- L.P. Hartley, “The Go-Between”
In Part 2 of “Value Investing in Down Markets” (Part 1 can be found here) I wanted to take the time to better understand the major drivers in why some value investor leaders did so poorly in the 2007 - 2009 market crash. There isn’t any simple answer. It seems to me there was a combination of events - intellectual complacency, a bias to follow what’s worked before, and some deeply hidden faults in our financial markets. Before going into the process itself (which will be Part 3 of this series), this article will look at a range of topics including the role of the balance sheet in deriving value, the changing make up of assets and liabilities, and issues driving the complexity of what exactly “value” means.
As they say, hindsight can be 20/20. The purpose of this piece isn’t to scorn or deride any particular value investor for their performance or strategy. Rather, I wanted to point out that blind spots to traditional value investment methodology ten to twelve years ago are just as prevalent today. As I read report after report and watch interview after interview, my concern is that we are as intellectually unprepared today as we were over a decade ago. If we are to maintain that value investing is the most successful form of long-term investing (indeed what other type of investing is there? Wouldn’t they be speculation?), then we need to perform better than we did in the last crash.
Lessons from the 2007 - 2009 Crash
Bull markets generally end when some asset bubble finally pops. This might be the discovery of shockingly unethical banking and market behavior (The 1907 Stock Crash), finding out that tulip bulbs suddenly aren’t all the rage (the Tulip Bulb Bubble of 1637), or realizing that earnings projections of 50% growth for 50 years simple aren’t realistic (1999 - 2000 Technology Bubble). The Great Recession and Market Crash of 2007 - 2009 was no different. In this case a bubble in real estate - fueled by cheap credit, incredibly risky financial products, and failure by nearly every oversight player - caused enormous losses across the board. What made this crash unique and surprised many was that traditional value gurus performed as badly as the general markets. This was a complete reversal of fortune from a group that significantly outperformed as recently as the 2001- 2002 technology market crash.
Value investors who performed poorly did so for several reasons. First, some failed to fully understand the risk that lay below the surface of assets in their portfolio holdings’ balance sheets. Over time, it became clear that financial products rated AAA by credit agencies or mortgage backed securities (MBS) were worthless. Second, many value investors stuck with their game plan that had worked over the last 50 years - look for companies with low P/E or P/B and back up the truck. Unfortunately, the basis for “(E)arnings and “(B)ook” value were deeply flawed. As an example, many investors saw financial stocks as remarkably cheap according to traditional valuation methods. As investors piled into financial stocks trading at single digit price-to-earnings ratios and book values at less than 1.0, it made sense to many that prices would rebound after the panic was resolved. Unfortunately these stocks kept dropping in price until - in a process completely foreign to value investors- balance sheet assets were marked down to zero and companies became insolvent. For those holding shares in these firms, they were “merged” away for pennies on the dollar or were forced to accept Federal TARP dollars, cease dividends, and take on the government as their largest shareholder. For those older value investors, the tried-and-true approach to buy on the low side and patiently await a rebound in prices became a nightmare of permanent capital impairment and horrific losses.
So what happened? How was it that leaders in the value investment community suffered such extraordinary losses? I would suggest many of the losses were due to two thematic issues and some specific structural changes that took place in the mid-2000s. These changes – and their associated impact on the financial markets - took many completely at unawares. First, the complexity of the financial markets created new products and services completely new to most investors. Examples of this included strategic shifts (collaterization created by demand for income) supported by new products (such as mortgage backed securities or credit default swaps). Second, the complexity of these products masked an interconnectivity where a seemingly isolated problem could create an enormous financial event. As one talking head asked, how could a housing market crash in Albuquerque bring down Lehman Brothers? Third, there was a broad-based push by both political parties to deregulate whole segments of the markets (such as the repeal of Glass Steagall) lead to a widespread outbreak of poor management oversight and aggressive risk-taking. Finally, there were the issues as old as when the first loans for grain crops were made in Sumeria - greed, outright cheating, and public/private corruption.
Here in Part 2, I thought I’d discuss several areas of interest that - I believe over time - can assist individual investors dramatically reduce their risk in the next down market. I’ve stated before that thinking about how you invest is more important than what you invest in, and this section is a prime example of this. I won’t be giving a list of the latest and sexiest business models or investment ideas. Rather this section will help you think about how a value investor should be thinking about a business – how that business makes money and how that impacts your investment selection. Thinking about a corporate balance sheet and how you can find warning signs about the business can head off horrific losses in the long term. So let’s start there.
Troubles on the Balance Sheet
As you look back at the seeds of the Great Recession and the market crash of 2007 - 2009, many of the problem began on the corporate balance sheet. It turned out assets weren’t as valuable as we thought, their value was sometimes interlinked with seemingly unrelated products, and the risk associated with some assets was far higher than anybody knew.
