RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

F Wall Street Hits #1 and Other Notes

with 2 comments

First, a big congrats to my friend Joe Ponzio, whose book F Wall Street is the number one best seller on Amazon.com in the investments category. Joe and I worked on a small number of projects several years ago, and, to the best of my knowledge, I was the first to write a guest piece for his web site.  More importantly, Joe is the real deal as an investor and among the nicest people I know.  He writes about investing with such clarity and insight that it reasonably makes the rest of us envious.

Second, I haven’t posted much recently; although, I have several items in draft.  So, let me bring you quickly up to date on the investments front.

I am increasingly concerned about the US economy, having crunched the numbers concerning the current accounts deficit.  With debt-to-GDP at over 90%, with the consumer, government, and the banking industry trying to de-lever at the same time, and with another potential leg down for the housing market, this recovery has the strength of a COPD patient on oxygen.  Add to this the looming challenges related to Medicare, the retrenchment by the federal government in their support to the states for Medicare and Medicaid, and the austerity initiatives in Europe and China, and you have the potential for a market crash, a la 1929. 

For those who are return-visitors to this blog, you know that I am not prone to overt pessimism, but the numbers are problematic and inescapable, and they prompted me to read Liaquat Ahamed’s Putlizer Prize winning Lords of Finance:  The Bankers Who Broke the World.  While the title might suggest a recounting of the 2007/2008 crash, it is actually about the central bankers in Europe and the US during the inter-war period between the end of World War I and the start of World War II — primarily focusing on the run-up to the market crash of 1929.

The lesson from that history is that the predicates of crashes are set long before the lit fuse becomes visible, and the result is, either, inflation or deflation — depending on the physics of international capital flows and the responses by government.  During that time frame, the challenges confronting England, France, and Germany were high levels of sovereign debt.  Germany owed reparations to England and France, and England and France owed war-time-funding debt to the US.  Germany chose hyper-inflation and England and France, to varying degrees, chose deflation.  Debt owed to the US and capital flows into the US created a speculative bubble in the stock market, which crashed when Germany and England defaulted and went off of the gold standard.  This led to margin account insolvency in the US, followed by bank runs and the downward spiral you learned about in school.

Now, recognize that, depending on whether you believe inflation or deflation is the likely consequence of current government policy, your investment decisions will differ significantly. 

If believing in the inflation scenario, you want to be in excellent companies with strong financial positions.  By this, I mean companies that have little debt (won’t take a hit if interest rates rise to keep pace with inflation and don’t require debt financing to sustain operations) and those that have pricing power for their products (can increase prices to keep pace with inflation).  If you are uncertain about which companies possess these attributes, read up on Michael Porter’s Five Forces to better understand the strategic competitive factors that sustain companies during challenging times (whether the challenge comes from the economy, government policy, decisions by the Federal Reserve, or competitors).

On the other hand, if you are in the deflation camp (personally, I’m straddling this fence and it is uncomfortable), cash is king.  When deflation hits, the value of cash increases.

Either way, cash provides flexibility.   If the market tanks and inflation follows, I’ll jump into inflation-resistant stocks, such as XOM, TEVA, FCX, etc.  If deflation hits, I’ll sit on cash or, better yet, invest in an ETF of stocks in India, China, or Norway (countries with growing economies and little sovereign debt); although, the 1929 crash in the US arrived despite our strong national balance sheet (suggesting that China and India are not safe, either).

Regardless, I’ve been increasing cash.  My concerns about the economy and uncertainties about whether we are likely to experience inflation or deflation, prompted me to do what I did at the start of the last crash — namely, sell any position about which I am not abundantly comfortable.  Although most of that has been accomplished, I may have some additional paring to do.   The result is that my cash position has gone from 10% to 45% , as the market moved up recently.  While I did realize some losses, profits significantly out-weigh losses, and our tax bill will reflect it at the end of the year.

The most significant profits were from the sale of my largest position — McKesson (MCK).  In my judgment, MCK is hovering around fair value, but that is not why I sold.  Instead, I sold MCK to make another purchase — a condo rental investment.

“Real estate!?!????” you must be thinking.  Yes, but it is a great value investment.  Let me explain.

The property in question was worth around $120,000 at the peak of the local market.  Since then, similar properties are selling for around $100,000.  The local market, by the way, is a small college town in the mountains, where student-rented condos and apartments are in short supply and the dorms are terrible.  To insure sale of the condo, the previous owners were offering it for $90,000, and, when it did not sell after a month, reduced the price to $80,000.  Still, it did not sell, because the banks are not lending.

