A Little Bit of History Repeating

In 1977, Warren Buffett wrote an article for Fortune Magazine titled “How Inflation Swindles the Equity Investor.” In the article, Buffett outlines the parallels between equities and bonds, and the impact of interest rates & inflation movements on both asset classes.

Given the interest rate and inflation debate raging today, I thought it worthwhile to revisit and study what had transpired in the past.

Interestingly, if we applied the lessons of this 1977 article to today's environment, contrary to the article’s title, it actually bodes well for future equity prices (see bold below), especially those companies compounding and reinvesting earnings rather than paying dividends.

Inflation, Duration, Compounding, Opportunity Cost

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment…When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner…For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities…

…I believe…that stocks, in economic substances, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact no varied much at all…in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years…

For the moment, let’s think of those companies, not as listed stocks, but as productive enterprises. Let’s also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an ‘equity coupon’…

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, the can refuse to play further unless coupons currently being offered rekindle his interest…

Stocks on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate…Individual companies can be sold or liquidated and corporations can repurchase their own shares; on the balance however, new equity flotations and retained earnings that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity ‘coupons’ won’t…

There is another major difference between the garden variety of bond and or new exotic 12 percent ‘equity bond’ that comes to the Wall Street costume ball dressed in a stock certificate.

In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor’s equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.”

Here is where things get interesting: 

“This characteristic of stocks – the reinvestment of part of the coupon – can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950’s and early 1960’s. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent was of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period raged far above book value…You can’t pay far above par for a 12 percent bond and earn 12 percent for yourself.

But on their retained earnings, investors could earn 12 percent. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.

It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it…

If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a further unusual characteristic – which was that most of the coupon payments could be automatically reinvested at par in similar bonds – the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy – and, of course, they paid happy prices.

Looking back, stock investors can think of themselves in the 1946-1956 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones Industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966…

This heaven-on-earth situation finally was ‘discovered’ in the mid-1960’s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percent and the reinvestment ‘privilege’ began to look different.

Stocks are quite properly though of as riskier than bonds…they come equipped with infinite maturities. (Even your friendly broker wouldn’t have the nerve to peddle a 100-year bond, if he had any available, as ‘safe.’) Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent on equity versus, say 10 percent on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

As Mark Twain said, “history does not repeat itself, but it does rhyme.” Food for thought. 

Wisdom from Steve Romick: Part 3

Continuation of content extracted from an interview with Steve Romick of First Pacific Advisors (Newsletter Fall 2010) published by Columbia Business School. Please see Part 1 for more details on this series.  

Creativity, Team Management

“G&D: We also noticed that you recently hired Elizabeth Douglass, a former business journalist with the LA Times, which we found interesting – can you talk about that decision?

SR: We are trying to do due diligence in a deeper way and get information that may not be easily accessible. For example, with Aon, Elizabeth will help us track down people who used to work for Aon and get their phone numbers…So, she is an investigative journalist for us, a data synthesizer, research librarian and just a great resource to have.”

During my tenure at the multi-billion family office, my colleagues and I used to joke about Manager Bingo. Instead of numbers, on a bingo card, we’d write certain buzz words – “private equity approach to public market investing,” “long-term focus,” “margin of safety,” “bottom-up stock selection with top-down macro overlay” etc. – you get the idea. In meetings, each time a manager mentioned one of these buzz words/concepts, we’d check off a box. Blackouts were rare, though not impossible, depending on the manager.

But I digress. In the marketing materials of most funds, there’s usually a paragraph or sentence dedicated to “proprietary diligence methodology” or something to that effect. Most never really have anything close to “proprietary” – just the usual team of analysts running models, following earnings, and setting up expert network calls with the same experts as the competition.

Here, Steve Romick describes an interesting approach: a “research librarian” and detective to organize and track down new resources that others on Wall Street have not previously tapped, thus potentially uncovering fresh information and perspective. This is not the first time I’ve heard of investment management firms hiring journalists, but the practice is definitely not commonplace. Kudos on creativity and establishing competitive advantage!

Benchmark, Hurdle Rate

“Beating the market is not our goal. Our goal is to provide, over the long term, equity-like returns with less risk than the stock market. We have beaten the market, but that‘s incidental. We don‘t have this monkey on our back to outperform every month, quarter, and year. If we think the market is going to return 9% and we can buy a high-yield bond that’s yielding 11.5% and we’re confident that the principal will be repaid in the next three years, we‘ll take that…We are absolute value investors. We take our role as guardians of our clients’ capital quite seriously. If we felt the need to be fully invested at all times, then we would have to accept more risk than I think we need to.”

Romick’s performance benchmark is absolute value driven, not to outperform the “market”. I wonder, what is a adequate figure for “long term, equity-like returns?” Is this figure, then, the hurdle rate that determines whether or not an investment is made?

Volatility

“Fortunately, people are emotional and they make visceral decisions. Such decisions end up manifesting themselves in volatility, where things are oversold and overbought.”

Emotions and investor psychology causes volatility (Howard Marks would agree with this), which is a blessing to the patient, rational investor who can take advantage when “things are oversold or overbought.”

