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A reply to Binve's post about valuation at the March bottoms in 2009.

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March 09, 2011 – Comments (12)

I shall reply, as best I can, to Binve's recent blog about the valuation at the March, 2009 bottoms.  Indeed, I shall even spend some time trying to dig up actual statistics to go with my points.  But before that, I would like to tip my cap to a blog made over the last week by HareyCareysGhost, right here:  http://caps.fool.com/Blogs/a-simple-hedge/551529.  I think that concept (hedging ones own life) may have some interesting possibilities.  

But first, I'd like to formulate a good reply to Binve's recent blog, which is located here:   

http://caps.fool.com/Blogs/the-valuation-bottom-of-2009/549216

I put this in a new blog because with teh CAPs game format, and Binve having made another blog since, and it being a few days old, probably nobody but maybe Binve will ever read a reply to that blog at this point.  This way the topic can be debated anew.  I'll copy this into his original blog also so that anybody who finds it by google or something can read it.

12 Comments – Post Your Own

#1) On March 09, 2011 at 11:39 AM, checklist34 (99.71) wrote:

CAPs refuses to put my barfbucket-hosted pictures in the original post, it only allows them in replies, so here's the content:

POINT #1:  DIVIDEND YIELD AND P/E RATIOS AT THE MARCH BOTTOM. 

argument #1a:  Dividend Yield.   Lets start with the often-used dividend yield argument.  "stocks are expensive because the yield is just 2%" or "stocks are expensive because the yield is just 3%", or a famous Canadian dividend investor bailling in early 2009, to much fanfare, from the market because markets typically bottom at a 5% (or whatever it was) yield and we were still only at like 4% or some such logic.  There is one critical flaw in this thinking, critical. 

It is buybacks, NOT DIVIDENDS that are today the dominant form of companies returning money to shareholders.  I AM NOT arguing that buybcaks are as good, frankly I think its fairly clear that they are not, but ...  Today buybacks are substantially more than dividends, in 1980 they were just 10% of dividends.  See this blog for details and links to the discussion:

 http://caps.fool.com/blogs/dividends-vs-share-buybacks/353816

See here for a chart showing the dividend history of the S&P:

http://www.comstockfunds.com/files/NLPP00000%5C416.pdf

In the early 80s bear market bottom, dividend yields got to about 6% at their peak.  They peaked at just under 4% at the march 2009 bottoms.  BUT, and this is a REALLY BIG BUT, if you factor in the fact that buybacks are now more than 1.5 times dividends (see link above) we would have an off-the-charts (since the depression) ratio of cash returned to shareholders as a percentage of the S&P.  Its probably not quite that simple, as we'd then have to factor out stock compensation to employees from the buybacks to find some kind of net buyback.  But in any case, the dividend yield did not make a historical high in march of 2009, but the "cash returned to shareholders" yield certainly did.  

The times they have a changed, probably for the worse, but the fact of the matter is dividends are no longer the dominant form of returning cash to shareholders, and for that reason we can no longer compare dividend yields today to historical ones.  

Point 1b:  the p/e ratio of the S&P

I become agitated when I see that chart that everybody paraded around in early 2009 showing the off-the-scale p/e of the S&P.   I accept its factuality..., but it just doesn't tell even part of the story.  These factors all play a role in why stocks were REALLY cheap based on earnings, maybe since-the-depression cheap.  

Every single one of the following things had a material impact on trailing earnings for the S&P, many were one time events, once in a lifetime events, some were not actual losses at all just accounting garbage, and so forth.  

1.  One time, single-company mega-losses.  AIG lost 12 figures that year.  THAT ALONE would have a material impact on the earnings of the S&P.  Assuming the S&P had a total market cap of around 7 trillion at teh bottom, and it would have had a p/e of, say, 14, that one cmpanies losses alone would raise that p/e to 17.5.  Throw in mega losses at GM, F and you probably now have a p/e of 20 just from losses at 3 companies.  

