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New investment post on Berkshire Hathaway

17 Nov 2014 by Jim Fickett.

Berkshire Hathaway update

A helpful summary on value strategies from Tweedy, Browne

9 Nov 2014 by Jim Fickett.

Tweedy, Browne Company, LLC is a small firm with a long history in value investing:

The Firm’s 94-year history is grounded in undervalued securities, first as a market maker, then as an investor and investment advisor. The Firm’s investment approach derives from the work of the late Benjamin Graham, co-author of the first textbook on investment research, Security Analysis (1934) and author of The Intelligent Investor (1949). Graham, through his investment firm Graham-Newman Corp., was one of the Firm’s primary brokerage clients in the 1930s, 1940s, and 1950s. It was through Graham that the original partners of the Firm developed brokerage relationships with investment legends Walter Schloss and Warren Buffett …

In 1959, the partners of then Tweedy, Browne & Knapp pooled their capital in a partnership investment vehicle. In 1968, the firm accepted its first outside money management clients as limited partners of this vehicle. In 1975, Tweedy, Browne registered as an investment advisor and began managing separate accounts for individuals and institutions. As of September 30, 2014, the firm managed approximately $21.4 billion for individuals, institutions, partnerships, off-shore funds and four mutual funds

Tweedy, Browne have made available a number of research reports, one of which is entitled “What Has Worked In Investing, Studies of Investment Approaches and Characteristics Associated With Exceptional Returns”, or “What has worked” for short.

What Tweedy, Browne have done is read about 50 published reports, each of which evaluates the results of following a particular value-oriented strategy in a particular market over a particular period. They have grouped these reports by strategy and market, and summarized the results. Although the general idea of “buy low, sell high” is obvious enough, there are many ways to implement it. The studies covered in this review evaluate cheapness relative to current assets, to book value, to profits, to cash flow, and to dividends. They also look at other indicators sometimes related to cheapness, such as insider buying and market capitalization.

The three most important conclusions are that (1) almost any form of “buy cheap” does give better returns than investing in an index covering the whole market, (2) this better performance does NOT come at the price of higher risk – value stocks decline less than others in a bear market, and (3) the definition of “cheap” giving the best results overall is “the stock price is cheap compared to book value”. The latter conclusion comes from a study by Fama and French:

the authors, through a regression analysis, examined the power of the following characteristics to predict future investment returns: market beta, market capitalization, price/earnings ratio, leverage and price-to-book value percentage. Their conclusion: price-to-book value “is consistently the most powerful for explaining the cross-section of average stock returns.”

The fact that “buy cheap” works is not a surprise, though it is useful to see how many studies confirm that it works in various forms. There are some surprises in the report. For example, one study concludes that among undervalued stocks, the ones that perform best are those for which the company is losing money. I would have expected the opposite – that positive income would be one more indication that the market was being irrational, while a company making a loss would be, in fact, expected to be a so-called “value trap”.

After reading “What has worked”, one realizes that there are some gaps in the current literature on value investing. Although it does seem intuitively that the basic strategy of “buy cheap” should work universally, formal studies cover only a very narrow scope. There are exceptions, but most of the studies cover American stocks, and most cover time periods in the last three decades of the twentieth century. This is, of course, a result of data that are more easily accessible. But it would be nice to see more studies extending to other domains.

The studies also leave open the value of active management. It is interesting that most of the studies show that some mechanical value strategy produces excess returns (over the whole market) of several percent annually. Tweedy, Browne's excess returns for the Global Value Fund, since inception in 1993, are about 4%. The possibility that a rigid, mechanical strategy might do just as well as an active manager is probably irrelevant for the small investor, because investing in a portfolio of a large number of stocks, with frequent turnover, would incur excessive transaction costs. But it does raise the question of whether it would be valuable for one of the big fund managers to introduce a low-cost fund that just invests mechanically in those stocks with the lowest price to book ratio.

Commercial property debt also in a bubble

6 Nov 2014 by Jim Fickett.

The Fed's easy money policy is encouraging massive issuance of poor quality debt that will eventually lead to defaults. This is most notable, and most important, in the corporate credit market, but is also significant in several other areas. The Financial Times pointed today to excessive prices and lax lending standards in the commercial property sector:

Years of low interest rates and intense competition between lenders has helped push US commercial property prices to a new record – surpassing a previous peak reached at the height of the credit bubble in late 2007 …

The new record comes at a time when regulators, bankers and others have been warning about the rapid rebound in certain types of commercial lending as originators loosen their underwriting standards to gain more business.

