Two years ago and one month ago, on September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. This marked the largest bankruptcy filing in U.S history. The effects of Lehman’s collapse shook the financial markets in ways no one expected.
The stock market experienced extreme volatility, moving in 1,000-point ranges; a money market “broke the buck” and lost money; and the Dow fell as low as 6626 over the next few months.
There are several excellent books that document the events leading up to Lehman’s collapse. Too Big to Fail by Andrew Ross Sorkin, and The End of Wall Street by Roger Lowenstein are two books that I would highly recommend.
I won’t try to enhance what Sorkin and Lowenstein have already written. Instead, I want to share with you a few lessons from the Lehman collapse that can help us be better value investors.
Lesson #1: The balance sheet counts
When Ben Graham and David Dowd wrote Security Analysis in 1934, they recommended buying companies that had strong balance sheets. Nothing much has changed since. Having been on leverage during the great depression, Graham swore off leverage and avoided it at all costs. His student, Warren Buffett, also followed that same lesson:
The most dramatic way we protect ourselves is we don't use leverage. We believe almost anything can happen in financial markets... [so] even smart people can get clobbered with leverage. It's the one thing that can prevent you from playing out your hand.
If we look at Lehman’s balance sheet as of December 31, 2007, what we find is a company that was highly leveraged. Shareholder equity was $22.5 billion and total assets were $691 billion. For every dollar of the company’s worth, they were controlling $31 of assets. In other words Lehman was leveraged 31 to 1. It doesn’t take a rocket scientist to see that a 3% move against them wipes out the total worth of the business.
Buying businesses that have highly leveraged balance sheets is playing with fire. The management of the company is willing to bet big to win big but can also wipe out a good chunk of the business’s net worth in a heartbeat.
When I research companies for our portfolios, I exclude companies that are highly leveraged. Keep in mind that not all leverage is bad and some balance sheets might appear highly leveraged when in fact they are not. It takes a bit of digging through the income and cash flow statements in order to come to a decision.
Lehman taught value investors that too much leverage when the market goes against you can be fatal.
Lesson #2: Know what you’re buying
A large percentage of Lehman’s portfolio was made up of hard-to-value mortgage-backed assets. When the housing bubble burst, these assets became toxic — they were impossible to value because nobody wanted them. Many of them ended up being worthless.
Lehman and many others on Wall Street stuffed their portfolios with securities that were extremely complex and had no idea how the securities would react in adverse conditions. Spreadsheets filled in with assumptions based on complex securities were believed as accurate. Lehman and others truly believed that these securities, which were backed by subprime mortgages, could not fail.
The assumption that housing prices would not decline in different markets at the same time…was proven false.
The ABX mortgage index, an investment-grade mortgage bond index, for example, was believed to be as steady as the rock of Gibraltar. In the search for higher yields, institutional investors put billions of dollars into these bonds AND then borrowed $25 to as high as $40 for every $1 of bonds.
Since they really didn’t have a handle on how these bonds would react if some of their assumptions were wrong, such as housing prices in several different markets would never all decline together, they had no way of quantifying their exposure if all hell broke loose. The index didn’t fall; it cratered and went down 98%, wiping out investors from banks to brokerage firms.
If you can’t understand the business, then you can’t value it. And if you can’t value it, you have no business investing in it. Stay away from complex investments and businesses; money doesn’t care how you make it. Regarding complexities, Buffett said that investors are not rewarded more for degree-of-difficulty:
If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.
Make your investment decisions on variables you can understand and are able to value. Otherwise you’ll never see what knocks you out because you had no idea what to look for.
Lesson #3: Have a long-term view
Lehman was founded in 1850 in Montgomery, Alabama, by Henry Lehman and his brother Emanuel when they opened up a dry-goods store. They eventually began trading cotton and the firm became known as Lehman Brothers.
Over the years Lehman helped finance the leaders of 20th-century business. Companies that would one day become household names — such as Sears, Roebuck & Co.; F.W. Woolworth; R.H. Macy; B.F. Goodrich; and RCA — did business with Lehman. The company fostered long-term relationships with its clients and had the ear of most of the U.S. presidents of the 20th century.
When Dick Fuld became CEO in the 1980s, the culture shifted from long-term relationships to transaction-based bond trading. Bond trading revenue took the place of investment banking, and bond traders ruled the roost. The firm was seen as an outsider, and many of the blue chip companies took their business to firms such as Goldman Sachs and JP Morgan. Lehman sacrificed long-term gain for short-term profits.
Most investors view stocks as nothing more than wiggles and jiggles on a chart. Their idea of a long-term holding period is days, not years. In fact, close to 50% of trades on the U.S. stock exchanges are made by high-frequency traders using algorithms to profit from very small price discrepancies.
By focusing on the long term, smart investors can take advantage of short-term and fundamentally unrelated market swings. Instead of being a predictor of price, and trying to predict if the next tick will be higher or lower, value investors base their decisions on the intrinsic value of the business and only make a trade when it is to their advantage.
Having a long-term perspective gives the patient investor an edge over the daily noise in the market.
It would be a shame for Lehman’s collapse to end up just as a footnote to financial history. It pays to learn the lessons made on someone else’s dollar and reap the benefits. While Lehman is no longer, the lessons learned from its demise should be studied so no one makes the same mistakes again.
