements for determining price multiples
    1. the company’s “general long-term prospects”
      1. Warning flags
        1. the company is a serial acquirer, gaining revenues and profit growth through the acquisition of other businesses
        2. the company is addicted to OPM and is continually floating debt or issuing new stock
          1. cash from operating activities negative, while cash from financing activities positive, on a general or recurring basis, means the company is not profitable in its own line of industry
        3. the company relies on one or only a handful of important customers to generate a significant share of its revenues and profits
      2. Positives in company analysis
        1. the company has a wide “moat” to competition
          1. brand identity
          2. monopoly or near-monopoly
          3. economies of scale
          4. unique intangible asset
          5. resistance to substitution
        2. the company is a marathoner, not sprinter
          1. revenues and income should grow steadily, not in spurts
          2. less likely to attract and then offend “hot stock” money
        3. the company sows and reaps
          1. the company should be spending on R&D to develop new lines of growth in the future
          2. 3-6% of revenues by industry is a typical measure
    2. the quality of its management
      1. is it looking out for #1?
        1. executives should not be paid too much
        2. company should not be reissuing or repricing stock options constantly
        3. use fully-diluted share totals when calculating EPS
        4. insiders should not be selling the company
      2. are they managers or promoters?
        1. mgrs should spend most of their time managing, not being in the media promoting the company’s stock
        2. watch out for accounting opaqueness, recurring non-recurring charges, ordinary extraordinary items and the focus on EBITDA rather than net income, etc.
    3. the financial strength and capital structure
      1. it should generate more cash than it consumes
      2. cash from operations should grow steadily over time
        1. use “owner earnings” (Net Income + Amortization + Depreciation – Cost of Stock Options – Unusual/Nonrecurring Charges – Company Pension Fund “Income”)
      3. capital structure considerations
        1. total debt ( + preferred stock) should be under 50% of total capital
        2. is debt fixed-rate or variable, exposing the company to interest rate risk (check footnotes)?
        3. check annual reports for “ratio of earnings to fixed costs” which can demonstrate if the company is able to make interest payments
    4. its dividend record
      1. the burden of proof is on the company to prove they shouldn’t issue you a dividend because they can grow the company better with the retained earnings
      2. the stock should not be split constantly
      3. stock buybacks should occur when the company’s shares are cheap, not at record highs
    5. its current dividend rate

Chapter 12, JZ commentary

  1. Accounting gimmickery
    1. make sure capitalized expenses really ought to be capitalized
    2. watch out for firms realizing revenues on their accounting statements that they have not actually earned
    3. inventory write-downs should not be occurring regularly if the company is using proper inventory accounting methods
    4. “net pension benefit” should not be more than 5% of the company’s net income
  2. How to avoid accounting fraud
    1. read backwards; the dirty secrets are buried at the end
    2. read the notes; never buy a stock without reading the footnotes in the annual report
      1. look for terms like “capitalized”, “deferred” and “restructuring”
    3. read more; check out Financial Statement Analysis (Fridson and Alvarez), The Financial Number’s Game (Comiskey), Financial Shenanigans (Schilit)

Chapter 14, JZ commentary

  1. Investing for the defensive investor
    1. Substantially all of ones stock picks should be limited to a total stock market index fund; or, 90% total stock market index fund and 10% individual stock picks
  2. Graham’s criteria for stock selection:
    1. adequate size; market cap > $2B, unless owned through a “small cap mutual fund” that allows for diversification
    2. strong financial condition; 2:1 current assets:current liabilities ratio
    3. earnings stability; some earnings for the common stock in each of the past ten years
    4. dividend record; the company should pay a dividend, even better if it increases over time
    5. earnings growth; 33% cumulative EPS growth over ten years, or essentially, 3% annual EPS growth
    6. moderate p/e ratio; current price should be no more than 15x avg earnings over past 3 yrs
    7. moderate price-to-book ratio; price-to-assets/price-to-book-value ratio of no more than 1.5
    8. alternatively, multiply p/e ratio by price-to-book and the number should be below 22.5
  3. Do the due diligence
    1. do your homework; read at least 5 yrs worth of annual and qtrly reports and proxy statements disclosing managers’ compensation, ownership, and potential conflicts of interest
    2. check out the neighborhood; check for institutional ownership ratios, over 60% probably means the company is overowned and overpriced
      1. if one sells, they’ll all sell; could be a time to find bargains in that stock
      2. check who the biggest holders are, if they’re money mgrs that invest like you, you could be in good hands

