“Investing is messy. You know that badly managed companies often deliver higher returns than well-managed companies. That sounds weird until you realize that if everybody thinks a company is well managed, they are going to push up the price. The price you pay will then reflect the management. And all you can then have is a negative surprise. Whereas if you invest in a company where investors think the management ‘can’t chew gum and walk at the same time’, the fact that they can do both is a positive surprise.”

— Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, on ESG (Environment, Social, Governance) Investing at the 2022 Code Conference

“Quality” At Any Price Versus Quality-Adjusting Prices

The above quote applies well to biases that stock market investors easily get caught in:

• We may grow too fond of the most popular “quality” investments of the day. We may forget that no risky, longer-term investments are ever unstoppable “sure bets”. If we then overpay for or oversize such positions too grossly we rely completely on a "bigger fool" to bail us out.

• And some very poor quality, poorly managed listed enterprises may return great shareholder value. But likely only if bought at depressed enough prices, with some potential upside catalysts.

We may buy both “high-price tag” and “low-price tag” businesses, measured by for example P/E ratios. But we are value investing only when we judge that we risk capital at price discounts to intrinsic value.

ESG = Emperor Sans Garments(?)

Let's go beyond PiggyBack’s single-minded focus on money-making and learning from value investing. Aswath Damodaran’s full presentation covers issues of capital allocation for society. Your Analyst recommends it for three main reasons:

1. ESG—Environmental, Social, and Corporate Governance—Investing is sold as a one-size-fits-all “solution” to hard-to-solve issues. These widely adopted institutional frameworks affect the long-term capital allocation of businesses and states. To ignore ESG is to ignore a powerful driver of capital flows.

2. ESG has become political. At this point, there is now a conservative “Anti-ESG” movement and even themed investment products.

3. Professor Damodaran delivers rational, wise, and unpopular criticism. To both ESG embracers and Anti-ESG provocateurs. The key question: Does the current idea of ESG as a “goodness” investing framework even make sense?

So, if you have not already watched the presentation, go full screen for 18 minutes:

Good Optics of Capital and Wise Uses of Capital

Economics is supposedly the art of rational allocation of limited resources. With one-size-fits-all ESG bureaucracies, we hand over a great deal of power over our societies’ scarce long-term capital. To no-skin-in-the-game advisors and consultants of politics and big business. Actors who reliably will want to respond to populist calls for whatever short-term, “looks good” action.

Examples of ESG controversies closest to mind for Your Analyst are in the Capital Markets and Asset Management industries:

ESG/Sustainability Investment "Research"

Imagine designing an ESG research framework.

1. Base it on some unarguably “good” but purposefully vague and very long-term vision or set of goals. Aggregate consultant insights on all the latest buzzwords and rating indices data to convince customers. Include metrics boxes covering environmental ("E"), social justice ("S"), and corporate governance ("G").

2. ESG rank/rate investments with the boxes. Convert sets or lists into “green”, “sustainable” and/or “stakeholder friendly” investment products.

3. Based on the indicated lower “ESG risk”, set these products’ prices higher at lower expected gross returns. Lower expected net investor returns even more by charging higher fees (refer to "proprietary" box ticking).

A Hypothetical

Would retirees say “Yes, of course!” if their retirement plan asked in clear terms:

“Would you like to be charged more for less as long as we provide you marketing material showing reduced ‘ESG risks’? You will do future generations a service!”

This exercise easily becomes self-justified box-ticking.

"Divestitures"

ESG has led to several industries becoming excluded or “uninvestable” when it comes to accessing institutional financing at attractive terms in public markets.

1. For example, fossil fuel energy. Productive and legal but ESG controversial energy assets of this industry are divested. In practice, this means that managements and boards of public companies just sell off unpopular assets to for example private equity interests at low prices. It is done in consideration of an undefined wider set of “stakeholders”, rather than for the shareholders to which the board has a fiduciary duty.

2. Oil, gas, and coal have clear pollution downsides. Many of us envision a future world that does not need to consume such resources. Near-term reality: The global economy still needs fossil fuels, until it does not. Environmentally bad, but a fact unless we willingly reduce standards of living for a few decades.

3. The result? Assets of the most criticized industries are predictably moved from high transparency to low transparency owners and operators. At the cost of public shareholders. To the benefit of ESG arbitrageurs, like private equity. The big irony? Basically, the same institutional capital pool pretends that just because it washes its hands from holding these investments via public companies, it can continue to make them via offshore private equity funds.

So how “good” is it this ESG “divesting”? The assets in question will still be productive until outlawed or being made uneconomic by competition from other solutions.

Consulting The Bathroom Mirror

The world is extremely unfair in terms of life opportunity outlook based on where, when, and to whom we are born. With globalism, access to opportunity improves, but it does so slowly and in a free, liberal world we can still never agree fully on “fairness”.

