Value Investing Forum

That chapter in Keynes that Montier is discussing is interesting. I think I read Grantham as saying it was the only chapter in the entire book worth reading. Keynes writing in the rest of the book is absolutely dreadful but I love the pretty face metaphor.

I did find an interesting article on their being too much finance: Guest Post: Too Much Finance

The graph at the end is of particular interest. I would suggest that there is, perhaps, a relationship between increasing debt and stock market growth. The fact of the matter is that at present, private debt is way too high and it needs to be reduced.

Hey guys ! I don't know how to predict the market but I can't find any good opportunities and that must be a sign that either it is fairly priced or overpriced ! I've  just found attractive JNJ, MSFT and CSCO…lately- I am holding 40% in cash right now in case there's a big drop and I can find some good oportunities… :)

Do you guys are finding good opportunities in the market now??

Take care & goodluckl

The rally is getting long in the tooth and has pretty much followed the progression in the expansion of money varying anywhere from a 0 to 4 month lag time. I feel we will continue to forge ahead as long as money supply expands but once it stops we will see a correction that will be significant enough to worry about. One thing I do not like is the market breadth is narrowing significantly.

What I fear is the change in tactics by the fed for the next go around. If there is no QE3 to follow the correction I feel  stocks will be a terrible place to invest on the long side.

somrh said:

Of course, they could just take all of that capital and spend it on some crappy mergers

As a side note, your thesis may not be incompatible with my thesis. Your thesis seems to be a short term one where as the one I'm advocating is long term. In the initial link I posted, Hussman's projections are 10 years. If you look at Shiller's PE ratios compared to 10 year returns (in his book) there is a relatively decent relationship. The relationship is even clearer when looking at 20 year returns:

See Second Image

So I have some sympathy for your hypothesis but I'd like to, at least, see some historical evidence of it.

I am new out here and want to know that what is this forum all about? Could someone out here tell me about it in details? I ll be grateful? 

Thank you. 

Post edited 8:27 am – March 17, 2011 by stormam

The junk bond market is well established and spreads are based on the expected default rate and the recovery of those defaults.  If I own 100 bonds, 5% default with a 50% recovery => I lose 2.5% of my capital.  Therefore, if I charge 3.5% above treasuries, then I am earning an expected 1% (3.5% – 2.5%) for taking on the extra risk.  Spreads move based on the perceived risk in the market (this is a general statement).  I don't know how to get more info on the index for you, I worked in high yield so I just ask friends for it.  It is based on most of the large liquid junk bonds currently oustanding.

My argument is that the S&P is likely to move up significantly over the next 6-12 months, barring exogenous factors I can't predict (like Japan).  People cite earnings multiples as an argument against my point, which I think is only one small part of the whole picture.  My point on free cash flow is that companies are currently making a lot of money and, further, have quite a bit already saved. 

Consider yourself in this position.  You have $5 million in cash and you're earning $500k a year with expenses of only $100k.  That would be fantastic, you've got money and are making/saving lots (that's a lot of money to make…).  At some point, you want to invest that money.  Companies are the same way.  They have a lot saved and are earning more cash than in a really long time.  I think there are a large number of businesses waiting for clarity on the economy, political policy or maybe just an attractive opportunity, etc… before investing.  But when they do, there will be a massive amount of capital going into investments.  Looking at things today and assuming things stay pretty much as they are plus/minus a bit is incorrect and misses the broader shift.

My point is there is a lot of capital and potential, which if unleashed becomes self-fulfilling.  People look for a better market to invest, as some people invest the market gets better, so other invest, so it looks better so we invest more, etc… etc… (I'm talking about companies, not stocks.)  Investing means hiring people.  It means factories buy stuff, which are made by other factories which need to hire people. 

Markets understand this and will react if it looks like companies are investing, employment is improving, etc…

Post edited 9:43 am – March 16, 2011 by stormam

Average junk spreads are mid 300s.  This is based on the long-term (last 40 years or so) default rates and recoveries.  During the latest recession, bonds were yield over 20%.  Since it was a credit crisis, credit based assets were very cheap.  Junk is riskier than Investment Grade so outperforms when the market is doing better.  The corporate bond market is pretty well tested at this point in terms of long-term returns, recoveries, etc…

The selection criteria is the JPMorgan Global HY index and is close enough within basis points.  FCF should do better in a recession as companies liquidate inventories and cut capex while stock values plunge => FCF/Market Cap (FCF Yield) increases. 