Analysts say many banks have swapped home mortgages in favour of lending to companies while a host of new lenders like hedge funds and private equity firms have also entered the space, helping to fuel the turnround in commercial pricing. …

Sales of commercial mortgage-backed securities (CMBS), which package loans secured by everything from office buildings to shopping malls, have surged as investors seek out the riskier but higher-yielding assets. …

Demand from yield-starved investors has kept borrowing costs low, with the average coupon for CMBS conduit loans currently at about 4.6 per cent, according to Moody’s, compared with 6.2 per cent during the fourth quarter of 2007. …

In a [Moody's] report released last week, Mr Philipp warned that CMBS standards are slipping: “Despite still-fresh memories of the run-up to the pre-crisis peak and the subsequent CMBS issuance shutdown, loan originators have reverted to old patterns.”

The corporate credit market is many times larger than the commercial property debt market. Nevertheless, every sector is important, first, because the trigger for the credit crisis could come from any direction, so it is important to keep an eye on all overheated sectors. And second, since there are so many overvalued and fragile markets, the next credit crisis will very likely see a highly correlated price drop across many kinds of assets.

IMF warning on US corporate bond markets

20 Oct 2014 by Jim Fickett.

The International Monetary Fund recently issued the latest Global Financial Stability Report, and highlighted in a blog post the risk in US corporate debt:

Heat Wave: Rising Financial Risks in the United States Posted on October 10, 2014 by iMFdirect

By Serkan Arslanalp, David Jones, and Sanjay Hazarika

Six years after the start of the global financial crisis, low interest rates and other central bank policies in the United States remain critical to encourage economic risk-taking—increased consumption by households, and greater willingness to invest and hire by businesses. However, this prolonged monetary ease also may have encouraged excessive financial risk-taking. Our analysis in the latest Global Financial Stability Report suggests that although economic benefits are becoming more evident, U.S. officials should remain alert to excessive financial risk-taking, particularly in lower-rated corporate debt markets.

… financial risk taking in corporate debt markets is rising and markets have begun to overvalue many assets. Spreads in the high-yield and leveraged loan markets are not far from levels seen before the financial crisis. The quality of new loans issued is also declining, especially in the leveraged loan market where the amount of leverage in new deals is rising. The number of “covenant-lite” deals which give lenders less control over issuers has increased. For example, many new deals allow borrowers to issue more debt in the future without obtaining prior permission from lenders.

Meanwhile, the risk that many investors could sell their holdings all at once is now even higher than before the crisis. Mutual funds, exchange traded funds, and households hold about 30 percent of corporate bonds as of the end of June 2014.The worry is that such “retail” investors could start selling suddenly if the value of their assets deteriorates unexpectedly.

Note that if the US junk bond market is the source of the next crisis or bear market, as I think likely, there may be no warning. In the last crisis there was general awareness among banks and hedge fund managers that there was a problem brewing in the mortgage markets, but the general public was blithely unaware. That made it possible for the informed investor to watch what was happening in the banks, and get some warning of the crisis. But in the current situation all investors know the market is overvalued, and everyone is watching everyone else to guess when the stampede will start. Once it does, it will be too late.

US continues slow, steady recovery

16 Oct 2014 by Jim Fickett.

In the last few years the US has made slow but remarkably steady progress in recovering from the effects of the financial crisis.

A few weeks ago gross domestic income, in addition to gross domestic product, became available for the second quarter. Growth in both GDP and GDI has been remarkably steady for several years now:

In the grand scheme of things, the small tick down at the end of 2013, and the tick back up in early 2014, which have generated miles of column inches, is insignificant.

Similarly, although many people have gotten excited by recent employment reports, the trend growth in the number of jobs is remarkably steady (and rather low):

The Fed is blowing bubbles that will later bite us. But for now the recovery is on track.

For background, sources, and past commentary, see the reference page US GDP.

New investment post on platinum

"Start getting ready for the corporate bond crash"

4 Oct 2014 by Jim Fickett.

I have been writing for some time that there is a major bubble in poor quality corporate credit, and that this weak point in the markets could play a role in the next downturn (Comparing subprime corporate and subprime mortgages).

In addition to a widespread concern that junk bond interest rates may have gone too low (even Janet Yellen has said, “Corporate bond spreads … have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward”), there is a concern among dealers that, as an unfortunate side effect of recent regulatory changes, liquidity in the bond markets has decreased significantly. Of course if rates rise and prices drop, a lack of liquidity could spark a panic. Blackrock, the asset management company, recently issued a report in which they analyze the causes of decreased liquidity, and suggest market reforms. In the conclusion to this report, they say,

The low interest rate, low volatility environment, coupled with the impact of QE on the credit markets, masks the amount of change that has occurred in the corporate bond market as decreased liquidity and the shift from a principal market to an agency market takes hold. A less-friendly market environment will expose the underlying structure as broken, with the potential for even lower liquidity and sharp, discontinuous price deterioration.

Most of us have a simpler word for “sharp, discontinuous price deterioration”. John Dizard, columnist at the FT, is blunt about it:

The Obama administration, Congress, and the Fed better start getting ready for the corporate bond crash. That is the message that BlackRock and other asset managers are trying to get across.

“It's tough to make predictions, especially about the future.” But investors should certainly take note of the danger.

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