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Excerpt from Chapter 6 of 'More Mortgage Meltdown'

Courtesy of Whitney Tilson. This is a true gem:

We are hearing that a large number of hedge funds are going to cash, unable to figure out this market and trying to avoid further losses. We’ve been doing the opposite – we added to many of our top positions as recently as this morning (Goldman at $85, less than 70% of tangible book!?) – and have paid a huge price…so far.

This was our playbook in late 2008 and early 2009 and we were a number of months too early then as well – but we played a strong hand all the way to the bottom and it paid off big time as we recovered from a five-month 33% drawdown in less than seven months:



With this in mind, I went back and reread Chapter 6 of our book, More Mortgage Meltdown: 6 Ways to Profit in These Bad Times (More Mortgage Meltdown: 6 Ways to Profit in These Bad TimesInvesting Books)), which we submitted to the publisher in the first week of March 2009, precisely as the market bottomed.

If we were to rewrite it today, we would change very little…

Here’s the beginning of the chapter and a more extensive excerpt is below. Enjoy!

The most pressing question we hear is: “Is it safe to go back into the market?” We wish we knew the answer. But even if we claimed to know, you would be well advised to ignore us because we’re no good at timing the market – and are skeptical that anyone else can consistently do so either.

Our analysis suggests that there is both good news and bad news for investors. First the bad news: as we discussed in the first half of this book, we think that the mortgage meltdown and credit crunch are so severe that both the U.S. and world economies are likely to be weak for a number of years, making it hard to imagine either corporate earnings or the multiples investors are willing to place on those earnings going up for quite some time. Thus, in spite of the devastation visited on equity markets over the past year, we do not think a sustained, meaningful comeback in overall share prices over the next year or two is likely.

Now for the good news: we think a severe, extended economic downturn is priced into the market, so we don’t think more major market declines are likely either. As Warren Buffett noted in his 2008 annual letter, “the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”

…Stocks certainly appear cheap, but that doesn’t make it an easy time to invest. Many value investors, ourselves included, have lost a lot of money buying stocks that appeared attractive based on a low multiple of earnings or book value – and then seen the earnings or book value disappear thanks to the terrible macro environment. In fact, traditional value stocks have done even worse than the overall market, thanks largely to the financial sector, as measured by the iShares S&P 500 Value ETF (IVE), which had declined 56% from the market’s peak in October 2007 through February 2009 vs. -53% for the S&P 500.

Oaktree Capital Management chairman Howard Marks captures the dilemma nicely:

In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you're considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it's generally a buy. When its price is higher, it's a sell. In a nutshell, that's value investing.

But values aren't fixed; they move in response to changes in the economy. Thus, cyclical considerations influence an asset's current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity.

To summarize, despite the carnage in the market, this is by far the most difficult investing environment we’ve ever encountered, one filled with both peril and promise, because the range of potential outcomes – for the economy and for individual companies – is so wide.

So how should you invest in such an uncertain and perilous environment? If you know what you’re doing and have courage and the ability to hedge, you could follow our path: invest with conviction on the long side, but hedge aggressively on the short side.

------------------------



Excerpt from Chapter 6

Advice for All Investors

The second half of this book shares detailed analyses of eight positions, five long and one short, that we held in funds we manage as of early March 2009. In doing so, we hope to teach others how to better analyze companies and become better investors, not give hot stock tips. We would be disappointed if readers went out and copied any of our positions without doing their own extensive work.

Before we go in-depth into some fairly advanced case studies, however, we’d like to share some thoughts about the current environment and review some value investing fundamentals.

Perils and Profits in the Market

The most pressing question we hear is: “Is it safe to go back into the market?” We wish we knew the answer. But even if we claimed to know, you would be well advised to ignore us because we’re no good at timing the market – and are skeptical that anyone else can consistently do so either.

Our analysis suggests that there is both good news and bad news for investors. First the bad news: as we discussed in the first half of this book, we think that the mortgage meltdown and credit crunch are so severe that both the U.S. and world economies are likely to be weak for a number of years, making it hard to imagine either corporate earnings or the multiples investors are willing to place on those earnings going up for quite some time. Thus, in spite of the devastation visited on equity markets over the past year, we do not think a sustained, meaningful comeback in overall share prices over the next year or two is likely.

