by Amit Kumar
TED Spread
A sharp increase in LIBOR (London Interbank Offered Rate), a benchmark short-term interest rate, reflects high credit risk in the banking system. Investors tend to flock to Treasury securities amid fears of a banking crisis and push down the Treasury yields, further widening the TED spread (figure 5.3).
VIX
VIX is a measure of implied volatility of 30-day options on the S&P 500. VIX tends to trade between 10 and 20 during periods of complacence and shoots up during market worries. VIX hit an all-time high of ~90 in October 2008, after the Lehman Brothers collapse (figure 5.4).
Spanish Sovereign CDS Versus S&P 500
Figure 5.5 shows the correlation between the change in Spanish sovereign CDS and S&P during the Euro zone crisis in 2011 and 2012.
FIGURE 5.3 TED Spread vs. S&P 500, 2011 U.S. AAA downgrade. Source: Federal Reserve, S&P Dow Jones Indices.
FIGURE 5.4 VIX vs. S&P 500. Source: Bloomberg, S&P Dow Jones Indices.
FIGURE 5.5 Negative correlation between Spanish sovereign CDS and S&P 500. Source: Bloomberg, S&P Dow Jones Indices.
Money Flows
Net monthly outflows of more than $2 billion can have a significant negative impact on the Indian stock market index.
Recap
• Comparison with the magnitude of past peak-to-trough corrections in the market can help to make sense of an ongoing crisis.
• Market behavior during a deepening crisis tends to rhyme. Look at history to understand if the crisis can balloon into a black swan event.
• Do not fight the Fed; they always have room to lend. Central banks can pump liquidity into the market for long periods of time.
• Predicting economic downturns to find short ideas is hard, but signs of tightening credit cycles can help to identify short ideas that are heavily dependent on credit markets.
• Economic data releases and market fear indicators can provide tactical trading ideas that are beyond the scope of this book.
Part II
How Successful Investors and Analysts Think
6
Value Investing
Plus ça change, plus c’est la même chose.
—JEAN-BAPTISTE ALPHONSE KARR
IN HIS INVESTMENT CLASSIC, The Intelligent Investor, Ben Graham made a clear distinction between investment and speculation: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”1 When Ben Graham published this book in 1949, he had spent twenty-six years as a portfolio manager in his investment partnership and thirty-five years on Wall Street. He had seen it all about investing during these years, and there are no concepts on investing that escape his breadth of knowledge and experience. Investing is not any different today, even though Graham’s book has reached the retirement age of 65.
Ben Graham: The Father of Value Investing
Ben Graham marked his foray into securities analysis with his bearish take on Missouri Pacific Railroad bonds in 1914. He was successful in the ensuing fifteen years on Wall Street with almost any investment concepts touted by modern-day investors, such as his merger arbitrage analysis of Guggenheim Exploration, hedging operations with the purchase of convertible bonds and simultaneous short sale of common stocks, participation in various Savold Tire initial public offerings, the active short sale of overvalued stocks, and shareholder activism with Northern Pipe Line. He did have an early tryst with failure in 1917 as he suffered losses in the stocks that he bought on margin—losses he had to repay over the next two years.
Graham’s generosity in sharing his rich investing experience and his decision to embark on a teaching career at Columbia University in 1928 became a boon for the later-generation investors. It was the beginning of a new learning experience for Ben himself as America fell into the Great Depression and his portfolio lost nearly 70 percent. His losses stemmed in 1932 as he drew on lessons from the crash to adjust his portfolio and wrote a series of articles for Forbes titled, “Is American Business Worth More Dead than Alive?” He also began working with David Dodd on the investment textbook he had conceived six years earlier, which would become an investment classic: Security Analysis.
Ben Graham on Value Investing and Short Selling
Ben Graham’s emphasis on proper mental and emotional attitudes toward investment decisions and knowing the difference between the market price and the underlying value of securities are the underpinnings of his value investing principles. He espoused the idea of investing in public utility companies at their net-asset value and reading the warning signs on growth companies, which are in line with his businesslike approach to investing.
Graham regularly shorted overvalued stocks, although mostly in the realm of an arbitrage or a hedging operation. He was not shy to cut his losses in his rare naked short positions, as in the case of Shattuck Corporation, a restaurant chain. In 1929, Ben Graham held $2.5 million of short positions as a hedge to his $4.5 million long positions; his shorts served him well as he closed them for a record profit after the market crash.
Graham made a clear distinction between value investing and short selling, as he pointed out in The Intelligent Investor. He also warned that analysts and investors must be wary to sell good companies short:
Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience. And selling short a too popular and therefore overvalued issue is apt to be a test not only of one’s courage and stamina but also of the depth of one’s pocketbook.
Short selling did not fit Graham’s definition of investments but rather qualified as mostly a speculative or trading operation. Ben Graham minced no words in suggesting that it was reckless for an average public investor to engage in short selling. Short selling exposes the investor to the vagaries and fluctuations of the stock market and is at odds with value investing, which seeks to insulate the investor. Value investors would sell stocks to raise the cash levels of their portfolios to express their bearish opinions.