2.  Once in a lifetime, mega losses in the entire financial sector.   Those trailing 12 months, from the march bottom in 2009, would (i think) have included losses that destroyed or basically destroyed, ambak, mbia, wachovia, washington mutual, merril lynch, and many, many more. It also included epic losses at BAC, C, WFC (who took a massive write-down for wachovia in that time), and everything else.  I submit, confidently, that a reasonable market participants job would be to look past these things (remember that hypothetical pe of 14?  It would have gone infinite JUST DUE TO non-recurring losses related to mortgage debauchery from the years prior.  

3.  Mythical non-losses that were reported as losses due to FASBs inbred mark to market accounting.  Yes, I just said "inbred" in a blog that I fully meant to be taken seriously, frankly, i think that understates the matter.  ACAS had a financial security on its books that was marked to, if memory serves, about $12 million.  IT GENERATED MORE CASH FLOW THAN THAT PER QUARTER, but due to the miracle of mark to market accounting, they could only claim it as worth $12 mil.  Insurers writing down book value of investments take losses, when those investments mark back up they DON'T book gains.  Its truly messed up, but that represents my understanding of mark to market as it existed in 2009.  Thank god thats over. I submit that probably 50 or 100 billion dollars of losses, absolute bare minimum, never actually happened, but were myths created by mark to market.   

4.  The incredible commodity bubble and pop led to cyclic companies being caught in what has to be a once in a lifetime bad position.  So you're a mining company, or Alcoa, or something.  Commodity prices in 2008 are higher than they have ever been, you're exited, you're about to bank unbelievable profits, you start up every plant, you fire up every smelter, you dig holes in the ground behind your house with a shovel after a long night of drinking, thats how excited you are.  And... then... 

Bang.  Commodity prices crash by 20, 30, 50, 75%, sometimes more.  Almost overnight (from what?  Q2/Q3 of 2008 to Q4?).  Suddenly you're left with plants running incredibly unprofitably, and you have to shut them down.  This involves layoffs and enormous one-time costs.   Is it rational to sit there and claim "the market is expensive", or is it rational to sit down and try to filter some of this kind of thing off?  Commodity companies got completely corn-cobbed and many reported massive, massive losses. 

5.  The sudden and stunning economic slowdown resulted in enormous write-downs of goodwill in Q4 2008 and Q1 2009.   Imagine that Binve started a company, "Binves miracle stock blog", or BMSB, and it generated $200k a year of income due to advertising on his site.  And then Checklist came along and bought it for lets say 500k.  Thats a pretty good deal for Checklist, as long as Binve doesn't quit, because he is getting a 40% return or something.  But, on Checklists balance sheet, he can't put any tangible assets.  Because all he got was Binves laptop, coffee maker, and 3 boxes of k-cups, because thats all the hard assets BMSB had.  They are worth about 500 bucks, so $499,500 has to be put on checklists balance sheet as "goodwill".

If the next year, Checklist takes over blogging, and nobody waants to read it anymore, and it quits making money, Checklist is required to write down that goodwill.  To zero.  Because its no longer making any money.  That goes as a $499,500 loss on my income statement, despite the fact that no cash was lost that year at all.  (i'd bought it the year earlier, i did lsoe cash, but its not really reasonable to say I lost it THAT ONE QUARTER.  

So many companies wrote down goodwill to the point where they lost YEARS worth of profits ina  single quarter.  ODP, OSK were two stocks that I owned that did that.  TCK wrote some down, ALOT OF PEOPLE WROTE SOME DOWN.  This was the critical aspect of buying ASH.  They would have violated their debt covenants, despite having a fine financial position, if they would have had to take a goodwill write-down on their purchase of Hercules... So the key to analyzing ASH was JUST analyzing whether they could justify keeping the goodwill.  They could, it wasn't even close.  

Goodwill write-downs are a tax benefit to a company.  Share prices had fallen so low, that, frankly, I think alot of CEOs simply "threw the baby out with the bathwater" and took as many write-downs as possible.  How much was the total goodwill write-down of the S&P in those trailing 12 months?  Gun to my head it'd be 100 billion plus.  HUGE. 

These weren't even cash losses.