The stock market experienced extreme volatility, moving in 1,000-point ranges; a money market “broke the buck” and lost money; and the Dow fell as low as 6626 over the next few months.
There are several excellent books that document the events leading up to Lehman’s collapse. Too Big to Fail by Andrew Ross Sorkin, and The End of Wall Street by Roger Lowenstein are two books that I would highly recommend.
I won’t try to enhance what Sorkin and Lowenstein have already written. Instead, I want to share with you a few lessons from the Lehman collapse that can help us be better value investors.
Lesson #1: The balance sheet counts
When Ben Graham and David Dowd wrote Security Analysis in 1934, they recommended buying companies that had strong balance sheets. Nothing much has changed since. Having been on leverage during the great depression, Graham swore off leverage and avoided it at all costs. His student, Warren Buffett, also followed that same lesson:
The most dramatic way we protect ourselves is we don't use leverage. We believe almost anything can happen in financial markets... [so] even smart people can get clobbered with leverage. It's the one thing that can prevent you from playing out your hand.
If we look at Lehman’s balance sheet as of December 31, 2007, what we find is a company that was highly leveraged. Shareholder equity was $22.5 billion and total assets were $691 billion. For every dollar of the company’s worth, they were controlling $31 of assets. In other words Lehman was leveraged 31 to 1. It doesn’t take a rocket scientist to see that a 3% move against them wipes out the total worth of the business.
Buying businesses that have highly leveraged balance sheets is playing with fire. The management of the company is willing to bet big to win big but can also wipe out a good chunk of the business’s net worth in a heartbeat.
When I research companies for our portfolios, I exclude companies that are highly leveraged. Keep in mind that not all leverage is bad and some balance sheets might appear highly leveraged when in fact they are not. It takes a bit of digging through the income and cash flow statements in order to come to a decision.
Lehman taught value investors that too much leverage when the market goes against you can be fatal.
Lesson #2: Know what you’re buying
A large percentage of Lehman’s portfolio was made up of hard-to-value mortgage-backed assets. When the housing bubble burst, these assets became toxic — they were impossible to value because nobody wanted them. Many of them ended up being worthless.
Lehman and many others on Wall Street stuffed their portfolios with securities that were extremely complex and had no idea how the securities would react in adverse conditions. Spreadsheets filled in with assumptions based on complex securities were believed as accurate. Lehman and others truly believed that these securities, which were backed by subprime mortgages, could not fail.
The assumption that housing prices would not decline in different markets at the same time…was proven false.
The ABX mortgage index, an investment-grade mortgage bond index, for example, was believed to be as steady as the rock of Gibraltar. In the search for higher yields, institutional investors put billions of dollars into these bonds AND then borrowed $25 to as high as $40 for every $1 of bonds.
Since they really didn’t have a handle on how these bonds would react if some of their assumptions were wrong, such as housing prices in several different markets would never all decline together, they had no way of quantifying their exposure if all hell broke loose. The index didn’t fall; it cratered and went down 98%, wiping out investors from banks to brokerage firms.
If you can’t understand the business, then you can’t value it. And if you can’t value it, you have no business investing in it. Stay away from complex investments and businesses; money doesn’t care how you make it. Regarding complexities, Buffett said that investors are not rewarded more for degree-of-difficulty:
If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.
Make your investment decisions on variables you can understand and are able to value. Otherwise you’ll never see what knocks you out because you had no idea what to look for.
Lesson #3: Have a long-term view
Lehman was founded in 1850 in Montgomery, Alabama, by Henry Lehman and his brother Emanuel when they opened up a dry-goods store. They eventually began trading cotton and the firm became known as Lehman Brothers.
Over the years Lehman helped finance the leaders of 20th-century business. Companies that would one day become household names — such as Sears, Roebuck & Co.; F.W. Woolworth; R.H. Macy; B.F. Goodrich; and RCA — did business with Lehman. The company fostered long-term relationships with its clients and had the ear of most of the U.S. presidents of the 20th century.
When Dick Fuld became CEO in the 1980s, the culture shifted from long-term relationships to transaction-based bond trading. Bond trading revenue took the place of investment banking, and bond traders ruled the roost. The firm was seen as an outsider, and many of the blue chip companies took their business to firms such as Goldman Sachs and JP Morgan. Lehman sacrificed long-term gain for short-term profits.
Most investors view stocks as nothing more than wiggles and jiggles on a chart. Their idea of a long-term holding period is days, not years. In fact, close to 50% of trades on the U.S. stock exchanges are made by high-frequency traders using algorithms to profit from very small price discrepancies.
By focusing on the long term, smart investors can take advantage of short-term and fundamentally unrelated market swings. Instead of being a predictor of price, and trying to predict if the next tick will be higher or lower, value investors base their decisions on the intrinsic value of the business and only make a trade when it is to their advantage.
Having a long-term perspective gives the patient investor an edge over the daily noise in the market.
It would be a shame for Lehman’s collapse to end up just as a footnote to financial history. It pays to learn the lessons made on someone else’s dollar and reap the benefits. While Lehman is no longer, the lessons learned from its demise should be studied so no one makes the same mistakes again.
