How the Crash Altered My Strategy
StockInvestor editor Paul Larson is keeping a wary eye on black swans, black boxes, and high-leverage companies.
The past several years have certainly been interesting ones for investors, with numerous remarkable events we are not likely to see repeated anytime soon. After living through the real estate market collapse, the Great Recession, a significant stock market crash, a credit crisis, and a recovery, there have been more than few learning experiences along the way. Here is how these experiences have altered my basic strategy in managing my personal accounts and Morningstar StockInvestor's Tortoise and Hare portfolios.
Handle Leverage With Care
It strikes me that a common theme among previous bubbles and subsequent collapses and panics is the presence of high amounts of leverage. Debt can fuel excess returns while a bubble is inflating, but it comes with a cost. Namely, debt reduces financial flexibility and can exacerbate the damage on the downside. Debt can also cause financial problems to spread. An unlevered institution can make bad decisions that cause it, and only it, to lose all its money. But a levered institution making bad decisions threatens borrower and lender alike.
In a personal portfolio, I think it is good advice to be very careful when using leverage, either through margin or options. We should always aim to make investment decisions on our terms, not the market’s. But if leverage is involved and not used properly, we could have the rug pulled out and be forced to sell at precisely the worst time.
In terms of looking at companies, I am more respectful of the power of leverage. Hare Portfolio holding Cemex (CX)—which has provided the Hare with an unrealized loss in excess of 50%—certainly provides a useful, if painful, lesson. For many years, the company used the cash flow provided by its core (and exceptionally strong) Mexican cement operations as a way to underwrite debt that it could use to acquire other cement and aggregates companies around the world. The playbook read like this: Take on debt, acquire firm, slash redundant expenses, use the expanded cash flow to pay down debt, repeat.
This strategy worked the first couple of times, but the company got caught with its 2007 acquisition of Rinker. The real estate collapse ate into the company’s cash flow at just the wrong time, not allowing the company to delever via operational cash flow like it had in the past. Plus, the credit crisis meant that the new capital the company was forced to take on came at much higher cost. The fact that our $12 fair value estimate for Cemex is well below what I paid for the shares is proof enough that I made a mistake by buying when I did. The silver lining is that CEMEX and peer company Vulcan Materials (VMC) (which has also provided the Hare a big unrealized loss) are in some of the best positions to see increased earnings should this recovery continue to gain steam.
But getting back to leverage: Between CEMEX and even Hare Portfolio disaster Boston Scientific (BSX) (which went from a profitable position to providing the Hare a realized loss of 24%), I have learned to be very suspicious of companies that use debt to make acquisitions. Most acquisitions destroy value for the buyer, and debt can make a bad situation worse. I have become a bit more strict in looking for balance-sheet strength in the companies I am considering.
Beware the Black Box
One thing that the crash taught me is to be more careful with companies for which a great deal of the intrinsic worth lies in difficult-to-value financial assets on the balance sheet. This is especially true with companies carrying a high degree of leverage. I much prefer companies with unleveraged balance sheets that generate a steady stream of cash flow from “real” businesses and have economic moats that will last decades.
The high amount of balance-sheet uncertainty is the main reason I sold Bank of America (BAC) in 2010, and I have also become less enthusiastic about Tortoise holding J.P. Morgan Chase (JPM). I still think that J.P. Morgan is a top-shelf institution with competitive advantages and outstanding leadership in Jamie Dimon. Yet it is the $2 trillion balance sheet (with an assets/equity ratio, even today, of 11.6) that makes owning this company a form of “faith-based investing.” I’m hoping that the company’s risk controls are sound and that its trading exposure is balanced, but we have no way of knowing for certain. (The “London Whale” situation of 2012 is a recent reminder of this.) The upshot is that I do not envision taking anything but a modest position in J.P. or any other large financial institution, given the inherent uncertainty.
Respect Perception's Connection to Reality
Another reason I am much more leery of banks is the fact that their business models are built on a foundation of confidence, and confidence is something that can very quickly disappear. We saw how Lehman Brothers collapsed in a disorderly manner when confidence in the firm vanished. Washington Mutual also collapsed when rumors of its failure caused massive deposit withdrawals, causing the bank’s actual failure. WaMu failed just weeks before the government’s rescue plans were enacted, unfortunately.
Of course, the fates of these failed institutions were sealed by actions taken long ago—bad bets on real estate combined with leverage—but the events surrounding their actual deaths illustrated that self-fulfilling prophecy is very much a real phenomenon in the markets. (And as a side note, the fact that credit default swaps, basically life insurance on companies, remain unregulated makes this especially true.) Either way, I am less enthusiastic about companies that depend on continual access to the capital markets to fund their businesses. StockInvestor portfolio holdings American Express (AXP), Discover (DFS), and CarMax (KMX) still routinely sell off their receivables as part of their financing strategy, but thankfully all three (especially CarMax) have taken steps to be more self-sufficient.
