March 29, 2011
“Embrace Reason, Shun Theories or Think Big, and Go Broke”
My speech, all gall, divides in three parts. What you shouldn’t do, what you should do, and what Jim wants me to do. “Aw Michael, just give them CUSIP numbers,” was my invite. I’m coming to that presently. The face of American investing is a spittle flying, neck vein popping, barnyard noise making character who spews economic nostrums twenty to the dozen. Foretell the economic future, make it loud and Croesus will grow jealous of your wealth shortly. Right. A generation of American investors has been taught this, and the idea is not only wrongheaded, it is dangerous, and I want to spend a few minutes illustrating why, but first a brief moment of personal history.
Slide 1 – General Theory
When I was an eighteen year old undergraduate, I sat in the stacks at Cornell reading John Maynard Keynes’ General Theory of Employment, Interest and Money because I wanted to know something of the original flavor of this one work I had heard so much about. I was besotted instantly, and within a fortnight I had consumed every major work that he wrote. Worse yet, I had started using words like fortnight and besotted. To an undergraduate mind, Keynes was instantly addicting. He was also a trading legend. He once cornered the market in wheat, the shorts surprised him by forcing delivery, and he calmly proposed to the Cambridge Dons that they vacate Kings College Chapel, so he could use it as his personal silo. In the event, this didn’t fly, but imagine the cheek in trying it on. He then claimed the wheat wasn’t in good deliverable form, got the sellers to clean it, the market recovered in the interim and he made a profit. Great stuff, no? And chapter 12 of this book is the wittiest and wisest 17 pages you will ever read on markets. Well worth the price of admission all by itself. It is also part of an elaborate front to conceal a dirty little secret, one that I only found out many years later from this book.
Slide 2 – The Economist as Savior
This is Robert Skidelsky’s brilliant work of scholarship, in three volumes by the way, and the title of this volume tells the story in typical British understatement. Keynes really was the savior of western capitalism. He also wasn’t what he seemed to be, and here I have to let Robert Skidelsky tell you the tale directly. This is from pages 524 and 525, lightly edited by me for concision.
“In 1929 Keynes had lost practically all his money, in 1931 he even tried to sell his two best pictures, his Matisse and his Seurat, but found no buyers. Keynes personal investment philosophy changed with his economic theory” says Skidelsky, which if I can interject, is better than you can say for most of us. After all, Keynes did once say, “When the facts change, I change my opinion. What do you do, sir?” Back to Skidelsky, “In the 1920’s Keynes saw himself as a scientific gambler. He speculated on currencies and commodities. His aim was to play the cycle. This was the height of his “barometric” enthusiasm, when he believed it was possible, by forecasting short term rhythms, to beat the market. The gambling instinct was never quite extinguished.”
But Skidelsky goes on,
“By the 1930’s (Keynes) was prone to dismiss this kind of activity as a mugs game. “I was the principle inventor of credit cycle investment,” Lord Skidelsky quotes Lord Keynes, and “I have not seen a single case of a success having been made of it.” Hmm. “Credit cycling meant valuing shares relative to money, or as Keynes put it, valuing them by last week’s results, rather than by their long term prospects.” By 1938, Keynes was going so far as, “I feel no shame still owning a share when the bottom of the market comes. I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself. Any other policy is anti-social, destructive of confidence, and incompatible with the working of the economic system.” This doesn’t sound like the wheat trader from the decade before, does it? Anyway, Skidelsky finishes with “Keynes’ new philosophy can be summed up as fidelity to a few carefully chosen stocks, his “pets” as he called them.”
The irony here grows really thick. Keynes never admitted to any of this publicly, Skidelsky tracked it down in Keynes’ private correspondence and his monthly statements. To get back to America today, the television prognosticators, half of whom have never read Keynes and the other half can be counted on to bollix up his name, are trying to be the little Maynard who, in fact, never was. And Keynes would have found this completely predictable. He wrote, “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.” Keynes, who never liked Americans much, would find it delectable that he is the defunctee they ape, again, the one that never really existed. By the way, Skidelsky goes on to inform us Keynes made 23 times his money from the moment he started ignoring his own economic theories in 1932 and became a value guy. Closeted, to be sure, but one of us nonetheless.