Chapter 15, JZ commentary

  1. You can practice stock-picking for a year, without investing any real money, and see how you do
    1. if you beat the S&P500, maybe you are good enough to pick stocks
    2. if you don’t, stick to index funds
  2. How to pick stocks for the enterprising investor
    1. Start with stocks that have recently hit 52 week lows
    2. use the ROIC method of analysis; ROIC = Owner Earnings / Invested Capital, where Owner Earnings is:
      1. Operating Profit + Depreciation + Amortization of Goodwill – Federal Income Tax – Cost of Stock Options – Maintenance (Essential CapEx) – Income Generated By Pension Funds
      2. Invested Capital = Total Assets – Cash and ST Investments + Past Accounting Charges That Reduced Invested Capital
      3. ROIC can demonstrate, after legitimate expenses, what the company earns from its operating businesses and how efficiently it has used shareholders’ money to generate that return
      4. ROIC of 10% is attractive, 6-7% in special occasions with strong brand name, focused management or the company being temporarily unpopular
    3. you can also look for comparable companies that have been acquired recently for valuations for the company you are looking at
      1. check the “Business Segments” (or “Management Discussion and Analysis”) section of the company’s annual report for industrial sector, revenues and earnings of each subsidiary
      2. then, check Factiva, ProQuest or LexisNexis for examples of other firms in the same industry that have been acquired
      3. then, look at past ARs for these companies for information about purchase price to earnings for those companies before acquisition
      4. this might reveal a “60-cent dollar”, a company whose assets and earnings are selling for 60% or less than the businesses might be worth to an acquirer

Chapter 20, JZ commentary

  1. The first objective of investing: “Don’t lose.”; this is Graham’s “margin of safety” concept in a nutshell
  2. Consider a market that is returning 5% a year, while you have found a stock that you think can grow at 10%; if you overpay for it and suffer a capital loss of 50% in the first year, it will take you 16 years to overtake the market, and nearly 10 years just to break even again
  3. The biggest financial risk we face is ourselves; ask yourself the following questions:
    1. How much experience do I have? What is my track record with similar decisions in the past?
    2. What is the typical track record of other people who have tried this in the past?
    3. If I am buying, someone is selling. How likely is it that I know something they don’t know?
    4. If I am selling, someone else is buying. How likely is it that I know something they don’t know?
    5. Have I calculated how much this investment needs to go up to cover my taxes and trading expenses?
  4. Then, make sure you have considered the consequences of being wrong by asking yourself:
    1. How much could I lose if I am wrong?
    2. Do I have other investments that will tide me over if this decision turns out to be wrong? Am I putting too much capital at risk?
    3. Have I demonstrated a high tolerance for risk by continuing to invest after large losses in the past?
    4. Am I relying on willpower alone to prevent me from panicking or have I made preparations in advance by diversifying and dollar-cost averaging?
  5. “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”
  6. Never make the mistake of following investment crazes or putting all your eggs in one basket; if you make one error, you will have wiped yourself out
  7. Instead, diversify, and always protect yourself from the consequences of being wrong just as much as you hope and plan to enjoy the benefits of being right

[amazon asin=0060555661&template=iframe image2]

A Record Of Some Misgivings

I’ve had a little back and forth with some other value investors recently on my concerns about some of DreamWorks Animation’s outstanding corporate governance and capital allocation issues. I figured it was probably time to put pen to paper and formally record some of these thoughts.

Capital mis-allocation

To start, I want to mention the capital allocation issues. Over the last four years (2008-2011), DWA generated approximately $508M in operating cash flow, or about $127M/yr. In that same period, DWA invested $217M in their business, or about $54M/yr, while it bought back $389M, or about $97M/yr, worth of stock and finally they retired $73M worth of debt, which occurred in one year (2009) and represented the last of their LT debt on the books at that time.

As you can quickly surmise, there was only $291M of FCF or about $73M/yr over that period to support $462M in buybacks and debt paydown, a deficit of $171M which appears to have been financed by drawing down cash on the balance sheet and potentially leaning on the revolving credit facility as well.

