The Yaht Club and The Rehab Walker
A couple of weeks ago, I spent a long weekend in New York — something I try to do a couple times each year. My friends and the circle they inhabit are largely Wall Streeters. The story of the last visit was different than prior visits. Where the normal topic of conversation at parties and social gatherings would typically focus on the economy and the investments world, it was largely absent — almost entirely absent. This was the weekend when Lehman failed, AIG was the focus of high-powered meetings seeking a solution that would eventually culminate in its dismemberment, rumors concerning Merrill heated-up anew, and Washington Mutual was included among the whispered names of firms in peril. This was the back story, where the problems confronting each were understood by all, even if the financial press was not yet reporting it (beyond Lehman, at least).
During that weekend, I attended a birthday party at a yaht club, where I met a very successful investor — one who trades his own account from offices in Chicago and New York. I asked what he liked in the market, and his list included several of the problem firms listed above. This surprised me, since he was clearly betting that some firms were too big to fail, and that this too big to fail posture included the stock holders. He saw the look on my face and responded, “If I lose it all, I can make it back.” That was the most indepth discussion of investments I encountered that weekend. Everyone else just seemed shell shocked, and, when I asked what positions made sense in the current environment, I was met with shrugs and uncertainty.
For the last two weeks I’ve wondered whether The Street had figured it out — coming to the consensus that would led to sector rotation. CNBC has reported that cash positions have increased dramatically, as if the dollar represents a safe haven, and that gold has increased, as well. Fiat currencies are no longer based on gold, which, while having industrial uses, is most prominently a repository of bling these days, and the dollar, even if temporarily stronger than the Euro, is a poor hedge against inflation or likely to provide an adequate return on investment. Neither is where the smart money is headed, but it seems questionable to conclude that there is such a thing as “smart money” in the current environment.
This weekend, a New York Times piece on society writer David Patrick Columbia contains the following:
One evening in late September, Mr. Columbia attended a dinner party with a number of extremely rich guests who had suddenly lost a good deal of their assets.
“The conversation went on about the summer,” he said, “about the children, about travel. Actually, no one was talking about it. They really don’t know how to even assimilate that information.” His loud, clear voice deepened: “We have been drinking champagne for a long time.”
…
“That’s a phenomenon in our society,” he said, “of people just standing facing danger and not moving. I remember the footage I saw of the tsunami, of people standing on a hillside watching it at the ocean’s edge, and they were startled and astonished and amazed. And then the ocean came and took them all away. They didn’t know how to get out of the way.”
On September 24th, I wrote about changes made to my investments portfolio and described this unusual level of uncertainty in the last paragraph of that piece. Since then, the Wachovia purchase by, both, Citibank and Wells Fargo hit the press, and continues to occupy it this morning. It appears that the Darwinian investments community is starting to mutate, to accomodate the new reality. The reality this week, however, is different than the reality that will arrive when the $700 billion arrangement between Treasury, the Federal Reserve, Capital Hill, and the banking sector takes hold, with new cash purchasing temporarily illiquid assets. There are two important realizations from this Darwinian change.
The first is to recognize that, while Wilber Ross and Warren Buffett are buying, their purchases are not market purchases in the sense that the average stock market investor understands it. They are not buying and selling stock, but, rather, providing capital where it is needed and where the terms are most favorable to sizable deals. The opportunities that will inevitably arrise for the average investor may be present, but they are not plainly evident — to me, at least. I scanned the S&P 500 this week for value stocks, where the value is not reliant on free cash flows or earnings but, rather, based on tangible assets, and I’m not happy with the results. Five stocks made the cut, but they are watch-list stocks, not screaming buys. They are Microsoft (MSFT), Occidental Petroleum Corporation (OXY), Nvidia (NVDA), Ebay (EBAY), and, believe it or not, Yahoo (YHOO). I am more likely to add to severely beaten down positions (current holdings) before buying any on that short list — prefering to deploy capital toward Freeport-McMoRan Copper & Gold Inc (FCX), Southern Copper (PCU), and BHP Billington (BHP) … commodity offerings all. It isn’t that I believe the emerging markets will continue to emerge during a world-wide slow-down. Instead, I believe commodity demand will not die completely (even in a pronounced recession), and each is cheap beyond imagination — with competitive positions that defy displacement.
Second, a Darwinian market, as with a Darwinian eco-system, relies on change — mutation. In both cases, the inhabitants morph and mutate, and it is from this that the next advance arrives … and this is a good thing. In fact, survival of the fittest follows from mutation, but survival of the fittest rewards mutations that provide a survival advantage and rewards best the mutations that cause a species to thrive. That is the positive. The downside of mutation is the punishment hurled at those which fail to render a benefit or, worse, represent a decrement or detriment. That is how extinction occurs. So, beware the Morph.