Things That Never Happened Before Do
Before the credit crisis, I heard it said repeatedly that housing prices in the U.S. have never fallen in the modern era other than in relatively short spurts in isolated geographic areas. At the time this was completely true. Also true at the time was the notion that mortgage loans very rarely soured. Homeowners would put their mortgage payment first in line and bend over backward to make the payment, lest they lose their home. In other words, the mantra “housing prices always go up” became a common belief. This mantra was held by homeowners, lenders, investors, rating agencies, and regulators alike. Sadly, we all know how the later chapters in this story turned quite ugly. I think it is entirely fair to say that this single incorrect belief about housing is behind a majority of the nasty recession and credit crisis that we recently experienced. The main lesson here is that black swans—rare and unexpected events—do exist and will continue to pop up in the future.
In this vein, one investment that I believe warrants caution today is sovereign debt, of which Treasuries are the most relevant for investors here in the United States. Though Treasuries are often considered to be a proxy for a “risk-free” investment, I think that they are anything but.
Consider that our country’s gross federal debt/Gross Domestic Product ratio is now close to 100% and that this figure eclipsed 100% only once in the nation’s history—in the years immediately following World War II. (And back then, there was a very robust post-war economy to help get out of the mess, something we don’t have this time around.) Meanwhile, debt continues to pile on at a very rapid rate. The federal deficit now represents approximately 8% of GDP, a level of deficit spending only seen in history during the Civil War and the two World Wars.
Greece hit a tipping point in 2010. Its government debt was at about a 110% debt/GDP ratio when the bond investors that were funding the debt basically said “no more” and began forcing an end to the country’s profligate spending. Sadly, Uncle Sam is on this same path along with many other developed nations, albeit a few years behind. While the odds of the United States government defaulting on its debt are extremely remote, it is nevertheless within the realm of possibility. A modestly more likely path—Uncle Sam taking actions to devalue the dollar (read: high inflation) to reduce the real value of previous obligations—would still be quite painful for those holding Treasuries.
Either way, I think the saying “if something cannot go on forever it must stop” is entirely appropriate here. I think that the most likely path of all is simply reduced government spending and/or higher taxes, which will be a drag on economic growth for several years to come. I’m not trying to be a sensationalist or throw a tea party here, I’m just pointing out that whatever path we go down, Uncle Sam can no longer be considered a no-brainer risk-free borrower.
Take Steps to Maintain a Long-Term Perspective
I’ve said this before, but it is worth repeating. Our primary competitive advantage while investing—and the reason the Tortoise and Hare portfolios have outperformed their S&P 500 benchmark—is not acumen in trading or timing the market. Our competitive advantage also does not come from having better information about our companies. In this day and age of full disclosure and rapid distribution of information, I believe that information-based advantages in the market are very rare, and becoming rarer.
Rather, the largest competitive advantage stems from simply having a better perspective. I attempt to maintain a long-term view in an investing world driven by short-term incentives. A bad quarter or a modest one-time charge from a company will not bother me, but a narrowing of the moat is worth paying attention to. I try to gauge where a company is going to be in five years and beyond, not where its stock is going to be in five weeks.
If we are to maintain this perspective-based advantage, we have to be mindful of our personal investment allocations. If we have money in the stock market that we will need for personal expenses in the next couple of years, our ability to look beyond the short term and maintain a steady hand during times of volatility is greatly eroded. One might say that to benefit from a long-term perspective, we should only invest long-term money.
The Fear and Greed Idea Still Works
An important guiding principle was cemented during the craziness of 2008 and 2009. Namely, “Be fearful when others are greedy, and greedy when others are fearful.” Those who sold their stocks in fear when the fog of war was at its worst in late 2008 and early 2009 simply turned paper losses into real ones. On the other side, those who bought during this period are generally (using a very broad brush here) looking at gains of roughly double their money on these particular investments. Those that simply held through it all are essentially back to where they were in summer 2008 before the crisis began. Whether 2009 was a good year or not is entirely a matter of perspective.
Over the past few years, the market has gone from full-throttle panic to today, where I think the needle is slightly tipping back to the “greed” side of the dial. At this update, the median stock in our coverage universe has a price/fair value estimate ratio of 0.93, far higher than the 0.58 it was at the height of the crisis. The bargains in the market have also gone from plentiful to scarce, as there are only three wide-moat 5-star stocks at the moment.
The volatility in the market is also a fraction of what it once was; the Chicago Board Options Exchange Volatility Index—the “Vix”—has gone from a peak near 90 in October 2008 to near 18 today. With what appears to be rising complacency in the market combined with a lack of bargains, I think that the most prudent thing to practice today is patience. It is times like this in which the core of the old “fat pitch” strategy makes sense. Namely, remember that there are no called strikes in investing, so don’t swing at the marginally attractive pitches. Wait for the slow pitches right down the middle before taking a swing.
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Paul Larson has a position in the following securities mentioned above: AXP, CX, DFS, JPM, KMX, VMC. Find out about Morningstar’s editorial policies.