I don't have past FCF data.  I appreciate Strategas giving me what they did.  17 years is a decent time-frame, not perfect.  My point is that companies are generating a lot of cash.  Everyone sits around wallowing about how little is going on but it misses the point.  Things are aligning very well for companies to begin significant investments, but this only happens if the opportunity presents itself.  When it does, we'll see significant improvements in capital spending and employment.

I'm extremely skeptical of junk bonds being used as a good indication of anything for discussion unless we add a number of qualifications. I mean, what is an appropriate spread for junk bonds? The historical spread is interesting only if markets get values approximately correct over long stretches of time (I don't buy efficiency, I only point out that efficiency is the dominant paradigm in business schools.) If junk bonds are riskier then they, too, should afford a risk premium (not just interest rate spread but a genuine premium when factoring in default.) See here, for example. (I'm well aware of the fact that a 2008 end date is unfair but I don't have good sources for bond returns. I think I saw returns ending in 2009 indicating junk bonds collectively did better than investment grade. But what selection criteria is being used here? That's a good question to ask. Junk bonds are an interesting financial innovation.)

So what I'd like to know is what is an appropriate spread? Minimally, the spread has to be sufficient to cover both defaults and give a higher return to justify the added risk. If that spread isn't acheived, then the junk bonds are overvalued as well. I don't know if they are overvalued or not.

As for the FCF data, that's interesting. The only comments I would make are this.

(1) I'd want use some sort of averaging (analogous to the P/E 10), especially for something like free cash flow which will have investments that should be factored in. (Aren't FCF yields high now due to lowered investment?)

(2) I'd want to see more data (I like the fact that Shiller's goes back over 100 years.)

I agree with you on bonds though. Much of the bond performance seems to be due to declining interest rates from highs in the early 80's. With interest rates relatively low now, I would expect that they will be going up in the future resulting in poor performance. But that really only makes me pessimistic in my views on both stock and bond returns (broadly speaking, individual investments will vary of course.)

stormam said:

I think March '09 was a generational low.  P/E multiples & margins (Jeremy's M&M's) compressed to the lowest levels we're going to see for a long time.  The S&P is where it was April 2001.  We've spent a decade of sideways, despite below-norm real growth (but still growth!).  We saw rock-bottom and it was terrifying.  This doesn't feel good, but a whole lot better than 2 March's ago.

 

The article you posted and the email Jae posted are interesting. I'll put the article on my kindle to give it a closer look when I have time. I just wanted to comment briefly on this.

I actually agree that the multiples in March '09 may be the lowest we'll see for a long time. But I'm not sure what conclusions you want to draw from that. I would draw from that the the S&P 500 isn't and won't be a good investment for the long haul. I think some Robert Arnott's work is interesting in this regard. See:

Bonds: Why Bother?

What Risk Premium is 'Normal'?

Much of the historical returns of the stock market in the past 80 years or so has been changes in multiples. So what kind of returns can we expect in the future? And is the risk/reward structure appropriate?

To be honsest, I think trends in the financial world have created this. As a result the risk premium is gone. Since markets are efficient and since greater risk implies greater expectation value, we can blindly dump our money in an index fund and get better than bond returns over long periods of time. That's the line we've been told and that's the line that investors have bought and that's what have made multiples so high.

FWIW, I had played with Shiller's numbers a while back and looked at both TTM and 10 Year earnings yield and compared them to bond yields and found an average premium. Assuming that the average premium should currently hold, that would imply S&P 500 is due for a 10% correction (I can't recall the exact numbers but it's not hard to reproduce.)

Alternatively looking at dividends (which is Arnott's preference, IIRC, from the second article), dividend yields are quite low (somewhere below 2%). With an historical real growth rate of only about 1% that puts real returns (via discounted dividends) at around 3%. Throw in a couple of points for inflation (the difference between treasuries and TIPS) and you get somewhere's around 5% give or take (again, assuming no changes in valuation.) But that would put you around the same yield you can get from a basket of investment grade corporate bonds.

