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A Jacobian Value Search: Invert, Always Invert!

July 10, 2009 | About:
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Geoff Castle

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It is a curious market. With macro and micro problems looming everywhere, sometimes one feels the urge to do nothing but hold cash. In looking for opportunities, perhaps one needs to find a new lens from which to analyze potential investments. Following the suggestion of Charlie Munger, we are drawn to the approach of the great Prussian Mathemetician Carl Jacobi. Invert, always invert!

For surely when we look back on this period ten years hence, we will realize that an intense focus on the various train wrecks and squeaky wheels of the current financial crisis may have led us to ignore completely the vast areas of opportunity. But to find these may require turning our thinking upside down.

What Was Working: Yield and Leverage

Summing up the great bounce of 2003 to 2007 in a simple phrase, it would be the quest for yield. Investors, we were constantly reminded in those years, wanted income and dividends.

It never seemed a particularly convincing explanation. What reasonable person, even if they did require a little monthly cash flow to pay for the necessities of life, would sacrifice the permanent value of their capital for want of a few more basis points? Jim Grant called these investors “yield pigs.” By the end of the rally the big plays – REITs and the oil and gas “income trusts” – traded at historically unexciting dividend yields, but massive price-to-book ratios. The value idea of 2003 was a tired momentum story four years later.

The Inverse of Yield

Investing for yield is a strategy that works only some of the time. In a world with a relatively fixed supply of money, investing capital to earn interest is generally worthwhile. As investors receive interest (or dividends) while at the same time retaining ownership of their capital, they increase their share of the overall money supply and become relatively wealthier. And wealth, when it comes right down to it, is a relative game.

However when money supply starts expanding unnaturally quickly – call it “quantitative easing”, “credit easing” or just good old fashioned money printing – then profiting from “yield” is a more complicated undertaking. Part of the investor’s income stream just keeps him even with the growth in the overall supply of money. The higher the growth in money, the bigger the premium investors require to stay in the yield game. At a certain point, the point where projected growth in money supply becomes very high, investors ought to look beyond mere yields.

In the days when we used to read the newspaper to get stock quotations, I once questioned why the annotation “p” appeared beside the dividend amount for certain shares listed on the Vancouver Stock Exchange. It turned out that the “p” indicated a stock dividend. What, I asked, is the point of issuing a stock dividend? The company stays the same size and everyone just owns slightly more shares? The more I look at “income producing” investments these days, be they t-bills or bonds or high dividend equities, the more I am reminded of these old stock dividends on the VSE.

The inverse of yield investing, in my view, is the ownership of scarce assets. These assets are owned not because of a yield, but because they are valuable and will maintain their “wealth share.” Money, as we all know, can be created for nothing. But you can’t print wealth.

More Practically…

But if we felt like taking our capital and walking away from instruments offering an increasingly dubious “yield”, where would we put it? Real estate, the asset class that throughout history has separated the noble from the commoner, would be an obvious place to go under normal circumstances. But as the central asset of the recent bubble, one suspects that real estate is over-owned, over-built and over-priced. And if that weren’t enough, we know real estate is extremely over-leveraged.

One non-yielding investment of interest is silver. As noted recently in this space, silver is scarce, of growing utility and significantly undervalued. Gold and platinum, although subject to slightly different supply and demand dynamics, ought to work out in a similar way.

Having made a pitch for shiny metal bars, one should not forsake all other assets. In my view there are many businesses which own assets even more scarce and useful than the precious metals. Two areas that look attractive are grain handling infrastructure and software.

Grains, grain handling and processing: Jim Rogers says that one day it will be farmers who will be driving all the fancy cars. That may be a bit excessive, but certainly the demand profile here is one of the least likely to be affected by the broader economy. If we have inflation, grains, whose inflation-adjusted price has declined approximately 50% from 1982 to 2009, ought to hold their own.

More interesting than the grains themselves is grain handling capacity, especially in cases where it is protected from competition. During the grain price spikes of the 1970’s, elevators filled up. On a growing commodity price there is less risk in carrying inventory and more speculators looking for a way to squeeze out shorts from the futures market. With higher grain inventories, handling capacity shrinks and operators should be able to exert significant pricing power. In terms of individual names, Viterra, Andersons and ADM should be worthy of some investigation in North America and Singapore-listed Wilmar International, whose focus is palm oil, also looks attractive.

Software: For different reasons, software companies may also be an attractive area to study. In a market that was willing to pay anything for yield, few cared for assets. Intangible assets, the stock-in trade of most software companies, were especially shunned. However, the right intangible assests can prove to be very scarce and may allow a software business to exercise considerable pricing power.

Screening the lower EV/Assets ratios results in a list of many fairly healthy software businesses with excellent balance sheets. I have posted at length on Novell Inc. and RealNetworks, but Microsoft and Cray Computer (a software business disguised as a hardware business) also look good to me in the longer run.

An embedded option of the software players are balance sheets which are stuffed with cash. As Venture Capital – the industry – faces headwinds, venture capital the concept may allow existing software players to pick up cheap interests in the next generation of innovative software franchises. As scarce assets, a growth software platform has few equals.

Investing based on scarcity, rather than on yield, has an admittedly counter-intuitive feel for anyone who has been involved in the capital markets of the past decade. But, to summon the wisdom of Sherlock Holmes, “When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

Geoff Castle

www.marketdepth.typepad.com


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