I see a couple problems here:

  1. This is a growth company but the company will not be able to finance its growth ambitions on its own now because it has used a ton of its own financial resources buying back stock, which means it’ll have to either issue substantial new equity at low prices or take on more debt to finance its future growth
  2. The buybacks occurred at a range of prices and therefore market valuations of the company, with many of them clustered at the high end of that range, implying the company is not good at determining its own value and buying back only when the company is on sale

The first issue concerns me especially so given the nature of DreamWorks Animation’s business– in the end, it is highly speculative and could easily fail, meaning the most appropriate financing type is equity, not debt. Debt is more appropriate for a low-risk, predictable, consistent enterprise (such as financing a real estate venture). Equity provides the kind of flexibility and endurance one needs to weather the potential storms in a business like DWA’s.

But by using up much of its cash, DWA has put itself in the position where it will have to either dilute existing shareholders at potentially disadvantageous prices, or else it’ll have to raise debt which I believe adds substantial extra risk because of the way it mismatches with their business fundamentals.

The second issue concerns me because I think it directly explains a lot of the apparent value destruction that has occurred at DWA over the last 4 years as communicated by the fluctuating market capitalization and I think it sets a precedent that is in the long-run bad for minority shareholders, not good, as people of the “buybacks are good no matter what” school of thought seem to believe.

In 2008, the peak price of DWA was $32/share and with 91M FDSO at the time, that amounted to a market cap of $2.9B. In early 2010, the company climbed to an all-time peak price of nearly $43.50/share and with 87M FDSO that amounted to a market cap of nearly $3.8B. The shares now linger back below their 2009 low of $18.56/share and very close to the all-time low of $16.52/share reached in January of 2012, trading around $17/share for a total market cap of about $1.43B.

Slice it how you like it but according to the market the company has conservatively destroyed almost $1.5B of value in that time and I’d say that’s primarily due to spending $460M on buybacks and debt reduction that could’ve been spent on growing the business or waiting for opportunities to grow the business. If you add that capital back into the business you’d get a market cap closer to $2B right now.

Most of the buybacks occurred near the $30/share range with relatively little of the buybacks occurring near the lows of around $17/share. This kind of capital allocation “discipline” can not be put to bed by arguing that “share buybacks are good if they happen at all”– the latter price represents a 50% discount to the former (or the former a nearly 100% premium to the latter, depending on how you want to look at it)! Are we supposed to be comforted by the fact that DWA’s management and board seem to think the company is cheap anywhere between $3B and $1.5B in market cap?

That isn’t a reasonable way to manage capital. You’ll never catch Warren Buffett making that kind of argument and I highly doubt you’d have much money to manage on your own if you adhered to that philosophy for long.

One of the replies I got back from another investor (see below) on this was that “what’s done is done.” That is an unacceptable response. What’s done is not done because it could very easily happen again and it is more than likely to do so given that the pattern set, the discipline demonstrated so far, is that the management and board of DWA is incompetent when it comes to allocating capital to share buybacks. This is a red flag and a way they could continue to destroy whatever value they create through their growth strategy in the future.

Golden parachutes for the pilot and the flight crew, but not the passengers

At the behest of another money manager with a value-based approach I had been communicating with, I decided to review the Form DEF-14A filed 4/11/12 for DWA. I had (admittedly) skim-read the thing when first performing due diligence several months ago, but I had not read it line-by-line as he had urged me to do, more on that fact in a bit.

As I read through it, I noticed a few things.

For one, I noticed that FRMO-owned companies own 9,614,089 shares or 13.1% outstanding, ostensibly for their ETF products. I am impressed with the strategic thinking of this organization and for the purposes of their own business they seem to be great capital allocators (of course, I have no idea at what prices they accumulated their position). But then it dawned on me that most of their products are passively-managed index ETFs and that took the wind out of my sails. I’m not necessarily under the impression at this point that they hold a stake because they think it’s a great buy, but just because it fits some strategy or theme for one of their proprietary indexes. So, that’s about 13% of the company potentially owned by “dumb money” in this case.

Then I noticed that the company utilizes Exequity and Frederic W. Cook & Co., compensation consultants, to determine executive pay. I’m working on a “digest” post of articles I’ve been reading about corporate governance and activism over at a now-defunct website nominally belonging to Carl Icahn (man, that guy seems a bit ADD at times the way he starts and stops investments, grass roots activism platforms, etc.) and I came across this post on compensation consultants which really set off alarm bells for me.

Think about it for a second– the managers are using company money, which belongs to shareholders, to hire consultants (multiples in this case) who charge millions of dollars and spend hundreds of hours trying to outdo each other in justifying outlandish executive compensation packages. In other words, they use your money to figure out how much they should pay themselves at your expense. It’s kind of like gilt-edged unionism for corporate executives. Why the hell is this such a mystery? Why do you need consultants to figure stuff like this out for you?

