Observations, Calculations, and Values
I’ve long felt that equity investors tend to overlook key aspects of leverage when evaluating companies. Investors look to P/E multiples, without adjusting those multiples for the amount of leverage used in the business. In this report, D.E. Shaw describes some good ideas about how to analyze leverage.
Like Buffet’s Squandersville and Thriftsville, Charlie Munger’s recent piece in Slate will go down as a classic.
http://www.slate.com/id/2245328/
Updated Sunday, Feb. 21, 2010, at 3:30 PM ET
The Europeans rapidly repopulated Basicland, creating a new nation. They installed a system of government like that of the early United States. There was much encouragement of trade, and no internal tariff or other impediment to such trade. Property rights were greatly respected and strongly enforced. The banking system was simple. It adapted to a national ethos that sought to provide a sound currency, efficient trade, and ample loans for credit-worthy businesses while strongly discouraging loans to the incompetent or for ordinary daily purchases.
Here’s one way to tell the degree by which the US Dollar is overvalued against the Yuan. According to The Economist:
The Big Mac index
Taste and see
Jan 6th 2010
From Economist.comBurgernomics shows the Chinese yuan is still undervalued
THE Big Mac index is based on the theory of purchasing-power parity (PPP)—exchange rates should equalise the price of a basket of goods in different countries. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value benchmark. So our light-hearted index shows which countries the foreign-exchange market has blessed with a cheap currency, and which has it burdened with a dear one. The most overvalued currency against the dollar is the Norwegian kroner, which is 96% above its PPP rate. In Oslo you can expect to pay around $7 for a Big Mac. At the other end of the scale is the Chinese yuan, which is undervalued by 49%. The euro comes in at 35% over its PPP rate, a little higher than half a year ago.
The folks at Bespoke Investment Group, writing on Seeking Alpha, offer this tidbit of wisdom:
Before rushing to hit the sell button, however, investors should be aware that the currently stratospheric P/E ratio of the S&P 500 is skewed by the negative quarterly results in Q4 2008 ($-0.09). That number will be replaced by an estimate of $16.73 in Q4 ‘09, which would drop the P/E ratio to a still lofty, although relatively more reasonable level of 20.1 times. What the bulls are really banking on, though, is strong results throughout 2010. Based on current forecasts from S&P, analysts are expecting S&P 500 earnings to rise to $74.98 per share in 2010. With the S&P 500 currently trading at 1,130, the P/E ratio on a forward basis comes all the way down to a much more manageable 15 times. Now all the companies have to do is deliver.
What I’d like to see is a historical ratio that adjusts PEs for leverage. Yes companies have had higher PEs in the last 10 years than they did in the 70s and 80s, but they were probably also more leveraged. Adjusting for leverage is tricky. If you’d pay 10x to buy 100% of a company, how much would you pay to buy 40% of the same company with 60% debt? It makes sense that the multiple should go up, but how much is a function of spread between the company’s borrowing rate and it’s investing rate. And this rapidly becomes a level of analysis way beyond a simple PE ratio.
One of the principal reasons investors typically cite for not holding their money in gold, and instead saving their cash in a government sponsored currency like Dollars, Euros, or Yen, is that gold doesn’t pay interest.
I’ve struggled with this idea for a long time. Dollars don’t earn interest by themselves either. They only acquire their interest earning properties when lent to another party to pay it back. So it’s the borrowing and lending of an asset that creates the interest, not the asset itself. And the market to borrow and lend dollars is enormous.
True, it’s much harder to borrow and lend gold. But it is possible to earn something resembling interest on gold. Over at Hard Assets Investor, Brad Zigler writes about how to do it. Here are a few excerpts:
Who Says Gold Doesn’t Earn Interest?
Monday, 04 January 2010 10:12 Real-time Monetary Inflation (last 12 months): 1.5%
Gold aficionados have for many years contended with the plaints about the metal’s sterility. “Gold doesn’t earn interest” is a constant refrain heard from nonowners. But that’s not necessarily true. Gold can offer a money market return regardless of its price trajectory. Spreads between gold futures’ delivery months, in fact, implicitly reflect short-term rate expectations. The gold market, through cash-and-carry operations, tells us what traders think short-term rates ought to be.