6.  Earnings today are understated relative to history, its just a fact.   Behold:

Photobucket

From here: 

http://www.businessinsider.com/deutsche-bank-fear-2010-5#-1

Earnings are understated now rleative to history, apparently, presumably due to some accounting changes.  Porte once sent me a link to why this is, but I don't know where that link is, because there are like 5500 emails in my inbox and it the search function is lame, and it would take hours to find it.

Earnings are apparently understated today, relative to history, by a solid 15%, and that spread was never wider than it was in the timeframe in question.  

7.  We buy things for anticipated future performance, right?  The forward p/e of the market was as cheap as it was in the 70s, despite the lack of a return to truly normalized conditions.   My argument here is simple:  how low did the forward p/e of the market ever get in the 70s?  As in price of the market relative to earnings the next full year?  7?  8?  Thats where we were at the March bottoms.  The market was priced at 670ish, what were 2010 earings?  80?  What about operating earnings (see point 6. above about how earnings are understated today relative to in the past, due to accounting changes that presumably reduce corporate debauchery)?  Were we not trading at a forward pe of about 7 or 8?  

8.  Companies were getting lean, very lean.  This fact was perhaps not tangibly predictable, but all the layoffs and cost cuts sure seemed to portend large profits to come.  It worked out that way, mroe or less, profit margins are at record highs.   I argue, ... mildly, that they can remain high for some time to come this time, because of the weakish business environment.  They tend to regress to the mean fairly quickly in the past, but will regress slower if business stays somewhat nervous about the future.  Why?  They just won't hire alot of people back.  

In sum, it was a complicated and confusing time, and more in depth analysis was needed to make a valuation call.  

Point 2:  price/book.  See an old thread here:

http://caps.fool.com/Blogs/are-stocks-cheap-or-not/218415

See also here:  

http://www.marketthoughts.com/z20090308.html

Which has this picture:  

Photobucket

It shows the P/B of the S&P falling to 1.2 in late 2008, which would put it around 1 at teh March, 2009 bottom.  The massive write-downs and losses over the next quarter or 2 would ultimately raise, I assume, the P/B of the S&P at the bottom.  But there is more to it than that...

From that same page:

More importantly, the book value of the S&P 500 is overstated relative to its lows in the early 1980s, as neither technology or biotechnology R&D spending (the biotechnology industry was not born until the late 1980s) is capitalized and treated as an asset on the balance sheet.  For example, Amgen and Genentech – two of the better performing stocks on the S&P 500 over the last 18 months, have P/B ratios of 2.42 and 5.49, respectively.  Even Microsoft, a mature cash cow in the software industry, has P/B ratio of 3.94.  Assuming (conservatively) that 15% of the S&P 500 are made up of such companies that did not exist in their current forms in the early 1980s, and assuming that the book value of such companies are understated by about 50%, the S&P 500's book value for 2008 is closer to around $638 a share.  On a R&D-adjusted basis, the P/B ratio for the S&P 500 is approximately 1.07, or its lowest level since the beginning of the greatest bull market in history in late 1982.  In addition, analysts are still projecting the S&P 500's earnings to be in the range of $35 to $50 a share this year, suggesting that the S&P 500's book value will continue to grow this year.  Based on the price-to-book ratio of the S&P 500, the core earnings power of the S&P 500's components, and the range of liquidity schemes implemented by the Federal Reserve and Bank of England, there is no doubt that stocks now present the greatest buying opportunity of our generation.

I sat down to consider this point once.  I thought about MSFT and what is, really, its book value?  Is it understated by 50% due to the reasons above?  Its p/b is 4.5.  Its p/e is about 10 or 11.  In all reality, its "book value", if its assets were capitalized like the companies that dominated the last time we had a big secular bear, would be understated by possibly significantly more than 50%.  Ditto ORCL etc etc etc etc.

Beyond that, by march of 2009, probably 100's of billions of dollars wroth of financial assets were marked down, wrongly, due to mark to market, that were destined to be marked up later.  The book value of XL has nearly doubled, HIGs has MORE than doubled, GNW nearly doubled, etc etc etc etc etc etc etc etc etc etc etc.  