This is a corporate governance red flag– this is not treating minority shareholders like equal partners but rather treating them like the sucker at the table. After all, Katzenberg owns about 15% of the company and because of the dual class share structure (another red flag, by the way), effectively controls the company himself which makes him an owner-operator (to be fair, a good thing)… you think he can’t figure out how much to pay his other executives in terms of what’s good for K-man and what’s not?

Preposterous!

Then I get to the actual executive compensation itself. Katzenberg is now paid a $1 annual salary, choosing to receive most of his compensation via stock options and other perks. Other executives are compensated quite generously and compensation has been growing. The value of options grants is $17M annually, or over 1% of market cap each year. Long-term incentive compensation is worth another $9.2M. Combined, that is $26M or almost 2% of the company’s market cap for a handful of top execs and board members.

Other things of note:

  • Lew Coleman, president and CFO, recently exchanged higher annual cash salary structure in return for decreased long-term incentive awards, does this show lack of faith in the long-term value of the company?
  • Ann Daly, the COO, has part of her compensation tied to performance of the company’s stock price, which is an idiotic practice given that it incentivizes her to manipulate the company’s operations to game short-term numbers meanwhile the company’s management has no direct control, in the long-run, over what the investing public thinks of the value of the company (yes, their actions will translate into better or worse valuations but in the end it’s like tying someone’s compensation to the weather)
  • Overall, tons of golden parachutes for just about everyone in the case of a change of control or a termination with or without cause, which are more blatant red flags and give minority shareholders an unfair shake

Then there’s the income tax savings-sharing agreement with Paul Allen, a former shareholder and financial enabler of the company which the proxy explains constitutes “substantial” payments to Mr. Allen over time (this fact being confirmed by the multi-hundred million dollar payable on the balance sheet). To put it simply, I don’t get this or how it works and so far no one has been able to explain it to me. It could be harmless, it could be disastrously unfair to minority shareholder. I really have no clue, it’s beyond my accounting and income tax liability knowledge.

My overall impressions were thus: it takes 66 pages to explain/justify DWA’s compensation practices and related-party special transactions. The company hires compensation and other consultants with shareholder money to determine what management should be paid. And shares are locked up and all change of control decisions will be made by Katzenberg. This company gets maybe a C in terms of corporate governance, which is average in relative terms but sucks in my absolute opinion.

In general, I am concerned about my own ability to understand the accounting behind the company’s compensation practices. And this dovetails with my lingering concern that neither I nor anyone else seems to be able to confidently and accurately model just how much cash specific or even any single movie title in DWA’s library generates for the company at different points over its life.

Bringing it full circle

A few days ago I posted a video interview of Rahul Saraogi, a value investor operating in India, along with my notes of the interview. I found the interview surprisingly impactful (I’ve been watching other interviews from the Manual of Ideas folks and unfortunately none of them have come anywhere close in terms of profundity) and the item that stuck out the most from the whole thing was Saraogi’s comments on the importance of corporate governance and capital allocation for the long-term investment results of minority shareholders.

To reiterate, according to Saraogi good corporate governance means dominant shareholders who treat the minority shareholders like equal partners, who do not treat the company like a personal piggy bank or a tool for furthering their own personal agendas at others’ expense. He says good corporate governance is binary– it either exists or it doesn’t, there are no shades of grey here. The issues I’ve cited above make it clear that DWA does not have good corporate governance practices. The fact that the Form 14A discloses the fact that both David Geffen and Jeffery Katzenberg are essentially using the company resources to the tune of over $2M per year to subsidize their ownership and maintenance of private aircraft is another good example– it is one thing to have the company reimburse them for expenses occurred in doing business but it is quite obvious from the way this agreement is structured that the company is basically paying for the major costs of ownership while they are deriving the personal benefits and exercising discretion as owners in name and title.

Similarly, capital allocation is critical in Saraogi’s mind and many companies and their management don’t get it– they either don’t understand it’s importance or how to do it, or they don’t care because they’re rich enough. I think a little bit of both is operating here. Certainly Jeffery Katzenberg is “rich enough” at this point. He’s worth several hundred million dollars at least, he has the company paying for his private aircraft and other perks and he has even said in interviews I’ve read that he’s got all the money he could need or want at this point and continues to work out of passion and interest. Normally that’s a good thing but in this respect it’s a bad thing because a person who operates as an artist rather than a businessman probably doesn’t care what their ROC looks like as long as they get to put their name on the castles they build.

