Street Capitalist: Event Driven Value Investments

James Montier (of GMO, author of Value Investing: Tools and Techniques for Intelligent Investment) was at the European Investment Conference recently, where he argued against the idea that mean reversion was dead. This isn’t the first time that he’s made the argument, a few months ago on his blog, he said:

In a recent article Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

Reports Of The Death Of Mean Reversion Are Premature (Behavioural Investing)

Anne-Louise Fogtmann has a good take down of what Montier said at the conference. Montier outlined his own views which I thought were interesting, particularly on cash:

Seven “immutable laws of investing” apply, Montier argued, as they have in the past:

-Always insist on a margin of safety.
-This time is never different.
-Be patient and wait for the fat pitch.
-Be contrarian.
-Risk is the permanent loss of capital, never a number.
-Be leery of leverage.
-Never invest in something you don’t understand.

With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” A few of his specific calls: Government bonds have no return potential; emerging markets look overvalued; and in a world where both bonds and equities could be too expensive, cash becomes a much more attractive investment, even when the yield is near zero. Not only is cash a better inflation hedge than bonds (it’s a zero duration asset), it can act as a store of value during periods of deflation.

GMO’s James Montier Says Rumors of the Death of Mean Reversion Are Greatly Exaggerated

The market’s had a pretty good run lately, making most equities more expensive for value investors. The dynamic between cash and equities is a really interesting one for us because we tend to hold portfolios that are more concentrated. Other investors might have the kind of allocations which allow them to replicate the movements of your typical indicies, but value guys tend to take a 5% to 10% position approach. This makes our allocation decision a bit more difficult. There’s a big difference between re-creating an index versus putting on 10% positions in full value/expensive stocks. This is why, for concentrated investors, it makes sense to shift to cash rather than equities. At the same time, there are pockets of value scattered throughout the market. While no one sector seems to offer compelling valuations, I have been spending most of my time analyzing select companies in industries ranging from energy to insurance.

Montier’s point about emerging markets being expensive is one that resonates with me. Take the case of Brazilian banks Bradesco (NYSE:BBD) and Itau (NYSE:ITUB). Both are priced richly at over 4x book value, but are generating high returns on equity (32% and 40%) implying an 8-10% return. If we dive deeper into the financials and analyst estimates, we can see that much of this is being driven on the prospect of loan growth. Brazil has a rapidly growing middle class and most people expect that financial services firms will be able to profit from that growth.

I agree that a developing middle class should be able to help the banks. In theory, as the banking sector in Brazil becomes more formalized, citizens should be depositing more money into banks and using them for payment transfers. That should lower the cost of funding for Brazilian banks. Plus, Bradesco and Itau are targeting for insurance income to make up 25% of their earnings in a few years. These are truly financial services supermarkets and I could see that part of the equation working out. But analysts are modeling loan growth at rates of 30% annually. I just don’t know if Brazil can sustain such growth levels. You could make the argument that much of the growth could be going to consumers, not commercial enterprises, but to me that kind of lending is much more difficult. At least when a bank loans to a business, the credit analysts can give a business a good scrubbing and have the business’ assets used as collateral. Consumer lending is an entirely different beast. They could try to increase the amount of mortgages on their books, but the problem there is consumer demand might not match up with supply, you might end up creating a mini-housing bubble.

To me, emerging markets at this point have a lot of things going for them. I do expect the BRIC countries to do well over the long term. But as a value investor I just don’t think you will get the margin of safety that you are looking for. Everything has to go right for them to warrant such high valuations. Buying right now is akin to being a trend follower or momentum investor. I have a list of great companies in BRIC countries that I usually check every other day. The way I figure it, given the way the global economy is going — any heightened level of volatility might trigger a pull back and make some of these companies a bargain. For now, you might be better off analyzing large caps with emerging market growth exposure. Those businesses still seem to be trading at attractive valuations.

My friend Miguel Barbosa has an excellent interview with James Montier (of GMO and author of: Value Investing: Tools and Techniques for Intelligent Investment). I thought I would give you a couple of excerpts, I believe the whole interview is worth reading and suggest you do so. Miguel tells me that he should have his second part up soon.