We were at least close to the lows of the last bear market in terms of price/book, when one takes into (as, in my opinion, a reaosnable man must) the fundamental changes described and discussed above.  Mark to market errors were the fundamental core of my call, Binve, the system was wrong, period.

Point 3:  distance off the trendline.  My favorite chart.  In 2006 we were on the trendline,from then to 2009 we had some inflation, and stocks fell by 50%. 

Photobucket

In fact, as far off as anytime in the 70s bear.  Roughly.

Point 4:  the incredible cheapness of individual stocks.   The market was cheap, I do strongly maintain, but individual stocks were SHOCKINGLY cheap.  All of the following HAD to go up at least 5 times if they didn't go bankrupt, MANY of them had to ten bag:

joez, bz, gnw, hig, xl, cno, pnx, ggp, fch, ash, osk, rcl, mtw, dow, lnc, tck, acas, ald, mcgc, lvs, mgm, AND MANY MANY MORE.  

My portfolio at the bottom had a price/book of <0.2.  After 5 bagging from the bottom it was still WELL under 1.  

The market was floated by "invincible" companies only.  Abbot Labs, Eli Lilly, Pfizer, Microsoft, Oracle, EMC, XOM, COP, WMT, and more.  If you filtered out those "invicible" companies, the valuations would very likely have been off the charts cheap.  The reason that the worlds best companies lagged the "trash" so badlyin the rally we've seen is that the worlds best companies sold off 10% or 20% or 30%, and the "Trash" sold off 90-99%, and then the "trash" lived.  Most of it anyway.  If something rallies 10 times, but had fallen 95%, guess waht?  its still down 50%.  Now what if it had fallen 98%?  Still down 80%.  

ASH was in no real trouble and was trading at less than half of its all time low, its all time low from the early 80s when it was MANY TIMES smaller than it is today.  

I accept that this point lacks data to support it.  But, gun to my head, guessing, filter out these "invincible" companies and we'd have had a price/forward earnings of 5 and a price/book of <1 at teh bottom. 

Point 5:  The Q ratio and replacement cost.  Whats the calculated replacement cost of MSFT?  of ABT?  is this something that ignores value that wasn't attained via purchasing a hard asset?  Ignores the cost of R&D?  It looks like it might be, but I'll have to read into it.

 

And therein lies my rebuttal.  Do I think that the market as a whole, sometime later this decade, at some value much higher than 670, may get "cheaper" on some trailing 12 months pe or something?  Sure, absolutely.  

Do I think that stubbornly refusing to accept the changes in accounting and the reality of buybacks-vs-dividends, and the reality of book value and how its treated will serve the bears well on that dip?  Nope.  

Do I think that, in our lifetime, we will get individual stocks as cheap as they were then again?  Nope.  You had HUNDREDS of stockst o pick from at <20% of book value and trading at price/normalized earnings power of <2, often <1.  

Those accounting points, and that note about individual stocks -vs- the market at large and the amazing differentiation that we saw between the "invincibles" and the rest of the market need to be considered and should not be quickly dismissed.  

I hope this was a worthy reply, good day. 

 

 

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#2) On March 09, 2011 at 11:41 AM, checklist34 (99.71) wrote:

honestly, and believe me I went over this so many times in early 2009:

I believe that every point made above is reasonable, and within the realm of factual.  I do not think any of them take anything out of context, resort to exxageration, or mislead.  I think that plain and simple, the arguments above are fair and accurate.  

I am willing to debate them with Rosenberg, Schiller, the lads from Comstock, or ANYBODY ELSE, even if I must debate this while drinking.  

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#3) On March 09, 2011 at 12:07 PM, leohaas (31.83) wrote:

The link to HareyCareysGhost's blog doesn't work. It is just a matter of removing the period from the end of the URL. For those who are too lazy to do that for themselves, click on the link in this comment...

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#4) On March 09, 2011 at 12:14 PM, binve (< 20) wrote:

checklist,

Excellent reply! And like I said in my last comment to you on my blog (which if you havent read you should: http://caps.fool.com/Blogs/the-valuation-bottom-of-2009/549216#comment553546) I have more agreement with you than disagreement.

