Investors Should Listen to Their Elders

Over the past few weeks stock market participants have had the great fortune that some of this country’s finest investors and commentators have spoken up regarding their views on the global equity markets and economy. Even “retired” investors such as Michael Steinhardt and Julian Robertson have weighed in. This provides a unique opportunity to analyze how some of the most respected and often prescient investors are viewing the ongoing crisis and what they think the future will look like. With Ben Graham having passed away and Warren Buffett (and to a lesser extent Charlie Munger) having to play the role of national cheerleader regardless of what his actual views are, I believe it is incredibly prudent to listen carefully to these elder statesman of investing. Accordingly, I have chosen some written and spoken words from a group of people that, based on experience, should have unique and useful insight on the markets.

1. Julian Robertson (Interviewed in the May Issue of Value Investor Insight)

I ask anyone to give me an example of an economy beefed up by huge amounts of quantitative easing that did not inflate tremendously when or if the economy improved. I think what we’re doing now will either fail, or it will result in unbelievably high inflation – and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening.

In a November 2006 interview in the same magazine, Robertson warned investors that overly indebted consumers would not be able to navigate the impending housing crisis and suggested that the effects on the overall economy could be quite dramatic. Now, a little more than two and a half years later, Robertson is again sounding the alert. This time it is about inflation and the potential for rapidly rising interest rates. In the article he even goes as far to say that the 20% interest rates the US saw in the 1970’s could end up looking low in comparison to what is in store in the near future. What is he doing to protect himself? He is buying Constant Maturity Swap Rate Caps, which basically are similar to puts on long term Treasuries. He is also looking into natural resource stocks and believes that stocks are going to be better than cash.

2. Robert Rodriguez (From his speech at the Morningstar conference entitled “Reflections and Outrage”)

Let me make my viewpoint perfectly clear, my trust has been severely shaken in the Federal Reserve, the Treasury, the Congress and the Executive branch of government in their collective judgment as to what is required and appropriate for a fundamentally sound long-term economic recovery…Governmental programs deployed to stabilize and grow the economy appear highly risky, especially those involving an unprecedented Federal intrusion into the private capital system. They have been implemented in an ad hoc fashion with little predictability and consideration for their long-term effects upon the economy…My financial market outlook is rather cautious. I believe the recent stock market rally is nothing more than a bear market rally…Many economists are forecasting an end to the recession by year end, and I have even seen one anticipating a “V” shaped recovery. If my previous comments about the stimulus plan prove to be correct, these forecasts will be wrong.

Rodriguez’s keynote speech at the Morningstar conference was, in a sense, a parting shot at the market and the fiscal and monetary leaders. He is about to begin a sabbatical that will take him away from his day to day involvement at First Pacific Advisors. However, I don’t think his scathing criticism of the authorities that have managed the crisis and very bearish comments on the market were attempts to go out with a bang. Both his most recent letter to FPA shareholders and this speech detail his legitimate concerns regarding the future growth and prosperity of the US. I think the most startling aspect, however, is his complete lack of faith in the government to help mitigate the effects of the crisis on consumers, homeowners, and the financial markets.

3. Michael Steinhardt (Interviewed on Bloomberg’s “For The Record”)

But, my sense is that we have had a terrific rally, we have had a vast amount of stuff: dollars--injections of all sorts of things into the economy--TARPs and other new programs and the ultimate effect is hard to know entirely at this point. But my sense is that this not will not change the course of what is going to happen very much: that the economy is weak, it will remain weak. Whether we have seen the weakest moment, whether we’re to decline at a lesser rate--that may be true because the rate at which we were declining was so precipitous. But I’m not sure that’s good enough. And my net feeling is that this rally does not have all that much more to go and the dangers out there remain consequential…The dangers in the economy are most everywhere.

Watching this conversation with Steinhardt was the best 25 minutes I have spent in a while. I highly recommend watching the full interview. In addition the above concerns, Steinhardt envisions a lot more pain for the US economy due to continued job losses and reduced consumer spending. He also details how distressed he is about the amount of “ugliness” we have seen on Wall Street. He is very worried that despite the change-focused rhetoric of the Obama administration, there is not enough legitimate desire to accept the short term pain required to fix the economy and Wall Street for the long run.