A cash-and-carry is accomplished by taking possession of gold through nearby futures (or the cash market) and redelivering the metal against a forward contract. A December 2010 gold contract, for example, might be purchased with the intent to take delivery and store the metal until the expiration of a December 2011 future sold short. If storage costs ran $10 per month per 100 oz. bar, a return of 1.1 percent could be earned currently. That’s a 63 basis point (0.63 percent) premium over one-year Treasurys.
In fact, the rates for one-year cash-and-carries - essentially “risk-free” transactions - have been, on average, 60 basis points above Treasurys this past quarter. Thus, the market’s pointing the way to higher Federal rates. How so?
Bill Fleckenstein writes a wonderful column on MSN Money on a weekly basis. Recently, he came up with this gem of wisdom:
We’ll know gold is overcrowded when . . .
For the long-gold trade
to really become too crowded, certain events will need to occur:
- Goldman Sachs (GS, news, msgs) will have had “bus tours” to a bunch of mines, like the tours it and other companies have arranged for different industries, particularly technology.
- The public will have to be involved in a major way, and we’ll see ads on Bubblevision encouraging people to buy gold instead of prodding them to sell their jewelry, as is the case these days.
- Banks will need to find a way to put money into gold — because no modern mania has ever ended without the banks finding a way to lose money in it.
- We will most likely need to see a frenzy of mergers and acquisitions, and a leveraged buyout or two.
Last, BusinessWeek will have to put gold on the cover, telling us how it’s the wave of the future, or some variation of that theme.
Joshua Brown is the publisher of an clever, interesting, and fun finance blog called The Reformed Broker. His Periodic Table of Finance Bloggers deviates a bit from the Periodic Table of the Elements, but it still does a great job of providing a good overview of a great many blogs about finance, including many that I’ve never heard of. Oxygen maps to 1-2 Knockout, and Hydrogen to Business Insider, which given their prolific posting makes some sense.
For what it’s worth, here’s the Periodic Table of the Elements from Wikipedia.
Paul Kedrosky’s chart shows the average P/E multiples of various exchanges around the world. He points out that for the price of one Chi-Next, you could buy seven Canadas (or by that logic even more Brazils).
Other observations:
* It makes me wonder if I were a CEO or a CFO pondering a public offering, that could list anywhere, where would I want to list? On the Chinese exchanges where I might get a higher valuation? Or would I prefer a lower valuation on the NYSE or Nasdaq, and the related SOX and reporting obligations? Makes me think twice.
* Both China and Brazil are growing mightily. Why then the massive difference in valuations? Short China/Long Brazil?
* Are the Chinese multiples the logical result of capital controls on the Yuan. Chinese savers buy Chinese stocks, because capital controls prevent them from buying in any other markets. This is the reason for the disconnect in valuations for companies listed in China and Hong Kong.
James Grant is interviewed on Consuelo Mack’s show, predicting a surprisingly strong recovery next year. A bold prediction from the guy known for predicting eight of the last four recessions.
At the Fall 2009 Value Investing Congress, David Einhorn delivered this insightful speech. Here are a few pieces of his wisdom:
On the Too Big to Fail Doctrine and Lehman
The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to makesure that no institution is too big or inter-connected to fail. The test ought to be that noinstitution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.
The lesson of Lehman should not be that the government should have prevented its
failure. The lesson of Lehman should be that Lehman should not have existed at a scale that
allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie,
Freddie, Bear Stearns, Citigroup and a couple dozen others.
On Government Accounting
When the government calculates its debt and deficit it does so on a cash basis. This
means that deficit accounting does not take into account the cost of future promises until the
money goes out the door. According to shadowstats.com, if the federal government counted
the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are
over $60 trillion. And that was before the crisis.
On Moody’s and Sovereign Risk
My firm recently met with a Moody’s sovereign risk team covering twenty countries
in Asia and the Middle East. They have only four professionals covering the entire region.
Moody’s does not have a long-term quantitative model that incorporates changes in the
population, incomes, expected tax rates, and so forth. They use a short-term outlook – only
12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s
makes five-year medium-term qualitative assessments for each country, but does not appear to
do any long-term quantitative or critical work.Their main role, again, appears to be to tell everyone that things are fine, until a real
crisis emerges at which point they will pile-on credit downgrades at the least opportune
moment, making a difficult situation even more difficult for the authorities to manage.
I can just envision a future Congressional Hearing so elected officials can blame the
rating agencies for blowing it, as the rating agencies respond by blaming Congress.