A few days ago, when discussing value investing, a friend asked me why value investing does not stop working. Value investing thrives because of certain inefficiencies in the market and it has been written about for more than 70 years now. So why doesn’t the market catch on? Montier provides us with an answer:

Miguel: Tell us about the price = quality heuristic? Why do investors overpay for beauty and underpay for toads…after all they are one step away from becoming princes are they not? This heuristic complements the Anginer et all study where ugly defendants are more likely to be found guilty and receive longer sentences than attractive defendants.

James Montier: We humans have a bizarre bias against a bargain. For instance, my friend Dan Ariely has done some great experiments in this field showing some pretty odd findings. Imagine you taste two glasses of wine one you are told comes from a $10 bottle, the other comes from a $90 bottle. You will almost certainly say that the $90 wine tastes much better. The only snag is that the two wines are exactly the same. So never come to dinner at my house, because I’ll give $10 wine, and tell you it costs $90!

The same thing happens with pain killers. It is why branded pain killers exist alongside generic equivalents. They both have exactly the same active ingredient, but people report the branded version works better.

I suspect that something similar happens with stocks. Stocks are the one thing we don’t like to see on sale. So a ‘cheap’ stock must have something wrong with it, and an ‘expensive’ stock must be a sign of quality – at least that’s the way we tend to view things.

The Anginer et al study shows some similar findings in the legal context. Ugly defendants get far worse sentences, than attractive defendants. We have a hard time believing that attractive people could have been bad – a kind of halo effect, if you will.

If you haven’t already, I really suggest you read Dan Ariely’s book Predictably Irrational, it is one of my favorites. Montier gets at why I think markets wont figure out value investing — the participants are too irrational. Usually, what you will see are investors who claim to practice value investing, only to abandon it when things get tough. It is a style of investing that requires levelheadedness, courage, and patience, which many investors lack.

One of the topics Montier touches on is short selling, which I thought was pretty interesting. Most value investors don’t short, so it is always nice to take a look at the ones who do:

Miguel: Tell us about the folly of using price to sales as a proxy for value.

James Montier: Price to sales is fine if you are looking for short candidates, but as a long side value criteria it makes no sense to be at all. After all as long as you promise to value me on price to sales, I’ll set up a business selling $20 bills for $19…I’ll never make a profit, but if you are looking at price to sales you won’t care.

Price to sales is typical of the drift up the income statement when the bottom line gets too demanding. If your PE starts to look expensive, get everyone to look at a less demanding metric, enter stage left price to sales. If that starts to look tough, abandon the income statement and look at the value based on eyeballs and clicks!

Miguel: What I enjoy about your writing is that you aren’t afraid to talk about “controversial topics” – yes I’m talking about your work on short selling. Can you quickly tell us what you have learned about short sellers (their characteristics, screens, etc).

James Montier: Short sellers are everyone’s favorite scapegoats. They make money when things go ‘wrong’. Of course, what the authorities forget is that simply because a short seller sells a stock, doesn’t mean it goes down – if only it were that easy we’d all be short sellers. As David Einhorn observed, I’m not critical because I’m short, I’m short because I‘m critical.

In my experience, short sellers are amongst the most fundamental investors you’ll come across. They understand the ins and outs of a business better than just about everyone else. They are highly skilled at figuring out poor economics when they see if. They act as acting police, helping to uncover fraud – something that the regulators used to do (a very long time ago).

My own work on short selling has focused on a number of areas. In general, shorts tend to come into a couple of categories: bad businesses (i.e. poor economics), bad accounting (obvious), bad management (the guys at the top haven’t got a clue). In addition I often look for several traits, such as expensive, unrealistic growth expectations, too much debt, and poor capital discipline (i.e. needless and tangential M&A).

I also created a measure called the C-score (C is for cheating or cooking the books). It aims to look for the quantitative red flags which often accompany bad accounting.

Excerpt: Details of the C score Page 263 of Value Investing Tools & Techniques for Intelligent Investment

1. A growing difference between net income and cash flow from operations.
2. Day sales outstanding is increasing.
3. Growing days sales of inventory
4. Increasing other current assets to revenues.
5. Declines in depreciation relative to gross property plant and equipment.
6. High total asset growth.

Miguel Barbosa interviews James Montier (Simoleon Sense)

Those are just two questions that Montier answered. There are many more over at Simoleon Sense and I highly recommend the interview.