Foreign Exchange

“The government is doing its best to destroy the value of the US dollar. We have made efforts to de-dollarize our portfolio, taking advantage of other parts of the world that have better growth opportunities than the US with more exposure to currencies other than our own.”

Inflation

“We are seeking those companies that are more protected should inflation be more than expected in the future…We are looking for companies where we feel the pricing power would offset the potential rise in input costs. That leads us to a whole universe of companies, while keeping us away from others.”

Invisible Hands Encore

Many thanks to Adam Bain of CommonWealth Opportunity Capital for tipping PM Jar about this chapter in Steve Drobny’s Invisible Hands. “The Pensioner” interviewed “runs a major portfolio for one of the largest pension funds in the world.” He seems to define risk (for the most part) as volatility. Regardless of whether you agree with this definition, the chapter is a worthwhile read because he brings the “risk” discussion to the forefront of the portfolio construction and management process – whereas many currently approach and manage risk as a byproduct and afterthought.

Oh, and he also provides some very unique thoughts on liquidity and illiquidity.

Risk, Expected Return, Diversification

While focusing too much on the (desired) expected return, say 8% per annum, investors lose sight of the actual level of “risk” assumed in the portfolio. The Pensioner believes that “investors on average, are led astray at the beginning of the portfolio construction process by focusing on a return target…the level of risk assumed to achieve that target becomes secondary.”

Currently, it is “common practice” to allocate capital “based on dollar value as opposed to allocating based on a risk budget. Oftentimes, this can lead to asset allocations that appear diversified but really are not…The goal is to build a portfolio that produces the maximum return per unit of risk.” Some may refer to this as maximizing risk-adjusted return.

A good risk management process should incentivize employees to be “cognizant” of risk, and to focus on “risk-adjusted returns, as opposed to just nominal returns…” and “…trade off between the marginal risk consumed by an investment and the investment’s expected return.” This concept is akin to a business’ focus on net income or cash flow, rather than top line revenues.

“Portfolio managers get themselves into trouble when they look at opportunities as standalone risks. The marginal contribution to overall risk is what is most important.”

In essence, “risk needs to be treated as an input, not an output, to the investment process.”

Risk identification is not always straightforward or all that obvious. For example, certain asset classes traditionally considered “nonequity” (such as private equity, real estate, infrastructure, etc.) actually have very equity-like qualities. Fixed income and credit is “really just a slice of the equity risk premium.”

Liquidity

For those interested in the topic of liquidity and illiquidity, I highly recommend the reading of the Pensioner chapter in its entirety. He presents some very interesting and unique perspectives on how to think about both liquidity and illiquidity in a portfolio context.

Perceptions as well as actual liquidity profiles of assets can change depending on the market environment. For example, in 2008, people learned the hard way when “assets that were liquid in good times…became very illiquid in periods of stress, including external managers who threw up gates, credit derivatives whereby whole tranches became toxic, and even crowded trades such as single stocks chosen according to well-known quantitative screens.”

“Illiquidity risk needs to be recognized for what it is, which is just another risk premium amongst many.” But how do you value this risk? That’s the tricky part, with no exact answer, but fun to think about nonetheless…

“By entering into an illiquid investment, you give up the option to sell at the time of your choosing, and as a result, an opportunity cost is incurred. Illiquidity is essentially a short-put option on opportunity cost and, if you were able to estimate the likelihood and value of all future opportunities, then you could estimate the illiquidity risk premium using standard option pricing theory. Of course, this is almost impossible in practice.” So in order to think about the cost of illiquidity, we must consider opportunity cost. Sound familiar? That’s because opportunity cost is also the essential input for the theoretical valuation of cash. For that, see our post on Jim Leitner, who has some wonderfully insightful thoughts on that subject.

Illiquidity is a “negative externality.” The evidence for this claim lies in 2008, when “many liquid managers were shut down, despite excellent future prospects. This was because clients, desperate to raise capital or cut risk and unable to sell their illiquid assets, sold whatever they were able to.” Therefore, illiquidity impacted not only those assets that were illiquid, but spread to negatively impact other asset classes.

Liquidity, Trackrecord, Volatility

Ironically, the illiquid nature and lack of pricing availability of some assets actually improved the volatility profile and trackrecords of some managers due to the “artificial” smoothing provided by the delay in mark to market. So there you have it: illiquid assets can sometimes be used to game the system for both returns and volatility. Disclaimer: PM Jar is not recommending that our Readers try this at home.

Volatility

PM Jar usually does not highlight mathematical or formulaic concepts. But the unique nature of this concept merits a quick paragraph or two.

Many have characterized the events of 2008 as “nonnormal.” But the Pensioner claims that 2008 events were not “exceedingly ‘fat’ or nonnormal…rather, they exhibited nonconstant volatility…A risk system capable of capturing short-term changes in risk would have gone a long way to reduce losses in 2008.”

The book provides the following explanation for stochastic volatility:

“Stochastic volatility models are used to evaluate various derivatives securities, whereby – as their name implied – they treat the volatility of the underlying securities as a random process. Stochastic volatility models attempt to capture the changing nature of volatility over the life of the derivative contract, something that the traditional Black-Scholes model and other constant volatility models fail to address.”