And people who get capital allocation don’t pay prices that range nearly 100% in value for shares they purchase, unless of course they’re absolutely convinced the intrinsic value still far exceeds such prices. I note here that while there is no evidence from the company that this isn’t the case, there’s similarly no evidence that there is, and I don’t think faith is a good basis on which to form a valuation. As an aside, none of the grade-A elite Wall St analysts on the earnings calls ever ask about this, and my e-mail to DWA’s IR on this topic and numerous others went completely unanswered, which is another embarrassing black mark for the company in terms of corporate governance.

Other voices in the wild

For those who are interested, there are now two recent write-ups on DWA over at Whopper Investments, the first on the value case for DWA and the second analyzing the company’s potential takeover value when compared to Disney’s acquisition of Pixar in 2004.

I really enjoy Whopper’s blog for the most part but I consider these two posts to be some of his weaker analytical contributions to date (which should be obvious from my remarks in the comments section of each, 1 and 2) and if anything that makes me even more queasy with this one– he mimicked a lot of my own unimpressive reasons for investing and I don’t generally find the sound of my own voice that soothing in cases like these, and he seemed unable to answer some of my deeper concerns, which could be evidence of his own shortcomings as an analyst or it could be evidence that these are questions with unsatisfactory answers by and large (I prefer to believe the latter at this point).

In a nutshell, at this point my major concern is that, even if the company successfully executes on its grand growth strategy it might not mean as much for minority shareholders as we might like due to outstanding corporate governance and capital allocation concerns. I seriously wonder if I and many other value investors like me are not blinding themselves to these “binary” concerns because the potential home-run hit possibility of getting in near all-time lows on “the next Disney” is just too exciting to resist.

Whatever I do, I’ve now written this post and put it in the public domain so I won’t be able to excuse myself later on by claiming I hadn’t thought about these issues.

Video – Michael Mauboussian On Forbes

Intelligent Investing with Steve Forbes presents Michael Mauboussin, chief investment strategist, Legg Mason Capital Management, author of Think Twice

Major take-aways from the interview:

  • 9%, 7.5% and 5.5-6%; the rates of return, respectively, for the S&P500, mutual funds and mutual fund investors, on average– why the discrepancy?
  • Mutual funds underperform the S&P500 on a total return basis due to fees; mutual fund investors underperform the funds mostly due to timing– most individuals buy when funds have done well, sell when they’ve done poorly, exposing themselves to underperformance and missing out on subsequent over-performance
  • Curiously, institutional investors underperform as well; the culprit is overactivity– people believe “if you work hard, you’ll be rewarded”, so institutional investors try to “earn” their returns by moving money around constantly
  • Increasingly, investment returns have to do with luck and not skill; all activities in life fall along a continuum between pure skill and no luck (running competition) to pure luck and no skill (the lottery); the “Paradox of Skill” states that the more skillful competitors are, the more uniform their results become and the more important luck is to explaining differences in results
  • How to accurately judge a manager’s returns? Sample size is important: the more decisions the manager has to make over time, the shorter time horizon can be used to judge them; the fewer decisions they make over time, the longer the time horizon used to judge them
  • Focus on process, not outcome; in investing– analytical process of ideas, behavioral/psychological process, and organizational process (constraints w/in the organization that impede performance)
  • Investing boils down to two activities: handicapping (looking at market assumptions via price and then backing into the scenario that would have to occur for that price to be reasonable, and judging the probability of it occurring) and bet-sizing (waiting until you have a strong advantage and then betting big)
  • Expectations-based investing process: back into the cash flow assumptions that justify current market price; financial/strategic analysis of the company and its industry to see if the company is likely to do better or worse than the market implies; then decide to buy, sell or do nothing– what’s built in? what’s likely to happen? then “over-under” rather than “I know precisely what those cash flows will be”
  • Systems that are entirely skill-based don’t revert to the mean at all; aside from fatigue, running a race 5x will result in the same, highly-skilled winner each time
  • The extent to which a system is not all-skill is the extent to which it can mean-revert, but the question is, what mean? A highly skilled person might come down off a peak but they will not revert to the mean of more normally skilled individuals, for instance (tall parents tend to have tall children, but they might not be as tall as the parents — mean reversion — but you also don’t expect them to go down to the height of the average population)
  • Investing is not all-luck, but it is luck-leaning on the continuum; the best way to judge managers is by process, not performance
  • “Buy cheap and hold”: consider the story of Bob Kirby and the “Coffee Can Approach” [PDF]
  • What can older investors do in today’s interest rate environment? Follow Jim Grant’s advice, “Roll back the calendar 30 years”, ie, nothing, they’re screwed
  • “Patience is the key” to great investment returns