4. Jeremy Grantham (from his quarterly update entitled “The Last Hurrah and Seven Lean Years”)

Probably the single biggest drag on the economy over the next several years will be the massive write-down in perceived wealth that I described briefly last quarter…This loss of $20-$23 trillion of perceived wealth in the U.S. alone (although it is not a drop in real wealth, which is comprised of a stock of educated workers and modern plants, etc.) is still enough to deliver a life-changing shock for hundreds of millions of people…So we’re used to the idea of a preferred V recovery and the dreaded L-shaped recovery that we associate with Japan. We’re also familiar with a U-shaped recovery, and even a double-dip like 1980 and 1982, the W recovery. Well, what I’m proposing could be known as a VL recovery (or very long), in which the stimulus causes a fairly quick but superficial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic and financial problems are corrected…We have all lost some confidence in the quality of our economic and financial leadership, the efficiency of our institutions, and perhaps even in the effectiveness of capitalism itself, and with plenty of reason.

To some extent Grantham has parted from his very bearish brethren and has actually pegged fair value of the S&P around 880. His view is that the unprecedented stimulus being provided the US government will have an initial positive effect on the economy and the stock market, potentially pushing the S&P into the 1000-1100 range. But he cautions investors that they should not interpret this as a sign of a legitimate and possibly lasting bull market. As indicated above he sees a long road to recovery because people’s confidence in the government, financial institutions, and in the stability of their own balance sheets will take years to come back.

5. Jack Bogle (Interviewed at Morningstar Conference)

This is the worst I have seen in my entire business career. It happens to be the sharpest market decline, the biggest…But much more than that this one seems to have had much more catastrophic, maybe economic consequences. The financials system’s misdeeds falling over into the general economy in a way that did not happen in any major way in 1973-74 or in the beginning of the-when the tech bubble bust-in the beginning of the 21^st century. This is the worst break, measurably, but it has also created the most difficult economy of all of them. So the pain caused by the--I’d say the disgraceful behavior of so many in the financial system--has spread over to vey innocent people. Wall Street taking advantage of Main Street…

(From his Wall Street Journal Op-Ed entitled “A Crisis of Ethic Proportions”)

The malfeasance and misjudgments by our corporate, financial and government leaders, de-dining ethical standards, and the failure of our new agency society reflect a failure of capitalism. Free-market champion and former Federal Reserve chairman Alan Greenspan shares my view. That failure, he said in testimony to Congress last October, "was a flaw in the model that I perceived as the critical functioning structure that defines how the world works." As one journalist observed, "that's a hell of a big thing to find a flaw in."

On numerous occasions during the interview with Morningstar, Bogle suggests that Wall Street’s fleecing of Main Street will have a lasting impact on retail investors and consumers. According to Bogle, aside from just the psychological damage, the lack of fiduciary care exhibited by a select few led to a contagion that has poisoned the entire economy. In fact, the constant theme of the two above pieces and his recent speeches has been that the people who are supposed to protect mom and pop investors--institutional money managers and government regulators--have failed miserably in their duties.

After reviewing this set of admittedly bearish quotes and excerpts, it is important to step back and consider the context. All of these men are by nature very conservative and are unlikely ever to be seen riding a mechanical bull with Jim Cramer on CNBC. Accordingly, the fact that they are concerned about the potential downside is not a surprise. To some extent all of these investors believe in the value investing mantra of protecting against permanent capital impairment and thus are understandably cautious, especially given the recent stock market rally and euphoria over potential “green shoots.”

However, even though (as anyone who reads my columns knows) I am pretty bearish regarding the stock market and the US economy over the near term, this is not why I decided to highlight the insights from these particular investors. While I do suspect that the current run up in the market will turn out to be nothing more than a painful bear market rally, it is not these men’s views on the resilience of the market that concern me. Specifically, I have been struck and honestly disheartened by the complete lack of faith (in just about everything I read) in the government and the Fed to re-establish prosperity without either causing terrible inflation or saddling future generations with a debt that cannot be repaid.

What scares me the most is that the group of investors highlighted above, who have shown throughout their tenured careers to be able to navigate very complex markets, candidly espouse their fears regarding the policy measures being implemented. From what I know of them, none of them is prone to exhibit hyperbole or make outrageous comments for the sake of publicity. That such measured and thoughtful investors have become so disillusioned by the events of the past two years should caution investors to not put too much faith in the potential for a smooth landing in which we basically go back to how things were during the boom. In other words, despite the emerging bullishness, capital protection should continue to be the focus of all investors.