We bought it for $70,000 in an all-cash deal, and still had difficulty securing insurance (such are the dysfunctions of the current economy).  Of course, the real estate market may decline further, but the market for student housing is favorable (the condo is within walking distance to the school and has its own covered bus stop), the school has an excellent reputation and is a magnate for students seeking a quality education in a great environment (minutes from hiking trails and ski slopes), etc.  Additionally, the previous owners renovated extensively (all new appliances and furnishings), and, because we paid cash, we confront no downside due to leverage.  By every imaginable measure, this was a value investment, where we bought at a discount to intrinsic value and with a nice margin of safety.

Now, honesty compels me to mention that our first renters are my son and the adorable young lady that tolerates him — so, I have every expectation that the property will be well maintained for at least the next three years.  They are, indeed, paying a competitive rent (with a small family discount), and Mom and I are not paying dorm or meal plan fees.  The swing in cash flows amounts to about $10,000 per year, which, over the next three years, will reduce our break even resale for the property to around $40,000 (before considering the time value of money and any maintenance costs). 

So, we bought a $120,000 property for $70,000, and break even is $40,000 in three years.

I should note that, since purchasing the property, we have bought back into MCK at about 10% or our prior levels.  While MCK is fairly valued, its future prospects are excellent (as a distributor of pharmaceuticals), due to the changing demographics.

Buffett is famously quoted as writing:

Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

http://www.berkshirehathaway.com/letters/2004ltr.pdf
{Note: Extended quote due to desire to retain context. The emphasis is mine.}

Well, currently, there is no more fearful market than real estate, but fear, alone, is not sufficient to warrant investment. Fearful or not, demand a margin of safety, because, from time to time, the sky may really be falling … or on the verge of doing so.

Now, allow me to say that I have no special insight into how the market will perform this year or next year. The cards are stacked against us, but the timing of their fall is uncertain. In fact, they may not fall at all. Moreover, I have not turned into a market-timing guru — that is beyond my pay grade and competence. I know my limitations, and, if I forget them, my wife will remind me.

Instead, it seems abundantly clear to me that, as a nation, our debt challenges are nearly as great as following World War II (when debt-to-GDP was 120%, but most other nations were comparatively worse off and individual savings was higher). Today, the world economy is not limited to the US and Europe, and most American’s couldn’t buy War Bonds if compelled by law to do so. Surely, this increases market risk, and, if it increases market risk, the required margin of safety required by intelligent investors should increase appropriately. And that is why I’ve moved more prominently into cash and diversified by buying real estate (under unusually favorable terms).

As for the stock market, recognize that there are some exceedingly attractive values today. As Legg Mason’s Bill Miller recently noted, XOM is trading at uncommon values today, and, personally, I’ve been buying Cisco over the past week — how can you not buy when the company has 40+% market share, the next largest competitor has just 5% market share, the stock has been hammered in the market, and is selling below intrinsic value (by my estimations).

Regardless, I have more dry powder than usual, and that dry powder is available to short the market if necessary. When is shorting, as a hedge to protect long positions, appropriate? When the market exceeds the following ranges by 10% or more:

Wilshire 5000 — between 9970 and 12800
S&P 500 — between 1000 and 1300
DOW — between 8970 and 11520

If the news is dire and prompts these measures to decline substantially below the range or if the market significantly exceeds the high end of the range, it may be time to short. Otherwise, the market is just gyrating, as it always has.

This range is based on the convention that fair value for the market is between 70% and 90% of GDP, with appropriate conversions for the DOW and S&P 500. Beyond the problem of recognizing that ours is now a global economy, there are two further issues with this measure. First, the range needs to be updated as GDP rises or falls. This range is up-to-date as of the latest release, but it will quickly become dated; hence, the 10% buffer. Second, it is difficult to know when a decline below the bottom of the range represents a buying opportunity or constitutes a shorting opportunity. To do this effectively requires an assessment of the macro-economic steering winds, and that is a judgment call only you can make at decision time.

Finally, I should note that I have positions in all of the stocks referenced (XOM, TEVA, etc.), and, as always, this blog is not intended to promote buying or selling decisions by you as an individual investor. Do your own due diligence analysis, make your own investing decisions, and, if the market treats us unkindly, be adult enough to accept responsibility for your choices and realistic enough to recognize that the future is uncertain and predicting it accurately is, at best, difficult and, at worst, impossible. We (you and I) do the best we can with the resources available, and neither of us can know what can not be known.

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Written by rcrawford

August 14, 2010 at 7:50 pm

Posted in General

2 Responses

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  1. In what town did you purchase your rental condo? As a real estate investor, I am interested.

    Mag

    January 31, 2011 at 1:11 am

    • Mag, it is in Boone, NC. I should re-emphasize that the terms were unusually favorable, both, in the purchase price and in the cash flows. The reason I mentioned it is to note the applicability of requiring a margin of safety with investments, even outside of the stock market.

      rcrawford

      January 31, 2011 at 12:00 pm


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