Ben Graham’s genius was not limited to stocks. His breadth of knowledge extended to English, philosophy, drama, and mathematics, among many other subjects. Irvin Kahn, one of his early disciples, provided a great biographical account of Ben Graham in a 1977 paper written with Robert Milne.
The purpose of this chapter is not to reinvent the wheel of value investing but to highlight the time-tested nuggets of value investing wisdom from Ben Graham and the superinvestors of Graham and Doddsville led by Warren Buffett—a legendary investor and protégé of Ben Graham. Intelligent Investor emphasized three important value investing concepts, among many others.
Mr. Market, Price Versus Value, and Margin of Safety
Ben Graham’s dissemination of these three concepts are at the core of value investing espoused by him. Stock portfolio fluctuations are almost a guarantee for any investor, and the only two possible ways for the investor to benefit from these fluctuations are the way of timing and the way of pricing. Graham pointed out the behavioral issue with the way of timing is that the speculator usually wants to make his profit in a hurry. In contrast, a serious investor does not expect to benefit from day-to-day fluctuations.
Mr. Market, the fabled character, changes his mind every day on the price of stocks; he is also subject to wild mood swings that can result in large fluctuations. Graham distilled his years of experience into this parable to point out that an intelligent investor’s strength lies in his independent judgment to buy wisely when prices fall sharply and to sell wisely when they run up. The way of pricing puts the investor in the shoes of a business owner, putting the focus on the intrinsic value of the business; timing is not important unless it allows the investor to buy stocks below intrinsic value.
The investor can determine a sound purchase price at a discount to intrinsic value by applying the concept of margin of safety based on the stock’s earning power or value of asset. Here, Graham made the imp
ortant observation that investors lose money mostly from purchasing poor-quality businesses during favorable business cycles as opposed to purchasing high-quality stocks at high prices. Warren Buffett and his longtime business partner, Charlie Munger, have further expounded the idea of high-quality businesses in their numerous letters and interviews; in their view, businesses with a moat around them pose significant barriers to entry, such as brand strength, customer captivity, regulatory protection, and inimitable products.
An investor’s ability to generate superior returns lies not only in behavioral strengths but also in the ability to understand business models and estimate the intrinsic values of businesses. Buffett and Munger tend to stick to their circle of competence. They have repeatedly advised investors to build and expand own their circle of competence in companies and industries that they find easy to understand.2
Value Investing Versus Short Selling
While the way of pricing constitutes the fabric of value investing and the way of timing is merely a supplementary consideration, the way of timing takes precedence for a short seller due to the short duration and complications arising from stock loans in short trades. Short selling is a speculative operation because it has an asymmetric risk profile, with its success depending on the prediction of stock moves, benevolence of stock lenders, and moods of the market. As Charlie Munger quipped in an interview with CNBC anchor Becky Quick on short selling, “We don’t like trading agony for money.”
Buffett explained Charlie’s rationale:
The reason he said that is because a stock, when you short it, can theoretically go to infinity. When you buy a stock at 10, you can only lose 10 points. When you short a stock at 10, it can go to 100 or 200. And occasionally you’ll get into a situation on a short where you may know eventually it’s going to turn out to be worth nothing, or very close to it, or it’s a fraud, but what it can do in between can be very, very unpleasant. We like to sleep well, and you can’t sleep well if you’re short a lot of stocks.
These legendary investors have repeatedly warned about the fallacies of short selling.
Seth Klarman also pointed out two key practical constraints on short selling in his out-of-print classic, Margin of Safety: restrictive short-sale rules that can cause stocks to remain overvalued, and the limited number of short sellers because most institutional investors are prohibited from short selling. Klarman echoed Buffett and Munger’s concerns with short selling: “A conservative investor may not feel comfortable with a professional short-seller no matter how favorable the results.”
What Motivates Hedge Funds to Engage in This Inherently Risky Practice?
The meat of the incentive structures of hedge funds is in profit sharing and their goal to deliver absolute returns regardless of the market conditions. Now, delivering absolute returns in a bear market is impossible without a short-selling product for hedge funds. How else can they “hedge” the downside risk in a bear market, after all? Their clients are willing to share part of their profit in return for the hope of an absolute return.
As we can see in table 6.1, hedge funds will earn twice as much as long-only funds, even if both of them generate an average return of 10 percent per year for 5 years (not compounded). Now, if these 5 years turn out to be the best bull market and the returns go up from 10 to 15 percent, hedge funds will earn 3.5 times as much as their long-only peers. Conversely, if these 5 years are a mixed bag of bull and bear markets and the returns end up negative, hedge funds will still earn at least as much as their long-only peers.
Table 6.1
Management fees for similar-sized hedge funds and long-only funds
If Value Investors Are Reluctant to Short Sell, How Do They Hedge Risks?