Amazing Michael Steinhardt Video

If you watch or read nothing else over the next few days, I implore you to spend 25 minutes watching this interview with Steinhardt. This is the first time I have seen him speak so extensively and I am incredibly impressed by his candidness and thoughtfulness. Here are some topics he discusses that I think are very relevant to the current investment climate:

1. His perception of the current stock market rally
2. His expectation for sustained and lasting returns in the equity markets
3. What both younger people with excess cash and older people without substantial liquidity should invest in going forward
4. His feelings about the "ugliness" that has plagued Wall Street over the last few years and his concern that we have not really learned any lessons as of yet
5. His fear that despite all the change rhetoric from the Obama administration, people do not appear willing to accept short term but necessary pain so that the entire economic system can function in the future
6. He discussed the role that hedge funds should play in light of the Madoff scandal and recent returns that indicate that very few managers were actually hedged to protect against downside
7. A Jack Bogle-like commentary regarding the lack of fudiciary obligation that he sees among most of today's money managers

(Hat tip to Trader Mark and Guru Focus)

P&C Insurers: A Sector Left Behind By the Rally

In my most recent article I discussed a conservative and proactive way to approach individual stocks even if the recent rally had made you wary of investing at the currently more elevated valuations. Another tactic that I will detail in this piece is to attempt to identify either specific stocks or entire sectors that have not participated meaningfully in this rally and are still trading at reasonable valuations. The most fascinating thing about the run up in the markets since the beginning of March is the extent to which it has been led by the sectors that had been the most beaten down: for example retailers, financials, REITs and early cyclicals. In contrast, even though just about everything is up from the early March levels, companies that people associate with stability such as consumer staples have actually trailed the market.

The S&P 500 hit a devilishly low level of 666 intraday on March 9^th but as of the close on June 2^nd had already increased 41.7% to 944. Talk about a bull market rally within a bear market. However, the overall market appreciation understates the dramatic increases we have seen in the shares of some of the stocks that saw the worst declines in the late 2008-early 2009 period. For example, since March 6^th American Express (AXP) is up over 136%, Macy’s (M) is up 90% and SL Green (SLG) is up over 186%. Accordingly, anyone who was familiar with these companies and had the discipline and fortitude to buy when everyone else was engaged in panicked selling has enjoyed some substantial gains. In contrast to these startling increases, the returns of some of the more staid companies with enduring franchises and dominant market shares have been mediocre. Take Coca Cola (KO) and Proctor and Gamble (PG) for example. Since March 6^th these two stocks are only up 25.2% and 17.1%, respectively, lagging the broader market by a substantial margin. While this is not too surprising since these stocks had not been under anywhere near as much pressure, it is indicative of the type of rally we have seen.

It was within this context that I began to look for sectors or companies that had seen some appreciation over the last 3 months but had not reached valuations that were out of line based on historical multiples and my realistic appraisal of the company fundamentals going forward. What I stumbled on was the not particularly exciting property and casualty insurance/re-insurance sector. This consists of a group of companies that write insurance and re-insurance for mostly property and casualty losses and have some specialty lines as well. Unlike their life insurance brethren, they do not have risky investment portfolios and don’t have exposure to dubious annuity contracts. As a result they by in large have not seen the extreme volatility that companies such as MetLife (MET) have (up 145% since May 6^th but still 54% below the 52 week high). There is no question that P&C insurance companies’ stocks have bounced way off of their 52 week lows, but what struck me is that they continue to trade at multiples that are well below their historical averages.

Below is a chart that details the current tangible book value multiple and recent average multiple for 8 of the companies in the P&C insurance space that I am following:

Ticker	Stock Price	Current P/TBV	2003-2008 AVG. P/TBV
AXS	$25.47	0.86x	1.44x
ACE	$45.43	1.39x	1.95x
AHL	$24.21	0.76x	1.32x
AWH	$38.01	0.97x	1.16x
ENH	$28.95	0.90x	1.30x
MRH	$13.95	0.85x	1.31x
RE	$72.78	0.95x	1.41x
WTM	$213.63	0.74x	1.51x
	Group Average	0.93x	1.42x

* AWH average multiple only covers the years 2006-2008

-Source: Capital IQ and my calculations

As the above table indicates, despite the exuberance we have seen in the markets these companies still appear to be trading at attractive valuations. As a group they are currently trading at 95% of TBV in comparison to an average of 142%.