I'd be interested in seeing some more stuff with FCF. My preference for dividends and earnings is partly based on the fact that Shiller already has the data available. (I prefer dividends for other reasons. After all, we pay money to the company to buy the shares in the initial offering and then pieces of paper get passed around for a while. What good are those cash flows if they never pass on some of those cash flows to its owners?)

That, of course, isn't to say that there aren't individual securities in the S&P 500 that aren't worth owning. (I currently have a position in INTC who you mentioned earlier). But I think looking at the S&P 500 and not making appropriate comparisons (say with bond yields) will result in overvaluation and continued overvaluation. That's why I'm skeptical of long-term returns on the index.

Post edited 2:39 pm – March 15, 2011 by stormam

I do agree margins will mean-revert.  "The competition reacts to fat margins…  so they fly in".  This is correct.  Markets work.  How does the competition 'fly in' to fight a company?  Investing.  It requires more than just a whim to attack an established business.  This means hiring people and building assets (intellectual capital, fixed capital, whatever may be needed).  It takes time to replace incumbency and have a product people will consider (even if it is cheaper, it needs some validation).  Now, as companies invest, margins will be impacted.  So guys attacking INTC must invest, but INTC must also invest to grow and defend. Strong employment growth will lead to revenue growth overall with potentiall gross margin contraction offset by operating leverage initially, followed by declining gross margins as competitive edges are eroded.  This is a long process.  If we ended 2011 with high 7s unemployment, or a clear path to it, I suspect the market would be higher, not much lower.

As for the one-time boosts in productivity I completely agree.  Innovation drives overall increases in the value of the 'world' (for lack of a better term).  We get better at things, but then people catch up.  Everyone is better off.  What is missing from your argument is the belief that new innovations will continue.  SaaS stocks may be over/under valued, but there is an upcoming structural change in the cost of doing business because of this software delivery model.  This will benefit early adopters, then eventually be competed away… until something new comes.  But do not accept the world as it is with the simple assumption that all good things go away and nothing positive emerges.  If that were true, the world would be 100% efficient and everything everywhere would be a commodity because the market works over time.  The beauty of the S&P (& US economy as a whole) is the survivorship bias.  It will keep kicking low/falling margin companies out in exchange for new high margin ones.

Historically, we tend to have peak multiples with peak profit margins, and trough multiples with trough profit margins (GMO does a good job of discussing this in a report, since you reference them.)  You said below, 'Stocks are allegedly cheap now, at 15.7 times 2010 earnings.'  Since this is a value site, I'll reference Buffet's comment that investing on past numbers is like driving on the highway using only the rear-view mirror.  A glib response, but you flat out ignored my point about B/S's and cash holdings, so there! My point is multiples are lower than they appear due to the corporate balance sheets.  Contrast this to 2007 when debt was much higher as a % of total assets on the S&P.

There is also no comment what-so-ever on free cash flow (FCF).   FCF and earnings are not correlated 1:1 (over the real long term, yes).  Very broadly, FCF can increase in a recession as companies liquidate working capital and cut investments, with capex falling below D&A.  As a company grows, it invests in working capital and new capex.  Earnings meanwhile get destroyed in a recession and grow well in a recovery.  I bring this up because at the end of the day, the world is run on cash.  As we sit here, every single day, companies are doing business and profitable ones are generating cash flow.  As it stands, that cash is sitting on balance sheets.  Let's assume earnings remain flat in 2011 (much easier post-Japan unfortunately).  A stock should still be worth more, assuming the multiple is flat, because it has generated more cash (you argue the multiple is too high, fair enough).  Even still, I reference companies with high single-digit FCF yields below.  So if none are growing, then they are generating cash flow => if the multiple fell from 15.7x -> 14.4x in a year, the company should be worth exactly the same due to the 8% cash flow yield.  Per your argument, margin contraction reduces FCF, and earnings would go down as well, so my math is unfair, I know.  I want to be directional so you understand my point.  Companies are producing cash and building value.  So are people, per the link given by somrh (positive savings rate). 

I think March '09 was a generational low.  P/E multiples & margins (Jeremy's M&M's) compressed to the lowest levels we're going to see for a long time.  The S&P is where it was April 2001.  We've spent a decade of sideways, despite below-norm real growth (but still growth!).  We saw rock-bottom and it was terrifying.  This doesn't feel good, but a whole lot better than 2 March's ago.

This isn't sustainable:

U.S. Household Deleveraging and Future Consumption Growth