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  • What are your return expectations?
    "Returns are not inherent to an asset class; they result from the fundamentals of the underlying business and [emphasis in the original] the price paid by investors for the related securities"

    Seth A. Klarman - from the Preface to the Sixth Edition of Graham and Dodd's Security Analysis

    I too often read statements like “stocks return an average annual return of 8%-10% over time”. Does that mean the long-term returns I should expect from equities are the same today as they were in 2009 when prices were 50% lower? If you believe that long-term fundamentals ultimately determine value, then it logically follows that returns are a function of the price paid – or else you’d be arguing that future fundamentals are somehow a function of the price you paid (side note to nit-pickers: in a very narrow set of circumstances George Soros essentially makes just such a counter-intuitive argument with his theory of “reflexivity”, but this is really centered around the dynamics of asset bubbles.)

    Klarman's quote also points to one of the biggest problems faced by individuals working at institutional investment management firms – they specialize by asset class, and usually even more narrowly in subsets of a given field. It’s not that these individuals don’t understand valuations… but let’s say you are currently a 33 year old technology stock analyst making $400,000 per year living in an expensive house, with two young kids about to enter private school and a wife who stopped working when the kids were born. Have you read a lot of stories about guys like this quitting in droves because their asset class is overheated and they expect disappointing returns over the next five years?

    Keep this type of context in mind any time you hear people talking more about relative valuations than business fundamentals. Of course, specialized knowledge of an asset class could help in an attractive valuation environment. But, if the market has bid prices across an asset class up to stupid levels, being smart on that field isn’t going to help much if you don't have the good sense to just avoid being long.

    Think about all of the technology and biotech research analysts on Wall Street: often degreed engineers or doctors, these very high IQ individuals write exhaustive reports about the minute technical details of routers, software, new drugs, etc.  They painstakingly pull the outputs of their analyses through market sizing models and competitive matrices to make detailed calculations of projected future performance.  Then price targets are derived by applying simple market valuation multiples or DCF analyses, which built with inputs from other overvalued securities.  Whatever errors are committed in the forecasting process are compounded (yes, in a technical sense) immensely when the punchline reads something like "we think this should trade in line with other cloud computing peers, currently at 40x estimated 2012 earnings" or, even better, "at 30x 2012 earnings, XYZ represents a compelling value at a 25% discount to its peer group average of 40x".  

    It's not really "garbage in, garbage out", it's more like making a prime, dry-aged filet mignon into cat food. 

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Feb 04 10:11 AM | Link | Comment!
  • Book review: 'Confidence Game' by Christine S. Richard

    There is no lack of reading material on the credit crisis. So many books, magazines, and newspaper articles have been written that it's already become a bit tired as a subject.  Much of writing was intended to cash in on the immediate popular demand, with authors and editors trying to synthesize and simplify the material down to the level of "mom and pop" investors.

    In addition, the scope of the crisis was (and, in my opinion, still is) so vast that it defies the ability of a single work to capture the full landscape of what happened. A fraud like Enron was well suited to a narrative of the people and events, such as Bethany McLean's 'The Smartest Guys in the Room'. Even events as large as the downfall of Drexel (and the end of an era) could be captured pretty comprehensively, as in James Stewart's classic 'Den of Thieves'.

    The 2007 vintage credit crisis can’t be packaged so neatly.  There are legitimate story lines (subject to much debate) that go back all the way back to topics like the U.S. abandoning the gold standard, the role of the fed policy starting ~Y2K, the politics of OFHEO and the GSE’s, and on and on.  I've read many excellent books on the crisis that are really broad macroeconomic treatises on central banking and fiat currencies.  Books such as 'Too Big to Fail' and 'The Big Short' (among others) attempt to capture the broad picture via a depiction of the major milestones of the crisis as experienced and influenced by some narrow slice of those involved.

    Thankfully, 'Confidence Game' by Christine S. Richard (Bloomberg, 2010) doesn't attempt to be another unneeded retelling of the excesses and errors that have been discussed ad nauseum elsewhere. Instead, the author focuses solely on the debate between Bill Ackman's Pershing Square hedge fund and the financial guarantor MBIA, adding a unique level of information and understanding due to her long-running coverage of the situation.