At this point, I see nothing suggesting a clear consensus or indication for how individual investors should morph to achieve a favorable mutation — beyond what I’ve written before.
This is important for two reasons.
First, if the professionals are uncertain and have that deer in the headlights perspective, no maven, pundit, or prognostication device or promoter is likely to have the answer. Sure, they will offer their opinions — secure in the knowledge that, if right, their reputations will blossom, and, if wrong, they will reside in abundant good company (their error forgotten soon enough).
Second, insitutional investors account for more than 70 percent of the market’s activity. In this environment, much of this is attributable to options covering, converting positions into cash to accommodate investor withdrawals or mark-to-market write-downs (which will change soon), or portfolio re-balancing (as some storied stocks exit the indicies, others replace them, and funds position themselves to take losses and eliminate speculative holdings prior to reporting). In other words, the trading environment and volumes are influenced by an abundance of motivations (including abject and debilitating fear), and few have any relationship to the companies for which a share of stock represents an equity stake or the intrinsic value of a given firm.
Soon, this will represent a once or twice in a lifetime opportunity, but it seems best to let the market have its mental and emotional breakdown (VIX above 30) and wait for the $700 billion Ritalin to take effect. We may be at a bottom (the patient isn’t out of the woods just yet), but, after such a trauma, I doubt the patient will avoid the need for fiscal therapy — relearning to flex its muscles and developing its coordination. Instead, this week, it sat up for the first time since surgery, and the nurses are just now wheeling in a walker — with wheels on two legs and sliced tennis balls padding the other two. It seems likely to require weeks — probably months, if not a year or more — before it attempts to compete in the hundred-meter hurdles or take flight on a triple Salchow.
Another set of great posts, RCrawford… Global sell-off continues as all the big players deleverage. I don’t know what the particulars are in the searches you’re doing, but now there are many companies trading at or below book value / intrinsic value / working capital. Of course, one must further investigate to come up with your own values.
Construction has been devastated, for example, Ingersoll-Rand (IR) just dipped below $25. Yahoo has their book value at 33.88. Div yield at 2.6%. (Note: Berkshire Hathaway has position in IR in the 30s, along with Trane shares converted into IR shares.)
Along with metals, Oil & Gas have been devastated across the board. Take your pick. Many are below NAV and book value. Conoco-Phillips briefly fell below it’s book value of $60.79 today, div yield ~3%. (Berkshire also had a position in this earlier around 60, but hid it’s disclosure about it’s stake in recent quarter.) Of course, the Oil Equipment / Drillers take an even bigger hit.
Back to our health insurers, UNH near it’s lows along with WLP. (Berkshire took position in UNH in high 40s!)
I’m not just following around whatever Berkshire does, but it’s always good to compare with what the guys with the best track record are doing, etc.
Also, another one I have been interested in is Domtar (UFS). Merger recently with Weyerhaeuser (WY) fine paper. Integrated paper producer that with International Paper (IP), controls roughly 60% of uncoated free sheet paper production (printing paper, etc.). Now raising prices and passing along costs. Has 28 mil acres of timber-lands, listed around cost. Currently trading at $3.36, yahoo lists book value at 6.24. Large debt load however.
Curious about your thoughts on these companies.
Another tough thing about these markets is one of portfolio/capital allocation– if your positions are going down along with the market, how to you figure what to hold onto, what to sell, to get more cash to invest in better opportunities–especially when you have substantial losses in positions you consider at bargain prices? I guess this is a classic issue.
Been quite an exciting time–this is my first real observation of a major financial crisis, all the previous ones (S&L, Asian), I was just a kid!
Looking forward to hearing from you.
Regards,
SC
SC
October 6, 2008 at 9:30 pm
Thank you for the question. First, as I wrote in the original piece, I suspect that no one has a lock on identifying meritorious investments in this environment. That would include me. So, as I go through each of the stocks you’ve identified, recognize the imperfection of the writer.
Second, I can only provide you with my reasoning behind rejecting each of the stocks you have identified. During this difficult time in the market, my standards for selection are significantly more stringent than they might otherwise be. Consequently, if you conclude that I am simply being “picky,” I am happy to declare “guilty as charged.”
Now to the individual stocks you have identified.