Time doesn’t permit me to go on in this vein, but Paul Samuelson famously said, “The stock market has predicted nine out of the last five recessions.” Milton Friedman thought you were insulting him if you asked him the direction of the stock market. Friedman passed away four years ago, but was witty and acerbic to the end. It’s the sadness of my life that I never offered to pay Alex Porter to ask Professor Friedman, “So, what names are you using in here?” It would have been a moment. My point is Paul Krugman is poor, and, happy news to this assemblage, he is always going to be poor. There’s no money in this. There is the possibility of a world of hurt though, if you find yourself following a prediction over a cliff. Here is what I mean.
Slide 3 – Alcoa Value Line Survey
Alcoa, with its two AA’s, is the first symbol alphabetically in the Standard and Poors 500 Index. It is also traditionally the first S&P company to report quarterly earnings. Why? With results like these over the last 17 years one would think that the SEC would have to drag the results out of them. Or maybe Alcoa executives would hide ‘til midnight Friday and put out a press release when no one would be likely to report it. But no, this capitalistic catastrophe is Johnny on the spot every quarter, and neatly illustrates an investing nugget my partner Edwin Levy and I stumbled upon nearly twenty years ago. After faithfully perusing the Value Line Survey every weekend for many years, we noticed that over half of the companies portrayed didn’t actually make any money. Value Line follows almost 2000 stocks in its main survey, so this is quite a mouthful, but so many of them look like Alcoa here. They report earnings, to be sure, and we all understand the denotation of “earnings”. We mean GAAP, or in some technology companies we mean near GAAP, but only after we fudge some of the expenses. We generally get the hang of Generally Accepted Accounting Practices. But when we say “profits”, it has a connotation very different. We know intuitively what a profit is at a local bakery. Profit, in every day speech, means money that we can take out of a business and spend on completely different things— schools fees, new cars, diamond rings—and when we come back on the Monday morning, we still have an asset to come back to. You can see for yourself that that in no way describes Alcoa. Every year they have to spend all their “earnings”—and I say that in sneer quotes,—their earnings get spent on capital expenditure, and then a whole lot more on top of that, just to get this sickly result. So many firms live forever in this “spend to survive” mode, and we don’t want them, ever! Alcoa was never a profit deal, as Steve Martin put it in “The Jerk”, not once in this 17 year moment. They always consumed more in capital expenditure and extending trade credit than they ever took in. And yet there was a bid on the floor of the New York stock exchange every single trading day. Why is that? Because someone had an opinion on how many cans the world was going to make, or aircraft America was going to build, or bauxite prices. They were thinking of something, but never, “Is this a good investment, that will throw off plenty of cash for the next 10 years, at an attractive price.” You need an economic theory, you need a Weltanschauung really, to do this badly. You couldn’t do this badly on your own.
Slide 4 – Alcoa Stock Price
And I am not cherry picking a particularly bad stretch for AA. It has been just this miserable ever since the Justice Department wanted to break it up in the 1950’s. The current owners might have liked to be put out of their misery at that moment considering what’s transpired since. Producing aluminum in America has been a miserable exertion for a long time, and you walked into the Plaza Hotel knowing that. But Alcoa is of a type that I am trying to get at. Does any competent investor ever look at airlines, or leasing companies, or steel mills and see profitable cash streams that the shareholders can regularly access? By the way, the Dow Jones Corporation seems to have come to this realization on its own. There used to be an investment method called “The dogs of the Dow” strategy. Alcoa is the only dog left in the industrial 30. The other 29 spots are now populated by the likes of 3m, and Cisco, and Mcdonald’s. This change makes it harder to beat the index than when it harbored the likes of Bethlehem Steel and its ilk.
Slide 5 – Zion’s Value Line Page
There are lots of cash sink holes like this, so if you think I am unfairly picking on AA for its prominence alphabetically, consider the last S&P member, Zions Bancorp. Zion’s is in Salt Lake City, –far from the madding crowd of binge era banking.