    The result is excellent.  The book is a well-written, fast-paced account which gives the reader the crux of the analysis performed by Pershing while staying focused on the story as it unfolded between regulators, management, the rating agencies, reporters and internally at Ackman's firm.  

    Yes, people have discussed the problems of the rating agencies and monolines extensively, but this book is not a regurgitation of what you’ve read elsewhere.  The book actually makes an original contribution of material that will be new to most readers (what do you know about MBIA’s dealings with Oklahoma jails or Pittsburgh crack houses?).  The author also had extensive access to Pershing’s personnel and internal files to document the story.  While the author weaves the unfolding story into the events concerning Bear Stearns, AIG, etc., she does this only to anchor it in the broader timeline of the crisis and doesn’t veer off on tangents to opine on outside issues.

    There is an underlying "one man against the world" theme similar to David Einhorn's 'Fooling Some of the People All of the Time'.  But the book doesn’t attempt to provide any detailed financial statement analysis or evidence to prove Ackman's point.  Indeed, for someone who even enters the story in the first-person along the way due to her news articles, I think the author does a great job remaining objective with relation to her subject matter.  Unlike many of the books on the credit crisis, she shows ample restraint in neither canonizing nor demonizing the various actors.

    If there is a flaw with the book, it’s that it might not be appropriate for every lay-reader.  I actually find this to be a positive, as you don’t have to plow through a “CDOs-for-dummies” chapter, or really any other superfluous material.  The result is a work that reads as quickly and clearly as a book-length feature article on Bloomberg News.  Don’t construe this as meaning that the book is overly technical or is too heavy with structured finance jargon; it’s really not.  But readers should at least be familiar with the basic concepts of CDO, CDS and the business of the AAA-guarantee companies to get the most out of this book.

    The book also raises a lot of questions about topics like moral hazard and morale hazard (those are two different things), as well as management integrity, regulation and market structure.  Here again, the author admirably refrains from providing opinion or ideas to fix the system, and stays true to her task of reporting the facts of a specific story.

    The most important contribution of this book might be to preserve a tale from the credit crisis that has been lost in the deluge of headlines.  If you talk about the credit crisis today, it brings up thoughts like Lehman, AIG, Bear Stearns, Fannie, and Freddie. The Ackman/MBIA fight is not top-of-mind, even among finance types.  It’s a story that never really made its way to the broader public and by the time it should have, it was overwhelmed by the cascading failures of the firms mentioned above.  

    Don’t pick up this book if you’re looking for a broad-based understanding of what caused the crisis and what needs to be changed to prevent the next one.  However, if you have a basic understanding of the problems that ballooned in the CDO market, this highly entertaining book is an original contribution to the genre and the best account to date of the role the monolines played in a multi-faceted market distortion.  

    Disclosure: No positions
    Jul 23 12:04 PM | Link | Comment!
  • Taking profits on FreightCar America (RAIL)
    I've been long the stock from around 20 as disclosed in my initial post from January 24, 2010 (full article here). My calculation of intrinsic value over the course of the cycle was approximately 30, using inputs for unit volumes and margins that I felt were reasonable and provided some margin of safety. At 20 there was a 50% margin of safety, but I think that gap has now been narrowed to the point of exit for the value investor. At current prices, the margin of safety is only 10%-15% by my analysis. Even if you are more bullish on future order volumes, I think the air is getting pretty thin up here.

    Per my most recent update (see here), I recommended an exit in the 27-28 range, and I personally place a sell limit at 27 (I think my shares were literally the first traded today as the stock opened at 27 and quickly traded up to 28 after an hour).

    The company's end-markets seemed to have turned the corner, and the stock has been on a tear lately. There should be many quarters of positive earnings momentum ahead and extremely easy comparisons to past periods, but for a value investor I think the easy money has already been had.  

    Disclosure: No position - author was long RAIL and has now sold
    Tags: RAIL, Exit
    Apr 12 12:29 PM | Link | Comment!
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