International Paper. International Paper, by discounted cash flows, is fairly valued, even after today’s decline in the market (posting a discount of just 4%). Replication value exceeds earnings power value (-7.51), its weighted average cost of capital exceeds its cash return on invested capital (0.33), its cash return on invested capital is just 3%, its free cash flow yield is 6% (below the historical market variance for the stock market of 6.8%), its operating cash flow growth rate is a -3% (over 10 years), free cash flows cover just 15% of current liabilities, its free cash flow growth rate is a -10% (over 10 years), its shareholders equity growth rate is a negative four percent, it has a Z-score of 3.03 (barely above the gray area for bankruptcy), and its earnings power value has never exceeded its replication value over the past 10 years.
Weyerhaeuser. Weyerhaeuser’s discounted cash flow discount is 27% (acceptable, but below my threshold as a deep-discount investor), its adjusted book value (2.97) is marginally above the acceptable range, replication value exceeds earnings power valued by 17.37%, is weighted average cost of capital exceeds its cash return on invested capital (0.22), its cash return on invested capital is just 2%, its free cash flow yield is just 4%, free cash flows cover current liabilities by just 17%, and earnings power value has never exceeded replication over the past 10 years.
Domtar Corporation (UFS). For those who may not be familiar with it, this is a paper and wood products company. Of the group of recommended stocks (your recommendation), this is one of the best, in my view. By discounted cash flow analysis, it is undervalued by 79%, and it has a price to adjusted book value of 1.44. Unfortunately, replication value exceeds earnings power valued by 22.37%, its average cost of capital exceeds cash return on invested capital (roughly, 12%), cash return on invested capital is just 7%, operating cash flow growth is just 3%, free cash flow growth rate is just 6%, earnings power value has never exceeded replication value during the past 10 years, and it’s Z-score is 2.10 (firmly in the gray zone for bankruptcy risk, with a 3.0 represents the upper end of the Gray zone).
Conoco Philips. This is a company that is barely above the threshold for adjusted book value (2.6 8), but enjoys a discount to intrinsic value by discounted cash flow analysis of 92%. Personally, I own Exxon and prefer it for a number of reasons. That, however, provides no information concerning Conoco Philips. In the most recent year, replication value exceeded earnings power value (1.31), weighted average cost of capital exceeded cash return on invested capital (by, roughly, 20%), cash return on internal invested capital was below my threshold of 15% (8%), and replication value has exceeded earnings power value for each of the prior 10 years. There are, however, a number of items that strongly recommend the stock (in my view). The operating free cash flow growth rate is 41%, free cash flows cover current liabilities at an attractive level (47%), the free cash flow growth rate of 44% is impressive, and their shareholders equity growth rate (49%) is more than enticing.
WellPoint. This is another strong selection on your part. By discounted cash flow analysis, it is undervalued by 55%, and it enjoys a price to adjusted book of 0.81 (a significant discount). Moreover, this is the only recommended Stock where the cash return on invested capital exceeds the weighted average cost of capital (10%). Free cash flow exceeded current liabilities by 28% (just over Benjamin Graham’s 25% threshold). There are, however, a number of negatives that concern me. First, earnings power value fails to exceed replication value (-0.53), and this failure is present in each of the past seven years for which there is reported data from MorningStar. While cash return on invested capital (11%) is the strongest for the various recommended stocks, it is marginally below my 15% threshold (at 11%). Its operational cash flow growth rate is just 0.0% over the past 10 years, as is its free cash flow growth rate and its shareholders equity growth rate. Most alarming, its Z-score is 2.53, placing it firmly in the gray zone for bankruptcy risk.
Ingersoll-Rand. This is a stock that is selling at just 3% below its intrinsic value, by discounted cash flow analysis. Its price to adjusted to book value of 1.36, however, is attractive, and, uniquely among the recommended stocks, its earnings power value exceeds its replication value (6.89x). At 8.86%, however, its weighted average cost of capital exceeds its cash return on invested capital (2.9%), and it posted just a 3% cash return on invested capital. Its free cash flow yield is just 6%, and it has a negative operating cash flow growth rate of -3% over the past decade. Free cash flows cover current liabilities by just 15%, and the free cash flow growth rate is 10% (4% for shareholders equity growth rate), leading to a barely acceptable 3.03 Z-score. Like all the stocks previously mentioned, earnings power value rarely exceeds replication value of the prior decade.
It is important to mention that each of us, as investors, possess different standards for identifying attractive investment opportunities. Clearly, you have a better understanding of the strategic positioning and forward prospects for each of the stocks you have recommended. My screen, therefore, represents a first cut analysis, designed to identify those rare opportunities where past performance and current fundamentals are nearly pristine. This is an abundantly difficult standard to meet. So, there is no right or wrong answer to this proposition.
Instead, we confront two fundamentally different challenges. Both of us are investors. As such, we frequently confront buying decisions that require a healthy dose of individual judgment. The difference between us is that mine is a public blog, that is strongly linked to my professional role as a professor of management.