Sure, it looked to be a solidly profitable mid-market bank, that could pay out sizeable dividends as a percentage of its earnings. Which left it woefully, and unexpectedly, short of capital when the tide went out. Between the losses and the explosive rise in the shares outstanding when Uncle Sam rode to the rescue, the Zion shareholders are not making a comeback anytime soon, although the bankers and their bonuses may. This point was brought home to me five years ago when I was extolling the virtue of buying profits over earnings, yes, valuing profits while giving stated GAAP earnings the back of my hand, when Hugh McColl ran up to me and asked, “Well, are banks cash generators?” I harrumphed, and hawed, and generally talked at random, and then the financial crisis taught me a more correct answer is, “No, not even almost.” One of the paradoxes of banking is that while the institutions are literally made out of money, over a cycle they are not very good cash generators at all. This has always been true, and today before you can get a dividend, the Fed has to hold a prayer meeting.
Lest you think I am exaggerating about how many cash sinkholes there are, think about the outrageous survivorship bias in my argument, that acts as an endless 12 knot favoring breeze at my back. I can’t show you the Value Line page for Visteon, for Delphi, for Chrysler, for General Motors—ah, wait a minute. I can show you that one, and it is inadvertently but so very piquantly Wall Street right to the ground.
Slide 6 – General Motors Value Line
Here you can see for yourself that General Motors has a brilliant future in front of it. Interestingly, it doesn’t seem to have a past, a fact I was wholly unaware of until I plucked this out of the Value Line envelope the other day. $135 billion lost, give or take, you need to be a forensic accountant to have a strong opinion but, all down the memory hole. This so reminds me of Anatoly Rybakov’s wisdom in Children of the Arbat, “Under communism, the future was always certain, it was the past that moved around dangerously and unpredictably.” Tolya, you didn’t know what the capitalists were capable of. Now I know a little something about bankruptcy courts and the wonders of fresh start accounting, thank you so much Lisa Hess, but I also know something about the court of public opinion, and this is a god damned outrage. To be sure, it would be difficult for Value Line to cram in all the zero’s to tell a more nuanced story than this, but that’s my point actually. If you need scientific notation to describe your losses, perhaps there was something amiss with your business model in the first place. And so it goes now. General Motors came public again on November 18th at $33, traded at $35 the next day, and is $31 now, seemingly according to plan. If there is one take away from my chat, let it be that we go through our holdings tomorrow morning looking for sinkholes, and asking ourselves, “Am I just in this from some economic nostrum that may never play out?”
Before I cross over into the sunny uplands of what to buy, Jim wanted actionable ideas, and I’ve got to be a little careful here, in that I left the short selling business some years ago. I am, in Shad Rowe’s expression, “A recovering short seller”, but I am thinking of making a comeback with the cable TV companies. I have long had a jaundiced view of the cable stocks because they are always going to make just one more big push in capital expenditure and then reap the cornucopia. This has gone on since I got in the business, and they never throw off the promised cash. But this time may be different because it’s so much worse. If you’ve got a teenager in the house, get them to show you what streaming video can do. This was a balky, annoying, pixielating, frame freezing mess of technology four years ago, that now works pretty well. Not as well as advertised, and certainly not yet delivering HD quality pictures. But it is getting better rapidly, mostly through the exertions of Jim’s wonderful pick, Akamai Technologies and most young people think streaming is way cool, and they are the market. They are also streaming everything to their computers, including, this year, the Yankee games. Live sports was supposed to be the barrier protecting the cable companies, the moat, if you will, and it is being breached. The problem for cable is two-fold. Streaming is a nightmare of a bandwidth hog, meaning cable has to put up way more money just to keep their systems from crashing. And the customers are pirating half the things they’re watching. How would you like to have put up lots more money today so your customer can cheat you more effectively next month? The government isn’t helping matters with its net neutrality campaigns. Amazing how often in politics the first one to capture the language wins the debate. If you’re a four square opponent of net neutrality, sounds like you are Donald Rumsfeld and you want to invade Switzerland, doesn’t it? What is really means is that the last mile provider has a hard time charging little Tommy more than grandma, and he consumes thousands more zeros and ones than she does. Also, allows him to conceal his pirating. As I say, I haven’t yet acted on this most ruinous display of capex run amuk, but if I do short one of them it is likely to be Cablevision. Cablevision has the sort of management dear to the heart of a short seller.