That is not to say that these companies have not faced significant headwinds over the past year. First off, despite not getting the press that Hurricane Katrina received, Hurricanes Ike and Gustav (apparently the national weather service let the guys who created South Park name the hurricanes) caused a severe amount of damage and led to significant losses for these companies. Furthermore, all of these companies have seen some losses in their usually conservative investment portfolios due to the dislocation in the markets. Insurance companies are often big buyers of the debt of financial institutions, securities that have obviously taken large hits as a result of the solvency concerns regarding many firms. Also, as the ABS and MBS markets got larger and more liquid, the managers of the investment portfolios bought these securities while relying on the ratings of the rating agencies. As a result, as the true value of the underlying collateral for these instruments has become more obvious, these companies have been forced to realize losses. Finally, even with the 41% increase in the S&P since early March, the index is down almost 35% from its peak in 2008. Accordingly, just about any equity portfolio has taken a beating.

However, most importantly, the pricing environment for P&C insurance and re-insurance has been relatively soft over the past year. At a recent meeting with Markel (MKL) CIO Tom Gayner, he indicated to the group of attending analysts that AIG’s continued presence in the market has absolutely distorted market-wide pricing. Specifically, Gayner believes that AIG is writing contracts at prices well below those of competitors and feels that these will eventually turn out to be extremely unprofitable. This practice has served to limit price increases that the other P&C insurers are willing to take and has kept the entire market depressed. As a result, smart companies are turning away business in order to retain pricing discipline. At this rate, according to Gayner, it is going to take a major catastrophe to help firm up pricing in the industry.

All of that being said, I believe all of these headwinds are more than reflected in the stock prices. In fact, a number of these companies had very good first quarters of 2009. Take Aspen Holdings (AHL) as an example. In Q1 2009 AHL earned $1.39 per share versus $.89 in all of 2008 and $1.40 on a trailing 12 month basis. If you annualize that number, the shares are trading at only about 4.4x forward EPS. Furthermore, the combined ratio (ratio of losses and expenses to net premiums earned) for Q1 was 84.5% and the company recognized $69.4M in underwriting profit in Q1. What those two items indicate is that AWL made money on its insurance operations and not just from its investment portfolio, In contrast, Fairfax Financial (FFH), which is run by famous value investor Prem Watsa, has traditionally had combined ratios at or near 100%, a fact that means that most of the company’s earnings have come from the investment portfolio. To me that sounds a little bit like a hedge fund operating with cheap capital and I personally would rather own a company that has a proven track record of profitable underwriting as well.

At the current price AHL sports a solid 2.5% dividend and is trading at 76% of tangible book, 42% below the 5 year average multiple of 1.32x. Also, with debt to equity of less than 9% and $663.6M of net cash on the balance sheet, it does not appear that AHL is going to be at the mercy of the capital markets any time soon. While the company does still have some non-agency MBS losses in the investment portfolio and is always at risk of being exposed to a major catastrophe, I think the valuation remains compelling even after the run the stock has had.

In conclusion, I think it makes sense for investors who are afraid to touch some of the stock that have led the rally to do more research on the P&C insurance/re-insurance space. Obviously these stocks were much more attractively priced in early March but that does not mean that there are not some bargains remaining for investors who have a long term time horizon.

Specifically, here are 10 attributes I would focus on when evaluating these companies:

1. Conservative investment portfolio with minimal ABS and MBS exposure
2. Historical combined ratios below 100% (except in major catastrophe years)
3. Gross premiums written flat to slightly up year on year as an indication of pricing discipline
4. Valuation on a price to book and price to tangible book well below recent historical multiples
5. Consistent dividend policy
6. Preferably strong insider ownership or recent share purchases
7. Consistent gross redundancy when it comes to future loss estimates as a sign of a conservative loss projection policy
8. Low debt to equity ratio and net cash on the balance sheet
9. Company and subsidiary credit ratings of A (from the dreaded S&P and Moody’s) or better
10. Long enough track record in the business so that investors can examine performance in soft markets, hard markets, and catastrophe years

(Picture courtesy of thepropertyinsuranceblog.com)

A Way to Be Proactive Even If You Missed the Rally

Feel as though you haven’t participated in the violent rally in stocks that has occurred since the beginning of March? I know I sure haven’t. My conservative stance on the equity markets has looked absolutely foolish with the benefit of hindsight. Oh well, better to learn these lessons now than when there is more than just my own capital at stake. After the recent run-up it would be easy to become paralyzed. As a value investor I like stocks less and less as they go up. I now feel like the guy waiting to buy the big screen TV because he thinks the price will be lower in six months. In addition, to some extent the appreciation in US stocks seems to have decoupled from what is going on in the underlying economy. While there have been plenty of perceived green shoots and news that is just less bad than expected, there still are a number structural weaknesses that stem from continuing unemployment, falling house prices, consumer de-leveraging and declining company profit margin. Given the combination of less attractive valuations and concerns about the future, it would be easy to throw your hands up and try to wait (im)patiently on the sidelines. However, I have a suggestion for investors who are looking to be more proactive.