Seth Klarman stands tall among modern-day value investors, and he is intensely focused on risk. His approach to hedging portfolio risks is not at odds with the intelligent investor approach because he eliminates the asymmetric risk profile and short duration nature of short trades. Simply put, his approach is akin to buying insurance for 5 years, where the payoff can be many times greater than the premiums in the event of an expected or unexpected crisis. Klarman’s small portfolio allocations in long-term insurance instruments, such as long-term equity anticipation securities and credit default swaps, have more than compensated for any portfolio losses during black swan events.
An Interview with a Value Investor
Jean-Marie Eveillard is a reputed value investor who employed a diversified approach to portfolio management while he ran First Eagle Global Fund from 1979 to 2004. He took a two-pronged approach to hedging systemic risks—raising the cash allocation in the portfolio when there were no compelling opportunities and buying gold as a form of portfolio insurance against market panics. The fund returned approximately 16 percent on an annual basis (or cumulative 44× returns over those twenty-five years).
I first met Jean-Marie at Columbia Business School, where he was a regular guest on investment panels and value investing classes. I was later formally introduced to him by one of his protégés at First Eagle.
Morningstar, Inc. presented its first Fund Manager Lifetime Achievement Award to Jean-Marie in 2003. In 2007, Fortune magazine named him one of Wall Street’s best value investors. First Eagle Global Fund had approximately 16 percent average annual returns during his twenty-six years at the helm. During these years, he stayed true to the value investing philosophy and a diversified investing style. Here, I interview Jean-Marie on his methods as a value investor.
Q: Let us begin with your early years at Société Générale. How did you convince them to venture into value investing?
I did not convince them. Gee, I wasted the first fifteen years of my professional life. It was not until 1968 that I was first exposed to Graham and the idea of value investing. In [the] summer of ‘1968, I met two Frenchmen at Columbia University and we used to cycle in central park. They told me about Ben Graham and about his classic, The Intelligent Investor. I was more interested in The Intelligent Investor than in Ben Graham’s other book on security analysis.
So, I did not find an investment style during my first five years and then the French bank did not let me venture into value investing in the ensuing ten years. Their own style was to trade in and out of the big stocks in the index; basically, they were closet index huggers. In late 1978, I came back to New York and heard Lee Cooperman talk about Warren Buffet very positively. I had to order physical copies of Berkshire’s annual reports for the last ten years because, remember, this was not the Internet era. I discovered Warren Buffett and how he made successful adjustments to the teaching of Ben Graham. As luck would have it, the bank sent me back to New York to run SoGen International Fund, a $15 million fund that was subcontracted to Smith Barney. I had full discretion over the fund and I worked alone—without even a salesman—for seven years until 1986.
In 1970, Société Générale did not want to do an offshore fund because there had been a big offshore scandal in [the 1960s] involving Bernie Cornfeld’s Investors Overseas Services. Now, if you only had a SEC [Security and Exchange Commission] registered fund, you could sell the fund in the United States but not in France. Société Générale had strong distribution in France but it could not sell my fund in France, and consequently, my fund did not grow from 1970 to 1978. Meanwhile, SEC called me to Washington in 1986 because they wanted to close my fund down due to a mistake in our Net Asset Value (NAV). We had subcontracted our accounting work but SEC wanted to hold us accountable for a five-cent discrepancy over the accounting treatment of accrued interests on some of the bonds we had sold. Ultimately, we got away with just a SEC warning.
There is a story about Napoleon: his entourage surrounds him when one of his aides says that a certain general is lazy. Napoleon retorted that the general had done well in the last battle, to which the aide replied that the general just got lucky. Napoleon said, “Did you say lucky? I want lucky generals.” So, I too was lucky.
Q: Could you contrast Buffett’s appr
oach to that of Graham?
Warren Buffett’s approach to value investing is more time consuming than Graham’s approach. As you have mentioned in this chapter, Ben Graham often talked about high-quality businesses, but he is known more for his deep value investing style. Buffett introduced more of the qualitative elements of value investing analysis.
The [19]70s were difficult for the stock market and it did not become easy to find Ben Graham–type stocks until the early [19]80s (i.e., deep value stocks). In [the] late [19]90s, I suffered because I refused to participate in the telecom boom stocks where there was absolutely no value. As a result, I lagged from 1997 to 1999 and our fund assets went down from 6 billion to nearly 2 billion, even though we were still making money.
Q: Why did the investors start pulling money?
When you lag on the market for six to twelve months, the investors begin to leave, and then they completely desert you if you continue to lag on the market for more than two years. Conversely, the investors do not start believing in your performance until you have a good run for one year. When I reflect back on this period, I find it painful because the board of directors turned against me and they decided in Paris to sell the investment advisory firm. They still did not fire me, however. John Arnold was either lucky or smart to acquire us at a really cheap price at that time. Eventually, the technology bubble burst in March of 2000. Inflows in my funds started after a hiatus of one year.