Now for the “to do” list
Slide 7 – Tupperware
Yes, I know. Many sophisticated investors discover they have incipient Tourette’s syndrome when I bring up Tupperware. “What, that’s your idea of a good idea? Who invited this galoot?” Well, yes. For one thing, find me the recession. You can stare long and hard at Tupperware’s results and never see one. Indeed, if Rick Goings, the peripatetic CEO, didn’t read the financial press, he’d never know that something had gone a little amiss in the financial world. Tupperware doesn’t have a finance subsidiary that can take your heart out while you’re not looking. This isn’t a GE or a GM. He barely has a receivable. What he does have is a cash machine with 2.5 million strivers looking to make it grow. It is 2 lines of businesses, today, with the traditional Tupperware line making up 65% of the business and beauty aids making up 35%, and 85% of all the revenues come from outside the United States, mostly the 3rd world, which is catnip to a fellow like me who worries so much about the long term value of the dollar. The fellows on the Tupperware side have been endlessly inventive, and they have to be, because as Goings likes to say, “The good part of Tupperware is it never wears out, and the bad part if you run Tupperware is that it never wears out.” Consequentially, you might not believe all the cooking accessories, recipes, chef’s secrets, and God knows what you can buy at a Tupperware party. To go with it, on the beauty aid side, bought from Sara Lee five years ago, hence the brief run-up in debt, this is a cash machine like no other. Third world women have shown again and again that lipsticks and face creams are not bought with disposable income. No, no—women treat this as an indisposable part of the family budget. These items are tougher to cut back on than any entitlement program you ever heard of. And the whole of this sells for about 13 times this year’s earnings, which is about exactly the same multiple paid for Alcoa’s putative estimate. For those of you new to this, the difference between “putative” and “fictitious” on Wall Street is usually the passing of a handful of seasons. How could two income streams as disparate Tupperware and Alcoa’s sell for the same capitalization ratio? Could economic forecasting have something to do with it? Because logic doesn’t. It would be inconceivable to me that great cash streams sell for about the same multiple as their cash gobbling brethren, except that I’ve seen it go on and on for so many years.
My next couple of thoughts are all large capitalization American companies, which is nothing like some sort of sweeping prediction from me. It is just that this is what is cheap in the world just now, and I think infinitely more inviting than a ten year American Treasury bond, or anything priced off it.
Slide 8 – McDonald’s
McDonald’s, with a 3.3% yield and selling at 12 times this year estimate, looks cheap just off its headline numbers, but it has a couple of things going for it that you might not intuitively guess. Because the basic business model of franchising restaurants is such a charming cash machine from the outset, McDonald’s competitors have noticed, and gotten themselves leveraged up as a consequence. Yum Brands, second in the industry to McDonald’s, has twice as much debt as equity, and it is considered barely leveraged at all, which might raise an eyebrow or two in this group. But many of the others, which have been financially engineered, sometimes to within an inch of their lives, like Wendy’s/Arby’s, or Burger King, or Jack in the Box, and the like, have been hurt by the recession far more than McDonald’s. Well, they were leveraged, that stands to reason. Now they may be wounded again, but in a different way, as McDonald’s said in its quarterly conference call a month ago that it has substantially hedged its food costs out into the next year and a half. Think about that for a minute. Does it conjure up pictures of Southwest Airlines and Ryanair?
Companies with healthy balance sheets can hedge, and companies without that blessing cannot, because no one will do a derivatives trade with them. Consequently they are in for rough sledding, especially if this inflation we don’t have gets worse. McDonald’s also gets 65% of its revenue from outside the U.S., and my dollar worries just never take an end. McDonald’s, by the way, isn’t just a cash machine for its shareholders. The average franchise makes about $2.3 million a year, roughly 10 times what a Starbucks franchise makes, so it is just a fortress of a company in the time of the new normal, which seems to mean punk growth and a lot of worry.
The one blemish to this story, besides the usual concerns about supersizing children and fretting over gasoline prices, is that McDonald’s at year end lost a truly transformative manager in Denis Hennequin. Hennequin took over McDonald’s France in 1996 and demanded to be left alone from Hamburger University. He said, “Pfft, this is France. We have no children, and Ronald McDonald is annoying.” So out that went. He said, “Pfft, this is France. Eating in your car is barbaric.” So out went the drive in windows. And he made France the second most profitable market for McDonald’s and was turning all of Europe into a more upscale place when he left. Sometimes companies benefit so from letting good ideas percolate from the bottom rather than pressuring them down from the top. Letting the locals do their own thing has been a big change in the culture at McDonald’s and I hope Hennequin’s leaving doesn’t mean reverting back to the old Hamburger U way or the highway.