Now for the good news: we think a severe, extended economic downturn is priced into the market, so we don’t think more major market declines are likely either. As Warren Buffett noted in his 2008 annual letter, “the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”

There are certainly good reasons to believe that U.S. stocks are cheap. As of the end of February 2009, the Dow Jones Industrial Average and the S&P 500 had both tumbled by more 50% from their peaks – the largest drop since the Great Depression – and were at lows not seen since 1997. Specifically, on March 2, 2009, the Dow hit a 12-year low, an extremely rare event that had occurred only twice before, on April 8, 1932 and December 6, 1974. In both prior cases, the economy and unemployment were still 4-9 months away from reaching their worst points (in 1974, the unemployment rate was only 6.6% and it peaked at 9% six months later), yet it was still an excellent time to invest: in 1932, though the market fell an additional 34%, within six months it was up 5%, and in 1974, December 6th marked the exact day the market bottomed and it was up 45% six months later.[1]

Valuation measures also indicate that stocks are cheap. Based on data from Yale economist Robert Shiller, U.S. stocks on March 3rd 2009 were trading at a cyclical price-to-earnings ratio of 12.3, their lowest level since 1986 and well below their historical average, dating back to 1870, of 16.3.[2] (The cyclical P/E compares stock prices to average earnings over the previous 10 years in an attempt to smooth out booms and busts.) Over the past 125 years, when stocks have traded at this level, they have doubled on average over the next decade.

Stocks certainly appear cheap, but that doesn’t make it an easy time to invest. Many value investors, ourselves included, have lost a lot of money buying stocks that appeared attractive based on a low multiple of earnings or book value – and then seen the earnings or book value disappear thanks to the terrible macro environment. In fact, traditional value stocks have done even worse than the overall market, thanks largely to the financial sector, as measured by the iShares S&P 500 Value ETF (IVE), which had declined 56% from the market’s peak in October 2007 through February 2009 vs. -53% for the S&P 500.

Oaktree Capital Management chairman Howard Marks captures the dilemma nicely:

In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you're considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it's generally a buy. When its price is higher, it's a sell. In a nutshell, that's value investing.

But values aren't fixed; they move in response to changes in the economy. Thus, cyclical considerations influence an asset's current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity.

To summarize, despite the carnage in the market, this is by far the most difficult investing environment we’ve ever encountered, one filled with both peril and promise, because the range of potential outcomes – for the economy and for individual companies – is so wide.

So how should you invest in such an uncertain and perilous environment? If you know what you’re doing and have courage and the ability to hedge, you could follow our path: invest with conviction on the long side, but hedge aggressively on the short side. Our positioning in the hedge funds we manage is roughly 100% long, but also 55% short, resulting in net long exposure of about 45%. In other words, for every $100 of capital we have, we’ve invested all of it and, in addition, have shorted $55 of stocks, which generates cash since shorting involves selling a stock, holding the cash, and hoping to buy the stock back at a lower price later.

What this means is that we’re finding enough incredible bargains to be fully invested on the long side, but are nervous enough that we want to protect our downside as well because as bad as things are, they could get worse. How much worse? Consider that the cyclical P/E ratio, while below its historical average, is well above previous bear market lows of 6 – meaning stocks could almost get cut in half again. We don’t think this is at all likely, but can’t rule it out either.

We tend to agree with Oaktree’s Marks, who has argued that there are three stages of a bear market. In the first stage, just a few prudent investors recognize that the still-prevailing bullishness is likely to be unfounded, he says. In the second stage, the market drifts down in an orderly fashion. By the third stage, everyone is convinced things can only get worse, volatility increases sharply, and the collective herd exits.

Marks pegged October 2008 as the point at which the current bear market entered its third phase. As he said at the time: “That doesn’t mean [the market] can’t decline further, or that a bull market’s about to start. But it does mean the negatives are on the table, optimism is thoroughly lacking, and the greater long-term risk probably lies in not investing.”[3]

In our view, the most likely scenario is that the markets muddle along, trading in a range, for quite some time. This is the type of environment when good stock picking, rooted in company- and industry-specific analyses, will shine – in marked contrast to the past year and a half, when portfolio positioning, long and short, as well as industry exposure mattered far more than bottoms-up analysis.

If we’re right, this is great news for value investors, as we are finding the greatest number of cheap stocks in our careers. With fear running rampant, some of the best businesses are priced today as if their earnings will never rise again, and many lesser businesses are priced as if they might go out of business entirely. While we profess no great insight into calling the bottom of the market, we have never felt greater certainty that with patience and perseverance we will be well rewarded by the stocks we own at current prices.

