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Digging For Value

I spent the weekend looking at my long positions to see if I wanted to own them without a protective put or any type of hedged exposure, thinking that I am a bit overly bearish at the moment missing around 30-40% of September's rise in my stock positions, net of some of my less liquid holdings like farmland (Ie September is a flat month for me after a strong gain in August) - However I will wait for the market to either move past 1150 convincingly and stay there for a long time or for the RSI to come down a bit before committing to the long side in a more meaningful way... My gut tells me October will not be pretty, and usually my gut is right more than my valuation analysis is right in the short term. 

Valuations are actually decent here on a forward basis but the CAPE and Tobin's Q suggest otherwise, making any real progress to value the overall market difficult at best. Maybe American companies don't need the same asset base to perform that they did in the fifties and sixties. Maybe blue chip companies can operate with twice the amount of debt they had in 1960 with little added risk, but to me the old school fundamental analysis ratios like price to book and price to sales are still important.

Earnings are good right now but all of this is rear view mirror analysis on many levels and does not address the risks that the same type of insanity will not repeat itself in the financial markets that occurred in 2008. Remember, most of the analysts got it wrong in 2008. We are getting awfully close to the recent mania highs of 2007 in terms of price levels in stocks, yet the joblessness and structural issues persist -- and yes the jobs and bank failures are lagging indicators.

The two credit unions that were seized Friday are costing the taxpayers a potential 30 billion in backstop guarantees -- okay, another drop in the bucket supposedly. What really worries me is that we have said that we are facing a potential second great depression and have enacted measures that have been similar to those of the Keynesians in the depression. We have used the fall in real estate and stocks to justify an enormous spending, bailout, and backstop program to "increase prices" in the economy. One most wonder, however, if this was a short term fix to a long term problem. Its a lot easier to focus on the risks than the upside at the moment -- Maybe this means stocks have a wall of worry to climb from here.

From 1929-1932 stocks lost 89% of their value, but today we are down a measly 25% from the recent 2007 highs... I know many people look at the Nasdaq in 2000 as the high so maybe there is some justification to believe that things are comparable to the 1930's today and this is why we need so much government involvement in markets. To me, the Nasdaq was really a corrupt ponzi scam so valuing that bubble in terms or real price declines and upswings is not relevant -- No government on earth should be bailing out tulip bubble mania participants. Was the persistent overvaluation in stocks over the past fifteen years really just a long drawn out bubble? I think so...
After spending ten years of my life trying to find "cheap" stocks when markets were at 20X earnings, I can tell you that it's a waste of time... There were very few cheap stocks on an absolute basis and you had to be a genius to find them. I did find thousands of cheap names in 2008 and early 2009, but today the stocks that tempt me are cheap on earnings and cash flows like JNJ, PG, and PM are highly leveraged with very little cushion from a net book value perspective... Has the LBO era made companies more disciplined and therefore much less in need of assets today than in the past? Maybe, but I do not view this as a positive for the value investor as a whole to have to buy great brands with negative tangilble book values. Berkshire Hathaway is the lone book value champion of the megacap stocks I follow, so I must trust that if Buffett is finding value in names like Bud and PG that cash flows from operations and strong business moats are more important than margin of safety from an asset perspective.

The QE2 types of financial maneuvers in Washington make for a difficult read on stocks. Are things as bad as they were in the thirties in which case PE ratios should not be in the 20 CAPE range? Or, is there some "new" bull case that I am not grasping? I am no expert on Politics or Econometrics myself, but as an investor I am ever more certain that I must learn more about these issues if I am to be correctly positioned over the next few years. The notion that companies are sitting on mountains of cash suggests that there is not a corresponding liability on their balance sheets... I find this a bit disturbing considering the Debt to Equity of the S&P has doubled since 1960.

I am a long term bull, but I feel the current environment just feels a bit awkward or risky at a 3X price to book value and 20X historical earnings. Even averaging the past five years of earnings gets us to the same 20X multiple. I cannot say if this is a sign of lasting economic expansion in which implied growth rates make the forward earnings estimates the right number to follow or not, only that such a strategy was greatly punished in 2008.