Slide 9 – American Express Slide
American Express is a cash generating champion, with pricing power to boot. Note the Value Line chart; they don’t even bother having a capital expenditure line, it’s so inconsequential to the business. I’ll chip in and tell you that they spent $878 million on capex in 2010, and generated in fact $4.1 billion in profits. And yes, I did say profits because here I think earnings and profits are just about the same thing at AMEX. And pricing power they have as a matter of right. Ken Chennault doesn’t have to work out which part of the economy goes up the first, or the most, or which price shoots ahead of another. Inflations are inherently lumpy, and if we get a big burst in inflation, AMEX should be a beneficiary of it rather than a victim. By the way, by telling you that we wake up every morning and go to sleep every night fearing inflation, did I just put an economic forecast by you? Well, I don’t think so. Look, when I warn against forecasting, I don’t mean throw away the A section of every newspaper for the next twenty years. If you want to join this school of value investing, you’re allowed to keep up on current events, and even better, you can remember some history. One of the lasting oddities of investing life is that all fiat currencies go down in value through time. The British Pound, the Swiss Franc, and the American dollar are the only three that can be said to have lasted in recognizable form, and they have all gone down precipitously in my lifetime. With that said, each time inflation breaks out, it always comes as a startling surprise. How can something that always happens always surprise at its next iteration? That is a logical absurdity, and the permanent condition of mankind. And surely at these absurd treasury yields, at 3.3% for a ten year bond, surprise, shock and horror await quite a few people if what always happens happens again. Anyway, at 12 times this year’s estimate and with a demographic profile 7 to 8 times better than their Visa and Master Card competitors, AMEX strikes me as safer for the long term.
However, no conversation about AMEX could be said to be candid if I didn’t say something about share buybacks. Somehow Wall Street has been sold a bill of goods that share repurchases always create shareholder value no matter the circumstance, no matter the price. That is malarkey. And while I don’t mind it at 12 times earnings, watching Chennault issue shares to the government at a low price only to buy them back at a much higher price is distressing, and a definite blemish on his record. It would truly be distressing if we all forget so soon that tangible book value is unimportant 98% of the time, but at those other moments, it’s all important. There are also moral issues with share buybacks that never get addressed. After all, if you really do think your stock is really cheap, don’t you owe it to your shareholder partners to tell them why they shouldn’t sell out to you. Sometimes you are treating your shareholders like partners, and sometimes like dupes, and regulation FD doesn’t help matters, but for the moment I leave it at that.
Slide 10 – Google Slide
My last idea also brings me round again to Anatoly Rybakov, who claimed whenever you wanted to hide something from the KGB it was best to leave it face up on the center of your desk. The neighbors would never think to look there. At this odd moment in capitalism, so much value is lying in plain sight, and we think Google is an example. Google makes more money than all the other internet companies Value Line lists in its internet section combined. The internet has been a remarkable destroyer of business models, but not much of a profit generator. Google steps in to that void. Google has $32 billion in cash on hand, which they got the right way. They didn’t borrow it, they have no debt, they didn’t sell something and the cash is the residue, it isn’t lying around from the IPO. This $147 per share is money that they made, and in only 9 years and a bit as a public company. Now I know there’s been some writing in the New York Times that maybe we should give the cash lying around at tech companies some kind of discount, perhaps because it’s not all in dollars and parked in a U.S. bank, or because it hasn’t been all taxed at American rates. But I would like to pose a question to the Timesmen. If you don’t like cash and the rapid accumulation of more if it, what is it you do like about business? This is silly quibbling from the Times, and if you subtract out the $150 in cash per share, and they earn the $31 a share or more I think they will, you just bought yourself a great inflation hedge at effectively 13 times earnings. And look at that record. Buffett and Munger went on and on at last year’s Woodstock about what a moat Google had, and while we’ll note Microsoft’s Bing has made some inroads, it still is hard to compete with these guys. I don’t know what new act in tights Google will come up with next, although last week’s news articles about how Google is looking to nurture old media content providers by stuffing pillows over their heads left me somewhat perplexed. I’m no great seer in this regard, but do you spend your days like me toggling back and forth between the Google page and the Bloomberg machine? This is nothing like insider knowledge, but can you imagine a morning when Larry Page gets out of bed and says, “I wonder if there is anything more in the financial space for us to do?” About two hours later Bloomberg will look like the Quotron machine did twenty years ago. The Bloomberg is some piece of expensive, archaic, annoying architecture, that looks ripe for the taking, and it would move the needle, at least for a year or two, even at mighty Google.