We won’t be greedy, however. In light of our macro concerns, we are now generally quicker to take profits on winning positions. Historically, we would try to buy 60-cent dollars (i.e., stocks trading at a 40% discount to our estimate of intrinsic value) and sell 90-cent dollars but today those numbers are more likely to be buying 30-cent dollars and selling 75-cent dollars. This is not a market in which to be holding out for the last dollar of value.

We’d also suggest that if you’re fortunate enough to be on the sidelines holding cash, that you average into the market slowly over the course of 2009.

Perspectives from Buffett and Klarman

For further perspectives on this treacherous environment, let’s turn to two of the greatest investors of all time: Berkshire Hathaway’s Warren Buffett and Seth Klarman of the Baupost Group. On October 16, 2008, Buffett published an Op Ed in the New York Times in which he highlighted the perils facing investors:

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary…And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.[4]

Yet Buffett was aggressively buying stocks. Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.[5]

In his 2008 annual letter, Buffett expanded on why he’s bullish on America:

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.[6]

Klarman sees opportunity as well:

In the past 15 months we’re starting to see stocks trade at whatever price. There’s a much higher probability that fundamental value investors in this type of period will be able to add value with specific stock selection… The chaos is so extreme, the panic selling so urgent, that there is almost no possibility that sellers are acting on superior information. Indeed, in situation after situation, it seems clear that investment fundamentals do not factor into their decision-making at all… The ability to remain an investor (and not become a day-trader or a bystander) confers an almost unprecedented advantage in this environment.[7]

Yet Klarman also offers words of caution:

The investor’s problem is that this perspective will seem a curse rather than a blessing until the selloff ends and some semblance of stability is restored.

The greatest challenge of investing in this environment is neither the punishing price declines nor the extraordinary volatility. Rather, it is the sharply declining economy, which makes analysis of company fundamentals extremely difficult. When securities decline, it is crucial to distinguish, as possible causes, legitimate reaction to fundamental developments from extreme overreaction...

In today’s market, however, where almost everything is down sharply, distinguishing legitimate reaction from emotional overreaction is much more difficult. This is because there is a vicious circle in effect (the reverse of the taken-for-granted virtuous circle that buoyed the markets and economy in good times). This vicious circle results from the feedback effects on the economy of lower securities and home prices and a severe credit contraction, and, in turn, effects of a plunging economy on credit availability and securities and home prices...

Ultimately, this vicious cycle will be broken and neither securities prices nor the economy will go to zero, just as they did not go to infinity when the virtuous cycle was in place. But throughout 2008, prudent investors sifting through the rubble for opportunity were repeatedly surprised by the magnitude of the selling pressure, and, in many cases, by the extent to which the deterioration in business fundamentals has come to justify the lower market prices. Many forced sellers, through their early exits, inadvertently achieved better outcomes than the value-oriented bargain hunters who bought from them…

Buying early on the way down looks a great deal like being wrong, but it isn’t. It turns out you won’t be able to accurately tell who’s been swimming naked until after the tide comes back in.[8]

Why Not Go to Cash?

Having suffered along with almost all other investors during the severe market decline that began in September 2008 (which showed no signs of abating by early March 2009), we’ll admit to having two feelings just about every day that we suspect are widely shared by other investors: first, we berate ourselves for being such idiots for not having foreseen the meltdown and gone to 100% cash or at least fully hedging our long positions. How did we miss something that seems 100% obvious (with the benefit of hindsight, of course, which is always 20/20)? Second, we want to stop the pain – and it’s very painful losing money seemingly every day, month after month, especially when it’s not only your own money, but more importantly also the savings many friends and family who have put their trust in you.

There’s an easy way to stop the pain and prevent future losses: sell everything and sit in cash until the situation stabilizes and stocks have started to recover. Surely there will be plenty of time to get back in, right? This is the approach taken by more and more investors every day, which is contributing to the market meltdown, but while we certainly wish we’d been smart enough to do this many months ago, it’s not what we’re doing today. Why? There are two reasons.

First, when we look at our portfolio and evaluate every stock we own, trying to find something to sell, we can’t find a single good candidate. For each stock, we’ve carefully evaluated the underlying businesses, come up with what we believe is a conservative estimate of its intrinsic value (making no optimistic assumptions; we think the economy will be in dire straights for the foreseeable future), and then compared this value to the current stock price. In each case, the stock is trading at a huge discount – anywhere from 35% to 80% – to its intrinsic value.