Inflation

All assets respond to inflation over the long-term – for better or for worse. However, in the near-term, some assets we commonly believe to be hedges to inflation often don’t work out as expected. For example, “Real estate and equities...get hit hard by unexpected inflation because even though they have real cash flow, they are still businesses, and the central bank response to inflation is to raise rates to slow demand.”

Leverage

The term leverage generally has a negative connotation, but in his mind, there are 4 different types of leverage – some good, some bad:

1. “Using leverage to hedge liabilities” – GOOD
2. “Using leverage to improve the diversification of a portfolio” – GOOD
3. “Levering risky positions to generate even high expected returns” – BAD
4. “Using off-balance sheet hidden leverage to make risky assets even riskier (i.e., private equity)” – BAD

It’s not leverage itself that’s bad, it’s how you use it – similar to how “guns don’t kill people, people kill people.”

Accounting Leverage – the type of leverage that “shows up directly on a fund’s balance sheet,” such as margin, repo or derivative transactions.

Economic Leverage – the leverage “born indirectly by the fund through some other entity.” Examples include highly levered public securities owned by the fund, or private equity allocations that have highly leveraged underlying holdings.

Hedging

When people hedge to put a floor on near-term returns, it entails “costs to the fund over the long-term because I am essentially buying insurance on my job and billing my employer for the premium.”

Klarman-Zweig Banter: Part 2

Here is Part 2 of tidbits from a conversation between Seth Klarman and Jason Zweig. Part 1 and the actual text of the interview is available here. Time Management

“…sourcing of opportunity…a major part of what we do – identifying where we are likely to find bargains. Time is scarce. We can’t look at everything.”

“...we also do not waste a lot of time keeping up with the latest quarterly earnings of companies that we are very unlikely to ever invest in. Instead, we spent a lot of time focusing on where the misguided selling is, where the redemptions are happening, where the overleverage is being liquidated – and so we are able to see a flow of instruments and securities that are more likely to be mispriced, and that lets us be nimble.

Team Management

“…we are not conventionally organized. We don’t have a pharmaceutical analyst, an oil and gas analyst, a financials analyst. Instead, we are organized by opportunity.” Examples include spinoffs, distressed debt, post-bankruptcy equities.

During the recruiting and screening process, Baupost looks for “intellectual honesty…we work hard to see whether people can admit mistakes…We ask a lot of ethics-related questions to gauge their response to morally ambiguous situations. We also look for ideational fluency, which essentially means that someone is an idea person…do they immediately have 10 or 15 different ideas about how they would want to analyze it – threads they would want to pull a la Michael Price…we are looking for people who have it all: ethics, smarts, work ethic, intellectual honesty, and high integrity.”

Michael Price, Creativity

Mike taught him the importance of an endless drive to get information and seek value, as well as creativity in seeking opportunities.

“I remember a specific instance when he found a mining stock that was inexpensive. He literally drew a detailed map – like an organization chart – of interlocking ownership and affiliates, many of which were also publicly traded. So, identifying one stock led him to a dozen other potential investments. To tirelessly pull treads is the lesson that I learned from Mike Price.”

Risk, Creativity

The process of risk management is not always straightforward and requires creative thought. “An investor needed to put the pieces together, to recognize that a deteriorating subprime market could lead to problems in the rest of the housing markets and, in turn, could blow up many financial institutions. If an investor was unable to anticipate that chain of events, then bank stocks looked cheap and got cheaper.”

Capital Preservation, Conservatism

“Avoiding round trips and short-term devastation enables you to be around for the long term.”

“We have picked our poison. We would rather underperform in a huge bull market than get clobbered in a really bad bear market.”

During 2008, Baupost employed a strategy of identifying opportunities by underwriting to a depression scenario. “We began by asking, ‘Is there anything we can buy and still be fine in the midst of a depression?’ Our answer was yes…Ford bonds had an amazing upside under almost any scenario – if default rates only quadrupled (rather than octupled, as we assumed) to 20%, the bonds were worth par – and thus appeared to have a depression-proof downside.”

“Our goal is not necessarily to make money so much as to do everything we can to protect client purchasing power and to offset, as much as possible, a large decline in market value in the event of another severe global financial crisis…we also want to avoid the psychological problem of being down 30 or 40 percent and then being paralyzed.”

Foreign Exchange, Benchmark, Inflation

“We judge ourselves in dollars. Our clients are all effectively in the United States…we hedge everything back to dollars.” Michael Price used to do the same. Please see an earlier post on an interview given by Michael Price.

“When Graham was talking about safety of principal, he was not referring to currency. He wasn’t really considering that the currency might be destroyed, but we know that can happen, and has happened many times in the 20^th century.”

Klarman is worried “about all paper money,” and has also mentioned Baupost’s goal to “protect client purchasing power.” Does he mean purchasing power on a global basis? Which brings forth an interesting dilemma: as the world becomes increasingly connected, and clients become increasingly global, will return benchmarks still be judged in US dollars and US-based inflation metrics?