Just a few points:

argument #1a:  Dividend Yield. ,

You are not refuting the point that I am making about the Dividend Yield, your are stating that they have gone out of fashion recently and that they are unlikely to come back into fashion. I give a counterargument why I think they will based on market observations. So in this case, we agree to disagree

Point 1b:  the p/e ratio of the S&P I become agitated when I see that chart that everybody paraded around in early 2009 showing the off-the-scale p/e of the S&P. 

Dude, this is starting to sound like a straw man rebuttal. I very specifically gave reasons why the nominal P/E chart (the one that everyone shows) is invalid.You are refuting a point that I specifically did not make.

I agree with subpoints #1-#8

(regarding #5, I would suggest against investing in BMSB :) )

I agree with your Price/Book observation.

Point 3:  distance off the trendline,

Here is my alternate take on that

ENLARGE

I agree with Point #4

I think Point #5 is a valid valuation measure, as I stated in my blog.

Like I said in my post, I wasn't looking or expecting to convince anybody. But I am very glad a conversation was spawned by it. Like I said here http://caps.fool.com/Blogs/the-valuation-bottom-of-2009/549216#comment553546 I actually agree with your stance much more than I disagree with it.

And like I said that night on one of your other blogs (can't rememember which), our short term and very long term positions are very much in alignment. Cyclical bull market continues for a couple of year. There will be a secular bull market starting sometime around 10 years from now and it will be very tradeable (i.e. we will be able to get in near the bottom). We even agree that there will be one more cyclical bear to finish out this secular bear. The only thing we really disagree on is the severity / depth. That's 3 out of 4 agrees and only 1 out of 4 disagrees. Not too shabby :)

And like I said last night, I always appreciate your views, even when you are SHOUTING rebuttals at me :) You are a tremendous asset to this community (much more than I am) and I look forward to your thoughts. And I definitely look forward to investing in the next secular bull with you! Until then, I am just being patient.

Thanks for a well thought out rebuttal..

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#5) On March 09, 2011 at 12:41 PM, Valyooo (99.44) wrote:

I don't know why you constantly say mark to market accounting makes no sense.  If you have a stock portfolio with $100,000 of securities, and the market drops 50%, using mark to market accounting your value is down 50%.  It doesn't matter if you are recieving dividends, your value is down a lot.  Book value plays a large role in valuing financial institutions.

I understand why you bought the BDC's, and yes it made sense, but so does mark to market accounting in its own way.

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#6) On March 09, 2011 at 12:43 PM, Valyooo (99.44) wrote:

Binve, in a few months I plan on getting into TA (theres some other stuff I need to learn first).  Any suggestions on books/articles/websites?

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#7) On March 09, 2011 at 12:55 PM, checklist34 (99.71) wrote:

Binve,

   my replies, and blogs, are always somewhat sloppy compared to those of many other CAPsters.  I would proofread them, but... it would take away from it sounding like I wrote it i think.  I had another blog once, like many, many years ago, and a friend from there who reads these told me back then that I had to quit editing and just type.  Plus I am extrmeely lazy and useless, in general, and do not particularily want to bother. 

    So, thusly noted, ...

ok

1a:  boy would I be happy if buybacks fell out of favor.  frankly, a return of dividends would probably contribute to the onset of a new secular bull.  

Maybe you are right.  People are getting tired of buttcaps like John Chambers and Michael Dell buying back billions of dollars wroth of shares in the $40s.  They want billions of dollars worth of dividends with which they can pay down debt, but some shares of Verizon, and stuff.  

1b) that reply is pretty automatic-for-the-keyboard, I have typed it so many times now.  But I wanted to put it into this thread, so that if anybody who stumbled across the threads sat down to read it, it was there.  Its important to me, I am sorry if its repetitive and annoying. 

You ever seen anybody give any actually detailed thought into estimating a 70s stile price/book for 2000's style S&P companies?  I think it would be challenging, full of guesswork, but very interesting.

point3:  i love your picture, I have permused it several times.  But I'd just argue that your second dip that goes to the bottom of the channel ... is deeper than any previous dip, which were all above teh channel.  The 09 dip got about as low as 1932 or 1974, to my eye. 