Maybe this is how the start of long bull advances always feel, but we have been sitting at a level that's just 25% below the all time high in many markets and I think psychologically that is very significant. In my mind PE ratios for the overall markets are tough to read and its best to stick to valuing individual businesses... Hedging the macro risk is secondary for me, although very important to protect capital.

Conoco seems fairly inexpensive at 5X depreciation plus net income. They still have ample reserves and hopefully for shareholders they will add to this in the future. I am thinking of getting back into BG and RJA even though they have had incredible runs of late. BG I would be a seller of the $55 March 11 put options, for example...That way if it gets to be cheap enough I can buy a full position. I have been using put sales effectively in ARII this year but lost ground with RIG using this strategy... The key is to stay diversified in the markets -- I have lightened up on my Silver, but still managed to do quite well in the metal and hold a 2% position in SLV. DBA still makes up an 8% notional allocation through leap calls. At times I get burned from hedging when my longs were underperforming the market. It is very hard to stay unhedged with the negative headlines and debt situation going on and I have been a raging bull for the past 17 or so months of the bull market. As a value guy I simply hate chasing momentum. I love buying crashes... So, inevitably I am at an impasse from a valuation perspective these days and have become somewhat irritable lately due to this valuation "soup" kind of equity market. 

Still, part of me worries that while things are somewhat better today then they were in October of 2007, on many levels such as per capita GDP, Debt to GDP, Fed balance sheet, state government balance sheets, etc... we are much worse off which would not justify peak stock market prices.

Buffett recently mentioned that we are still in a period of deep recession after earlier stating that we would not return to a double dip recession. It takes courage to admit when you are wrong -- and even more courage to admit when you're wrong even though you are right in the long term. It was good to see Buffett mention per capita GDP because I think the rich people and the investment class have made out relatively unscathed. When the recession first started, however, it was as if the investment class was the only segment to be punished... Today I think the opposite is true -- the poor are still in the depression and the rich are only 25% away from the peak... QQQQ investors are even closer to being even... So where is this "great depression" in financial markets? Clearly, there is no easy way to mitigate risk in the currently.

Buffett never hedged a day in his life but would hold cash when he could find nothing cheap enough to buy. Graham was a little different in that regard. I think Graham may have used the technique of shorting stocks against his longs before the crash and not after the crash of 1929. Graham did accept that some hedging techniques were not the same as speculation, but I do believe his main investment thesis was that stocks would outperform bonds over time, and that buying a basket of undervalued cigar butts would outperform stocks on the whole. What would he do today in an environment with about four or five cigar butt stocks, many of which have been cigar butt stocks for years (Tandy and Audiovoxx are both holdings of mine, thank you very much Mr. Market) 

Today it is hard to commit to such a simple investment program. Losing 57% peak to trough is a difficult experience but not being involved in the fast and furious rebound is proving to be an even greater pressure on most investment advisors. Managers are increasingly forced to remain fully invested due to benchmarking of performance. It is one thing to lose money if the market loses more than you in this industry, and a totally different thing to miss a giant move higher in the stock market. If you lag on the way up in money management you get fired -- the same holds true on the way down... This is why many in the investment world have it very easy -- the goal is not making money for your clients at the plain vanillas and index and closet index shops, but beating a particulat benchmark. Beating the benchmark is what makes the fund manager money whether the market is up or down. This approach has merits of course in that the market has risen steadily for hundreds of years. However, the same "long only" or "permabull" strategy does not hold true for many other nations such as post 1700 England or post 1985 Japan, etc...Look, I am one of the most die hard, formerly gun toting Americans around, but even I have to wonder if China or India with all of their resources and human capital are not better situated than America is going forward. Are we post 1950 USA all over again with some deleveraging going on or are we post 1700 England in which case our stock markets will not rise for another hundred or so years!