Benjamin Graham, widely considered to be the father of value investing – he taught Warren Buffett – once said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”[9] By this, he means that over short periods of time, stocks can trade almost anywhere depending on the whims, fear and greed of investors, but over time they will trade based on the earnings and financial fundamentals of the underlying businesses. We’re convinced that the market today (early March 2009) has become almost entirely a voting machine. We’re also convinced that someday – we can’t predict when – it will again become a weighing machine, and that we will be well rewarded for our patience.

One might agree with this, but still want to sit in cash until the market stops acting like a voting machine, so why don’t we recommend this approach? Buffett and Klarman provide the answer. Buffett writes:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over...

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value…

Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”[10]

And Klarman adds:

While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.[11]

It’s a fatalistic attitude – “I fully expect that the stock or mutual/index fund I’m buying today will be lower in the future” – but it’s the only alternative to complete paralysis in this terrible market.

The Threat of Premature Accumulation

Investing too early is one of the more common sins of value investors. Watching as that well-researched idea you loved a few months ago falls 20% to 30% can be painful and nerve-racking. Fairholme’s Bruce Berkowitz calls it “premature accumulation.”[12]

Getting your timing wrong is inevitable – especially in current markets, in which stock prices continue to plumb new depths in a wide variety of industries. Value investors like us can be particularly susceptible to bad timing because we often buy on bad news or bet on turnarounds – both of which have the unfortunate habit of dragging on much longer than expected, often causing share prices to continue to decline.

Although the pursuit of perfect investment timing is laudable, a more realistic goal is to respond smartly when timing isn’t so perfect. If a stock you bought declines, there are three options. You could throw in the towel, promising to get back in when the company’s situation starts to improve. You could sit tight, comfortable that the stock remains undervalued but not enough to add to the position. Or you could buy more, in the belief that the stock is now even more undervalued.

Your choice is one of the most important, yet difficult ones you’ll make as an investor, as Richard Pzena, of Pzena Investment Management, points out: “I believe the biggest way you add value as a value investor is how you behave in those down-25% situations…We probably hold tight 40% of the time, and split 50/50 between buying more and getting out. Making the right decisions at those moments adds more value, in my opinion, than the initial buy decision.”[13] When we asked Pzena what he most often did in such cases, he estimated that he bought more, sold and did nothing in roughly equal proportions.

Each situation is unique, but if you’re able to look beyond near-term trouble, you have an advantage over many professional investors. The Wall Street trading mentality and pressures on money managers to put up strong quarterly or even monthly performance numbers can make it hard for them to own obviously beaten-down stocks. Bosses may not want to hear why something looks attractive two years out if it might not go anywhere in the next six months. Investors see holdings of unpopular stocks and call managers to ask, “Don’t you read the newspaper?” But it’s precisely such negativity that creates bargains for investors with the patience and resilience to endure cheap stocks becoming even cheaper.




[1] U.S. Equity Strategy FLASH, J.P.Morgan, 3/2/09, pp. 4-5.

[2] Stocks Finally Start Looking Affordable, David Leonhardt, New York Times, 3/2/09; http://economix.blogs.nytimes.com/2009/03/02/stocks-finally-start-looking-affordable

[3] The Limits to Negativism, Howard Marks, Memo to Oaktree Clients, 10/16/08

[4] “Buy American. I Am.,” Warren E. Buffett, New York Times, October 16, 2008.

[5] Ibid.

[6] 2008 Berkshire Hathaway annual report, www.berkshirehathaway.com/2008ar/2008ar.pdf

[7] The Baupost Group, L.L.C. Third Quarter Letter to Partners,10/10/08.

[8] The Baupost Group, L.L.C. 2008 Annual Letter to Partners,1/27/09.

[9] The Warren Buffett Way, Robert Hagstrom, John Wiley, 1997, p. 99.

[10] “Buy American. I Am.,” Warren E. Buffett, New York Times, October 16, 2008.

[11] The Baupost Group, L.L.C. 2008 Annual Letter to Partners,1/27/09.

[12] Fairholme Capital Management conference call, 11/25/08, p. 5/6; www.fairholmefunds.com/player/nov25.pdf

[13] Value Investor Insight, 2/22/05, p. 3.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


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