Pencil thickness anda ll of that at play here, bigtime, I realize.

Point #5:  honestly had never heard of that Q mojo, I will have to read about it.  Which will take a long time, so I couldn't before blogging here.

Thank you, Binve, we will see what value I am to the community going forward.  Past results, etc.  

I do confess that I like to SHOUT when I type, I guess I try to type as if I was talking, and one can't throw his hands up with a keyboard, lol

We basically agree, I guess, except:

1.  I think we got as close to the bottom of your channel as we will, although I don't one bit doubt we get way down there again, but... to a much higher level.  10 years is a long time, and that channel will have moved up a great deal. 

So I think we plummet at some future time to 1000 or 1100 or 1200 or something, but I just don't see another plunge anywhere near 700.  To get a 4-5-6 years from now drop to that kind of level, we would be grossly exceeding the all time distance-from-trendline record.  I just don't know if I could believe that could happen.  

Again, pencil line thickness and all.  

 

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#8) On March 09, 2011 at 12:55 PM, checklist34 (99.71) wrote:

thanks, leo, I flubbed up the link.  I think HCG's concept is pretty awesome, though.

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#9) On March 09, 2011 at 1:05 PM, checklist34 (99.71) wrote:

Valy, the concept is good, I don't dispute that one bit.  But it just can't be applied as it was, it cannot be applied to illiquid markets.  In my view, and I guess that'd be a whole nother hour of typing in another blog, it was a significant contributor to the magnitude of the panic in late 08/early 09.  

But the problem is what happens if a amrket goes illiquid?  And the only sellers are forced sellers?  Ala late 2008 for many things?

We all own a business of some kind, whatever.  One of our assets is a package of mortgages we paid, say, $100 million for.

We sit down and analyze it,  its kicking out $8 million of cash flow per year or something, we add up all 20 mortgages it contains and conclude that for all practical purposes only 5 are realistically risky.  The loan to value on those is maybe 0.8, the overall loan to value is perhaps 0.6. 

We conclude that, frankly, the thing is likely to at worst suffer about 5% capital losses, but its kicking out 8% interest and we'd probably recuop 1 or 2% of tthose capital lossses in payments made before those mortgages default anyway.

But say the market goes into a complete panic, and those things start selling for, say, 60 cents on the dollar, 50 cents.  

Is it reasonable for our company to have to take a 40 or 50 million dollar loss when our realistic max loss, excluding interest, is a few million?  

Thats exactly what was happening, Valy, situations literally that dramatic, and even much more dramatic.  

On the flipside, say interest rates dropped hugely, and our $100 million portfolio paying 8% could be sold for $200 million.

Is it really reasonable to claim a huge profit if we don't actually sell it to the market, but rather just hold it?

It was a grossly flawed system, and the chaos in late 2008 revealed those flaws dramatically.  

When a market goes illiquid and crashes beyond reason

A)  reasonable sellers will not sell at the market, as in the example above, why on earth would we sell when we really weren't in that bad of a position?

B)  the only sellers, therefore, become forced sellers and

C)  the market fails, and forcing mark to market on people raises enormous trouble.

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#10) On March 09, 2011 at 1:06 PM, checklist34 (99.71) wrote:

it failed because it created losses that weren't losses, in my view, Valy.

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#11) On March 09, 2011 at 1:10 PM, checklist34 (99.71) wrote:

the bearish view that the changes to it, frequently called "mark to myth" accounting is probably not without some merit, but it is materially false to state that every loss reported under the old system was realistic.  Many weren't. 

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#12) On March 09, 2011 at 1:22 PM, leohaas (31.83) wrote:

Agree with all your points, except the one about P/B. One can only draw conclusions about this metric if book value can be dertermined reliably. I would argue that that is a stretch, has been a stretch for many companies since at least the start of the dot com bubble inflation, and it really was a stretch 2 years ago.

I have only used P/B as an argument for buying or selling a stock once. I do not expect to use it in the near future.

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