Therefore, two types of stock occupy my personal portfolio – those that represent judgment calls and those which meet a higher standard. For example, I have current positions in BPT, E, PFE, PVX, and TSM, which, for various reasons, fell into the “judgment call” category but have never been mentioned in this blog. The strength of those choices did not rise to a level at which I felt comfortable making a recommendation to the average investor – even though two of those stocks provide a dividend in excess of 10%. When your reputation rides on the recommendation, the criteria for selection increases significantly, and, when recognizing that many investors lack your experience, that obligation (as a matter of professional ethics) rises even further. I hope you understand.
Thanks,
Robert
rcrawford
October 7, 2008 at 7:23 am
Robert,
Thanks for that thoughtful first-cut analysis. I agree, there are some inputs (margin expansion, pricing power, etc.) that aren’t reflected in the financial history, which of course puts them more into the judgment call territory. Also, do you have any links or know of any books that discuss how one comes up with “replication value”? I did a google search, and your site search, but nothing that describes that valuation process.
One more thing: My language probably came across too vague, but it was not my intention to list the stocks as recommendations. More as case studies for discussion. People can come up with their own decisions. I too, do not want to bear responsibility for other people’s purchases!
Best,
SC
SC
October 7, 2008 at 11:34 pm
Thanks, SC. I understood and appreciate the use of the specific stocks as cases for discussion and referred to them as “your recommendations” for lack a better term.
As for Replication Value, this is a concept found in Bruce Greenwald’s latest book, “Value Investing: From Grham to Buffett and Beyond.” He takes Graham’s approach of adjusting book value (described in “Security Analysis”) and makes further adjustments for R&D and advertising, to identify what a new market competitor would spend to achieve the same market standing as the firm being considered. He uses this as a point of comparison to Earnings Power Value, with the difference between the to represent franchise value. If the difference is positive, the company has a franchise (akin to what Buffett calls a “moat”). If the difference is negative (i.e., Replication Value exceeds Earnings Power Value), not only is there not a franchise value, but, more importantly, the company’s growth investments (growth CapEx spending) is detrimental to the investor.
Keep in mind that, while a firm may be a beneficial investment if not growing, the power of compounding is not present. Moreover, it would be a mistake to value a company based on Discounted Cash Flows under such a scenario, unless the free cash flow growth rate assumptions are zero or less.
You should find other blog entries that use the terms Replication Value and Earnings Power Value, as well as references to Bruce Greenwald. http://rcrawford.files.wordpress.com/2008/05/shld101.jpg provides an old version of the calculations for Replication Value in a single year, and http://rcrawford.files.wordpress.com/2008/05/shld12.jpg does the same for Earnings Power Value. Looking at the sheets is not likely to be sufficient — so buy the book to better understand the concepts and the reasoning behind the calculations.
Thanks,
Robert
rcrawford
October 8, 2008 at 3:08 am
These markets are haywire. All commodities have been absolutely crushed. You mentioned FCX: it has ~$90/sh just in gold reserves on it’s balance sheet and now it’s trading in the 30s. There are many MLP gas / utilities MLP’s with significantly hedged production yielding 10-20%. Every oil/nat gas/driller devastated. Take your pick for all the big consumer staples names too. Munger’s Wesco (WSC) is trading below cash / share with essentially no debt. Berkshire’s Mid-american is purchasing Constellation for $26.50 in cash, but CEG was recently trading below $22.50. Considering the government is now making loans to companies of all sorts, wouldn’t that reduce the risk of bankruptcies? I see on tv all the big shots saying they are staying away…but seems like so many disconnects between long-term fundamentals of solid companies and their prices…
Best,
SC
SC
October 11, 2008 at 1:03 am
SC,
I agree about the mispricings, but, regardless of Munger’s connection to WSC, I am staying away from financials. This is not in response to the recent turmoil in the sector. Instead, it is the lack of transparency present in all financial firms.
Even if able to draw reasonable conclusions about their cash position, their investments are obscured, and, even if willing to make such an exercise of faith, their cash flows are uncertain and, consequently, the present value of those future streams are indecipherable.
If a firm if worth the future wealth returned to the investor (discounted to present dollars) plus its accumulated shareholders equity, that valuation is dependent on future cash flows. Remove that and you are left with the shareholder’s equity, alone — which can be diminished by the poor judgment of management.
Personally, I would prefer to partner with more transparent firms — even the occasional retailer –, because I can subsequently apply a significant margin of safety (50 percent or more). I just don’t see how the conservative investor can do this with financial firms, given the uncertainties surrounding their accounting.
Thanks,
Robert
rcrawford
October 12, 2008 at 7:56 am