Video – Joel Greenblatt On Forbes

Intelligent Investing with Steve Forbes presents Joel Greenblatt, adjunct faculty member at Columbia University, co-CIO of Formula Investing

Major take-aways from the interview:

  • 70% of active managers can not be passive index funds like the S&P500 due to high costs, high fees
  • Unfortunately, for the 30% who beat the index over the last 3, 5 and 10-year periods, there is no correlation with how they do over the next 3, 5 and 10-yr periods
  • A disadvantage to standard index investments is that they are market-cap weighted; the more overpriced something is, the more of the index it represents, the more underpriced something is, the less of the index it represents
  • A superior alternative is equal-weight indexes, for example, in the S&P500, Stock #1 is allocated the same amount of capital as Stock #500; errors are therefore random rather than systematic
  • Greenblatt’s firm created a “value-weighted index”: the cheaper something is, the more weight it gets in the index
  • Key metrics for analyzing a business
    • High adjusted FCF
    • Returns on tangible assets
  • Why do good companies sell cheaply? People are worried that earnings power over the next few years will not be as good as the past so they’re willing to sell at a discount; institutional investors will systematically avoid uncertainty and provide you opportunity to buy cheap
  • Most business schools are teaching Efficient Markets theory, not Benjamin Graham; good news for value investors because it means you have less competition

The Infinite Regression Investment Philosophy

Courtesy of the 2012 FRMO Letter to Shareholders [PDF]:

If one were to look at the 100 US public companies with the largest defined benefit pension plans, one would find the likes of Exxon Mobil, General Electric, Pepsi, Verizon and UPS. As of the end of 2011, using these largest 100 as a proxy, American companies recorded perhaps the largest underfunded status ever, certainly within the past dozen years, both in dollar and percentage terms. And this follows a helpful three years of double-digit annualized returns on their plan assets.

Moreover, there is much reason to expect this position to worsen. The discount rates they use to determine the present value of all their future estimated pension obligations is about 3 times higher, at an average 4.8%, than it should be, since we know the average investment grade bond yield today to be about 1.3%. This means that the obligations are actually far larger than currently presented in these companies’ financial statements. Moreover, these pension plans, on average, still presume to earn almost 8% on their plan assets. Yet, over 40% of the plan assets are invested in bonds. Assuming, as one must, that 40% of these pension plan assets will earn 1.3% at best, then those bond portfolios, all else equal, can contribute only 0.5% to the return of the entire plan assets. This leaves the remaining 60%, most of which is invested in equities, to produce the balance of the 8% expected return, which means the balance must produce about a 13% return every year.

First, one is hard pressed to suggest that this reality will come to pass, so that one should expect much larger funding deficits in the coming years and, it follows, much larger contributions to those pension plans, which in turn must detract from shareholder earnings and earnings growth. That pending reality, though, is less interesting than this one: that these companies, by dint of their investment philosophy and practice, place the major portion of their equity assets in the S&P 500 (and other indices representing essentially the same, largest companies in the US), in order to attempt to earn the highest risk-adjusted expected returns. Yet the S&P 500 to a significant degree is composed of the set of companies with the largest pension plans, which are problematic as described above– these companies are investing in themselves for future returns to restore their pension plans, even as they themselves are problematic because of these pension plans. But this is their formulaic process, and the tools by which this process is measured and implemented are these self-same indices.

This is Free Lunch-thinking.

By the way, value investor Geoff Gannon (much beloved on this site) has written a lot about Dun & Bradstreet, a company with an underfunded pension liability sword hanging over its neck. He makes the case for why this is not something to worry about with DNB but I have to say it’s the one thing making me hesitate about jumping in to an otherwise compelling franchise opportunity.

In general, I try to avoid companies with employee pension plans, at least the defined benefit variety. They may be “private” and “voluntary” but to me they smack of socialism-lite. They’re uneconomic and based upon absurd assumptions and unrealistic expectations. They are, like Social Security, promises that can’t be kept and must eventually be broken.

The trouble is, shareholders will almost always be sacrificed first because we exist in a culture today that penalizes capital and sees the equity holder as a villain and cheat.