The first thing to point out (thought it may seem obvious now) is that not all assets (or liabilities) are created equal. Ben Graham intuitively new this when he created different discount rates between cash and a production plant. The most important distinction is between current – or short-term – assets and liabilities versus long-term assets and liabilities. At a strategic level, a significant proportion of impaired capital was caused by two problems between current and long-term assets and liabilities. First, what appeared to be current (or short-term) assets with high liquidity simply were not. Whether it be a mortgage backed security with a AAA rating or some other derivative, the value of the product turned out not to be commensurate with its assigned value. This led to massive markdowns and blew some large holes on corporate balance sheets. Second, many of these assets turned out to be linked with other products which led to rippling detonations across entire markets.
In this section I want to address the four major sections of the balance sheet and discuss what investors should be looking for (in terms of safety) and what to avoid (in terms of risk to their investment capital.
Current (Short-Term) Assets
At Nintai, current assets play a vital role in ascertaining value and safety. We love cash and marketable securities on the balance sheet. While many investors don’t like to see excessive amounts sitting around, we rarely complain seeing cash making up 30 - 50% of assets as long as management continues to generate returns on capital in excess of 25%. Cash (and marketable securities to an extent) are oxygen in bear markets. Ask someone at the former Bear Stearns (now JPM) or Lehman Brothers how they feel about cash on the balance sheet today and compare that against their comments in 2006. You might be surprised by the difference in opinions.
At Nintai, we generally invest in asset-light business models, so we put much less weight on this than other more traditional value investors. From our perspective, we look for management to utilize long-term assets to a.) create wide/deep competitive moats and b.) thereby generate superior returns on capital. One long-term asset that raises alarm bells at Nintai is goodwill. According to Investopedia goodwill is “recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process.” In other words the acquirer has overpaid for the acquisition. For example, after Sprint (S) acquired a majority share of Nextel in a $35B stock deal in 2005, it took a $30B write down in 2008. This write down reflects that Sprint paid $35B for $5B in assets. Not what we consider outstanding allocation of capital. This reduced total assets from $97B in 2006 to $64B in 2007 - a shocking 34% decrease. Return on assets went from 1.3% in 2006 to -36.6% in 2007. Any company carrying a goodwill as a large percent of total assets tells me management aren’t really savvy capital allocators and I likely don’t want them managing my capital.
Current (Short-Term) Liabilities
One of the chief destroyers of investors’ capital during the 2007-2009 crash was the business model based on short-term financing combined with long-term lending. Consider Lehman Brothers. Without getting far too technical, Lehman was using short-term commercial credit paper as a means to fund daily operations. Lehman was dependent on other institutions to roll their debt every week. If that commercial paper couldn’t be rolled, Lehman could run out money real quick. Which it did. Without real solid liquidity (like cash), Lehman found itself at the mercy of the commercial paper market. Take a look at your portfolio holdings. How dependent is each one on short-term financing? If the company has a lot of short-term liabilities, make sure it has a lot of short-term assets.
Two things are of concern in long-term liabilities. The first is long-term debt. Does the company have the ability to pay this off? I don’t mean by measuring it with some non-sensical formula like EBITDA. Can the company meet it’s debt obligations from operating cash flow? Second, if the company offers a pension, is it fully funded? If not, how much is the shortfall and how does management expect to address it? This can be a ticking time bomb if swept under the rug.
As I mentioned earlier, many traditional value investors saw companies during the 2007 – 2009 crash and thought - from a balance sheet perspective - they looked pretty cheap. Unfortunately, the structure and make-up of assets completely fooled investors into thinking they were purchasing at a discount to fair value. In some cases, they couldn’t have been more wrong (just ask investors in any of the large investment banks of Bear Stearns, Lehman Brothers, or Merrill Lynch).
So what are we left with after cleaning up the wreckage of the crash? Do investors still face the same risks as those who saw investment opportunities in late 2007? Has Wall Street changed and mended its ways to prevent such a collapse again? The answer is yes and no. Today we are told that leverage on Wall Street is far down from the 40 - 45:1 ratios we saw in the real estate market heyday. That is certainly helpful. But I would argue there are three areas where risk has not been reduced and investors are still at risk of serious capital losses unless they roll up their sleeves and do a lot more research. In addition, I think there are still too many players who are fighting the last war – using traditional value measures that might miss underlying risk and leave them open to some very ugly returns.