The first thing an investor can do is identify companies that he or she feels have sustainable business models, credit-worthy management teams, and little dependence on the capital markets but are not trading with a suitable margin of safety at the current levels. John Templeton famously employed the strategy of researching companies that he felt fit his criteria for a quality business, establishing a price that he would buy such a company at, and placing open-ended orders for the stock at that value. This served a few desirable purposes.

First, it is often most difficult to buy when a stock or the market is continually falling. Therefore, having a pre-placed order means the decision has already been made to buy at a certain price, regardless of the pessimism in the market. As long as the long term fundamentals for the company have not deteriorated meaningfully, this strategy takes a lot of the emotion out of investing. This kind of buying discipline can really lead to outsized returns because it entails being greedy when others are by definition acting based on fear. Also, instead of deciding to forgo researching a company that you would like to own, this strategy allows you to evaluate companies without the current stock price in mind and likely diminishes any potential anchoring bias (for example a fixation on the 52 week low/high or current stock price).

This type of investing is something that I have recently begun to dabble in as well. Along with searching for unloved net-nets, I have been updating my prior research on stocks I really liked to reflect the multitude of changes that have occurred in the global markets over the past year. If you look at any of the equity research on my blog, you will see that I establish prices for which I would be willing to accumulate shares. As opposed to stopping my research half way through when I determined that the stock was not an immediate buy, I completed the research. Then, I established an intrinsic value and came up with a price that I would be willing to pay that included a margin of safety that would allow me to sleep at night, given my company specific concerns. Now, this may be a strategy that is far too conservative for some investors. It also could be seen as a waste of time, especially when you consider the amount by which the stock would have to fall to reach my price target. However, by doing a thorough analysis of these companies I have become very familiar with fundamentals of the specific sectors and know enough about the competitors that I would be comfortable investing in them with only a little more research in the event those stocks pulled back substantially.

Let me briefly go through an example of how this process works. Just yesterday I finished updating my research of Cerdayne (CRDN), a company whose main business is supplying ceramic body armor to the US military. Shares of CRDN fell dramatically throughout the early part of this year as a result of the general malaise in the market combined with concerns regarding the timing of armor orders and diminished troop levels in Iraq and Afghanistan. Despite having a very tough Q1 2009 in which many of my concerns were realized, the stock has run up from $14 when I first began looking at it to over $22 now. However, from my perspective there has been no change to my fundamental thesis for why I believed the stock did not offer a significant enough margin of safety in early March. At that time I suggested a price around $10.50 would compel me to begin accumulating shares because at that price I felt that the company’s strong balance sheet provided sufficient downside protection.

Due to the continued uncertainty regarding armor orders and a tough operating environment for the rest of CRDN’s businesses, I still believe that my previous entry point is justified. While the shares would have to fall more than 50% to get back to that level, with as volatile as this market has been anything is possible. In the worst case scenario the stock never gets there and my order never gets filled. The best case scenario is that I own a debt-free company with some real growth potential at a very attractive price. From my point of view it is a win-win scenario; kind of like a lottery ticket I don’t have to pay for. Hey, you never know.

(Picture courtesy of Robin Mills at Elfwood.com)

Updated Research on Ceradyne (CRDN)

Here is my updated research on body armor supplier Ceradyne (CRDN). This is a long piece that is similar to a sell-side initiation. I discuss the market for body armor as well as the markets for CRDN's other products. I also compare CRDN in terms of margins and valuation to other specialty military suppliers such as AeroVironment (AVAV) and Force Protection (FRPT). For anyone interested in a thorough and comprehensive review of a company I did a lot of digging regarding CRDN.

I started to look at the company when the stock was around $14 because it was on the verge of becoming a net-net. It has run up a lot (along with everything else) since then and is certainly nowhere near as compelling. Due to the uncertainty regarding the timing of orders for the company's new XSAPI body armor from the US military and the dependence on elevated troop levels around the world, it is hard for me to justify buying this stock without a much larger margin of safety. Specifically, I would be much more bullish on the stock if it pulled back to around $10, an event that sure does not seem likely in the near term.

Ceradyne Updated 5-29-09

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Bernanke Parody Video

From the Columbia group who created the "Regulators" video about Warren Buffett, here is an equally entertaining one about Ben Bernanke using Boyz II Men's "On Bended Knee" for inspiration.