If you think you’ve heard a bit of an echo in this speech, I think so too. At the last Grant’s conference, from this very podium, I heard Vivian Pan of Hamlin Capital extol the return enhancing and risk minimizing virtues of dividend paying stocks. She had great numbers as to how much additional Alpha gets generated. In mid-speech, I was thinking of tackling her, before I remembered Oscar Wilde’s dictum, “The only thing to do with good advice is to pass it on. It is never any use to oneself.” Most of us live just that way. Ms. Pan is working in a very productive vineyard, but my point is maybe it’s the cash generating properties of her dividend payers that is the great attraction. After all, nobody ever paid a dividend with a projection or a promise…. Oh, ok, there are toggling PIK bonds, but nobody smart ever bought one. My point in this is that if you are already in a good vineyard, there is no point in picking every third grape.
My penultimate thought is that in the entire financial calamity that befell us, surely Anna Schwartz had the best line. “Mr. Bernanke knows only two amounts – 0 and trillions.” She wrote that on July 25, 2009. Think about how energetic the always heroic, to himself, Fed chairman has been since then. He has had equally heroic money printing help from his associates worldwide. Indeed, I could hardly believe my ears this morning when I heard Jim Bianco regarding the Bank of Japan. If this wave of liquidity ever came back at us, I like the cash generating prospects of AMEX and McDonald’s, Google and yes, even lowly Tupperware, far better than a ten year Treasury note or even a gold brick.
My last thought is in the nature of a “Cri du Coeur”, actually, at a Grant’s conference. Human beings are incentive based animals, and we have profoundly changed the incentive scheme in capitalism worldwide. When Ford Motor can honor its obligations, General Motors does not, and Lisa Hess can point out in London just last month the powerful advantage fresh start accounting hands the latter, future behaviors are sure to change. When Ally Financial, the old GMAC rump, can broadcast endless commercials billing itself as the friendly bank, the one that will offer you higher interest rates than any competitor, indeed, stopped only by Sheila Baer at the FDIC, because she fears for her own losses to come, that is a different world than the one I grew up in. Almost a year ago we paid $13 a share for Hudson City Savings Bank, the largest U.S. based bank not to take TARP money. We admired Ronald Hermance for everything he had done right through the crisis. We sold it a month later at $12 and it trades today at less than $10 because there is no way of writing good mortgages in this environment, no matter what your intentions. William Cohan wrote in House of Cards that the die was cast at Bear Stearns when the executive committee set up one criterion, and one only, return on equity, to reward themselves, and on a sliding scale, to boot. The numerator was certain to grow larger, with all the risk and leverage they could find, and the denominator would be shaved smaller, through dividends or share buy backs, because that’s how they were incentivized. And this is a worldwide phenomenon today, as any German politician will tell you, unless you forcibly stop her. What I am getting at here is that notwithstanding Dodd-Frank, I have not seen a single step back to the bygone age when if your institution failed, you lost your summerhouse. Charles Munger likes to say that he has studied incentive schemes and their outcomes more than anyone he knows, and every year he comes away convinced he didn’t spend enough time at it. I am held back by the copybook maxims of my youth in understanding this profound change, but make no mistake, I am only looking for understanding. I am a practitioner. I want to benefit from the profound change, or at least not get run over by it. It is up to Jim to thunder at the “wrongness” of it all, as I am sure he so ably will. I have often, only half jokingly, said that Grant’s Interest Rate Observer is the greatest Scottish religious tract ever written.
But younger and more supple minds than mine are not going to stop at my benighted moment now. They are going to get the hang of this before I do, and going to understand the consequences of this profound shift in capitalist incentives. When you do, would you give me a call?