Innovation and the Balance Sheet
Innovation is still alive and well on Wall Street. We see it every day. For instance, Societe Generale has rolled out their total return swap product along with UBS’ bespoke trades via swaps, certificates and notes. Both look to take advantage of the last 30 minutes of frantic day trading. This type of innovation (though in this case for institutional investors) continues to be increasingly opaque in nature and incredibly niche-based in its usage. What’s most concerning has been the continuing innovation in products that end up on balance sheets and remain there like landmines waiting for the next market volatility to jostle them and set them off. Three of these are of particular interest to us at Nintai and we keep a close eye on them.
I wrote about these in detail in an earlier article (“Fata Morgana and the Illusion of Safety” which can be found here), but to summarize these are loans where companies provide little back-up information and collateral while the loaning entity has little recourse to collecting on defaulted agreements. By the time of crash, nearly 75% of all leveraged loans were covenant-light (cov-lite) loans. This market collapsed to less than 5% in 2009. But like many bad pennies on Wall Street, they seem to make a return as soon as the bright lights are turned down. As I mentioned in my article “Fata Morgana: The Illusion of Safety”, cov-lite loans are equal (percentage wise) to where they were in 2006. Dollar wise they are nearly 25% greater. What impact they will have on valuations isn’t really clear. For those institutions who make the loans, exactly how much strength can you place on getting a return of their capital? If defaults spike and the company has no recourse, will this drive valuations down even further?
Securitization: The Rose Blooms Anew
A huge shock to older value investors was the interconnectivity between debt instruments which were like hidden booby traps that exploded across the financial markets leading to stunning bankruptcies, government takeovers, and Federal Reserve interventions. The seemingly random interactions and resulting shocks to the system led to considerable permanent impairment of investor capital (examples include Washington Mutual, Bear Stearns, Fannie/Freddie Mac, etc. etc. The list is profound in its size and scope). One would have thought the markets would have learned from the mortgage backed securities (MBS) blow up or the credit default swap (CDS) debacles, but amazingly the asset backed security (ABS – of which MBS is part) market is nearing the three-quarters of the levels of 2007. The question going forward of course will be what asset class is at risk of touching off an entirely new credit crisis. It is unlikely to be a mirror image of the 2007 – 2009 crisis, but certainly will have the ability to create havoc in the general credit/debt markets.
Interconnectivity Between Debt and Other Obligations
It’s unclear what the risks are between markets that are increasingly securitized, products that are bundled far more frequently, and the far greater complexity of such products. For instance, a principle protected note is a fixed income security that guarantees a minimum return equal to the investor’s initial investment regardless of how the underlying asset performs. Theoretically, credit quality plays a role in the “guaranteed” minimum return unless the issuer goes bankrupt, because then nothing is guaranteed and you lose your entire investment. Another piece is that the investor must hold the note until maturity, otherwise they are at risk of losing principal. I only bring this up to point out that a principle protected note is far more complex than placing your money in a savings account. All of the dependencies to make the note work - credit quality (subject to change) interest rates (subject to change) length of ownership (subject to change), underlying asset returns (subject to change) - make for high interconnectivity. That then makes projections, returns, security, and risk highly variable and uncertain. Wall Street comes up with new concepts like the principle protected note on a daily basis. Being able to reliably imply fair value to such products is increasingly impossible. A traditional value investor finds themselves increasingly at sea when an investment opportunity might have hundreds of these situations on its balance sheet.
During the 2007 - 2009 bear market, many traditional value investors saw opportunities and utilized a traditional approach in calculating value. This approach unfortunately misjudged a multitude of factors that changed the type and risk of assets on corporate balance sheets. Over the course of the bear market, a wide range of companies were forced into bankruptcies, merged away, or received large injections of capital from the Federal Reserve. Investments in many of these companies became permanently impaired as more information came out about the underlying value of the companies. For many older value investors, this period was akin to the great market crash of 1929. Methods which had worked for decades such as looking for companies with low price-to-earnings ratios or seeking out banks with price-to-book ratios of less than 1, proved to be disastrous as the complexity of the problems facing the economy and companies became clear. Not enough has changed to say we are out of the woods. Even today, when an investor looks at the balance sheet of a company today, you might see a financial model that has built in risk capable of all-too easy self-destruction. Especially in financial services sector - but certainly not limited to it - companies operate in an economic environment in a dizzying state of change. Everything from negative interest rates to a Wild West regulatory atmosphere are pushing the limits of traditional accounting and financial models. What caused significant damage to traditional value investors’ returns in the last bear market has the chance to wreak even greater havoc in the next.
In Part 3 of this series I will review the steps in value investing where the process went wrong and how to avoid it in the next bear market. Going forward, the challenge for investors will be how to apply our values (such as buying an asset at fifty cents to the dollar) which making sure of the underlying security of the implied value. Looking out at today’s world economies, monetary policies, and financial models, it can be challenging to find quality companies at reasonable prices. Nobody ever said it would be easy, but it certainly is an incredibly interesting time to be a value-based investment manager.