I think the FED is counting on the tendency for investors to chase a rising market for the current low volume rally to continue, as I feel they want the market to move substantially higher from here creating a wealth effect and adding to hiring as well as to the money supply. Personally I feel this approach is going to enrich the rich people at the expense of the poor people and that because this approach is not moral it's also not the right way to do things. The Feds have repeatedly commented that they will use whatever necessary to fight "deflation" which I believe relates to stock prices in their minds as well as real estate and consumer goods. Food and Energy price increases obviously don't count. They  are volatile, but lately only on the upswing. One thing I am watching is the price of grains versus the S&P. I do not believe a substantial or substantive rally can persist as long as the price of grains rise faster than the price of stocks -- eventually this will turn into a massive consumer spending issue.

As I read somewhere earlier today, the Oil and commodities boom of 2007- early 2008 did not cause the crises in financial markets but it certainly added to it -- That's why my Grains-Stock ratio is telling me to be a bit worried lately. I suppose Technology is better suited for this new world we are in and also that consumer staples will likely do fine. Names like Coke, McDonald's, Clorox, Sears... all of these companies can and will continue to perform well...At some point I will have to capitulate and buy them even though they are not all that inexpensive -- the alternative is not suitable for my clients. That is the problem with debasing a currency -- malinvestment... the tendency for investors to have to play hot potato with their money in a highly inflationary environment. I do not believe that speculators are driving this rally but forces that are greater than we have been able to comprehend to date.

What will the long term effects be of all this stimulus? There is really no way to quantify risk when we have never been this indebted as a country. The artificial nature or gut feeling I had regarding the stock market rally of 70% off of the lows and the  leadership in the market has me a bit worried. 

But as you know its a market of stocks not a stock market. We have to concern ourselves with buying bargains, and if we want to hedge we have to find profitable or at least inexpensive ways of doing so when the markets move with our undervalued stock positions and against our shorts. Timing the market truly is a difficult enterprise which I am not an expert in -- Finding value and knowing when to stay hedged is what I strive to do best. 


These are all stocks I will be thinking of buying this week. I will likely use options where the premiums are large, so hopefully we do correct this week and my hedges are not wasted as they were earlier in the month. Although I was able to catch most of the rally, I missed a good 3% of the move on Friday. We live and we learn and we stay in the game. 

If anyone finds some very cheap stocks to discuss please comment below.



Still the overall stock market looks overbought technically and October is always rocky, so I am staying pretty flat, maybe get 50% net long if there is a solid correction, otherwise I will just have to cut losses quickly on my hedging or use put spreads instead of collars.

Finding the trajectory of the US economy relative to the rest of the world will shape the market going forward, not just stimulus. I am a die hard American patriot, but I am also a realist who knows that just because the past was one way does not mean the future must be exactly the same. The FTSE is far cheaper then the S&P for example and so are may other developed stock markets around the world. Chinese stocks are way down and Japanese stocks are so underloved that only 18% of the Japanese are bullish on the Nikkei. Maybe it is time I look overseas for bargains and stop trying to value the US stock markets and US companies exclusively.

Best Wishes for a profitable week.

Below is an excerpt regarding the real estate market and recent gains in the Case Shiller Index...

"More worrying to the market is the fact that in July homes sales fell 27.2% from the prior month to the lowest level since 1985. In an emailed note, Dean Baker , the co-director of the Center for Economic and Policy Research in Washington, said, "the effect of this plunge in sales on prices should be clear."

"With the demand side of the market having largely collapsed with the end of the tax credit, it is virtually certain that prices will resume their decline, completing the deflation  of the bubble," Baker said.

Paul Dales, U.S. Economist at Capital Economics, warns that investors moving in the housing market should not "be fooled into thinking" gains shown in the S&P/Case-Shiller indices mean "conditions in the housing market have stabilized…they have not."

Dales said the increases are only due to higher demand from the homebuyer tax credit and have yet to reflect the 34% decline seen in home sales once the credit expired."

Disclosure: Long all mentioned