As opportunistic value investors, we can consider investing in “ESG risk premium” by:

1. Observing developing “uninvestable” themes that are becoming excluded by ESG. Follow capital outflows and increasing costs of capital to lower valuations.

2. Readers who invest other people’s money are responsible for agreed-on ethical considerations. These may exclude some, but not all “ESG risk” investments.

3. With unconstrained capital, for example our own, we have a great responsibility to ourselves and the world. Here we can ignore optics and ratings. Instead, we must face the mirror and confront our conscience. Is this potential “ESG risk” investment in an activity that we want to or can even tolerate supporting?

What is certain is that everyone will certainly not agree on subjective issues of morality.

Well-Regulated Capitalism

As for the bigger issue of how the free capitalist world allocates capital. The costs of unproductive or sub-optimal long-term investing made in the name of ESG are borne by society. Externalities, to use the economists' vocabulary.

As a society, we may of course reach a consensus to allow, restrict or outlaw some business or government practices. Well-calibrated and restrained technical regulations that are built up and reformed slowly over time are likely a better practical solution to any E, S, G, or other major problem areas than trying to “codify” morality. Combining regulation with a willingness to trade goods, skills, and ideas despite differences in beliefs has led to great human progress historically.

So short-term pessimists on political games and virtue signaling, long-term optimists on human ingenuity?

PS: Sign up for Aswath Damodaran's very underfollowed, free Substack newsletter “Musing on Markets”. Like the Professor's website, it is a goldmine of investment-related wisdom, valuation models, and data:

Strategy: Cool Bear Market Heads Prevail

Value investing in bear markets requires keeping a cool head.

1. Initially, a cool head not to buy. Here we must avoid relative “value” trades that only anchor on percentage drawdowns from peak valuation, or on relative multiples versus peer investments. But also value traps, with deteriorating absolute fundamentals and no clear catalysts.

2. Eventually, a cool head if we reach truly depressed valuations, in absolute and intrinsic value discount terms. There we need it to buy bargain opportunities as aggressively as allowed for by risk mandates and prudence.

Most human investors will make errors of both (1.) commission and (2.) omission. Our emotions and market sentiment become less reliable during periods of more extreme price movements. As value investors, we can try to reduce making large errors in stressed markets by reducing the puzzle to good old boring fundamentals.

Affiliate Marketing: This article section contains affiliate marketing links, labeled “(paid link)".

PiggyBack Promotes: TIKR Terminal

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The TIKR Terminal (paid link)

PiggyBack’s Value Elsewhere

Free value investing content and other recently enjoyed curiosities with “shelf-life”.

Listen:

The Illusion of Knowledge (~53 min)

“Clearly, Buffett’s name goes at the top of the list of investors who’ve succeeded by shunning macro forecasts and instead focusing on learning more than others about ‘the micro’: companies, industries, and securities.”

Howard Marks, Co-Chairman of Oaktree Capital, on why most of us active, fundamental investors cannot rely on macroeconomic forecasting (Recommendation).

Reads:

Entering the Superbubble’s Final Act (~10 min)

“If the bear market has already ended, the parallels with the three other U.S. superbubbles – so far so strangely in line – would be completely broken. This is always possible. Each cycle is different, and each government response is unpredictable. But these few epic events seem to act according to their very own rules, in their own play, which has apparently just paused between the third and final act. If history repeats, the play will once again be a Tragedy. We must hope this time for a minor one.”

The quote is from Jeremy Grantham, co-founder & Chief Investment Strategist of GMO, in a piece on the U.S. stock market development in this summer of 2022. The summary: a bear market rally from the continued bursting of a historical valuation “superbubble” (with weakening fundamentals).

While not a precise forecast for market timing, do not ignore historically treacherous stock market conditions as doomsaying. Think of it as more of a risk-reward map indicating that “the bang for the buck” is yet in not broad U.S. stocks.

A Taxonomy of Drawdowns (~10 min)

Deep bear markets push most broad stock portfolios into a sea of red. In some sense, a drawdown from previous market value peaks to lower troughs is just a repricing under uncertainty. But drawdowns of course relate to business and financing fundamentals playing out differently than what the consensus recently imagined.

Here fellow Substack publisher Byrne Hobart of The Diff takes a step back to present a stock market drawdown “taxonomy”. In Your Analyst’s view, this three-category framing catches many of the drawdown risks and opportunities that are longer-term relevant for us fundamental value investors.

The Diff

A Taxonomy of Drawdowns

Welcome to the free weekly edition of The Diff! This newsletter goes out to 40,782 readers, up 655 since last week. In this issue: A Taxonomy of Drawdowns Watercooler Shows Smart Thermostats Substitutes and Complements Monetization Apple Ads Diff Jobs…

Read more

4 years ago · 18 likes · Byrne Hobart

The Illusion of Knowledge (~10 min)

See Listen above.

Charts:

Chart of the Week - Global Equity Risk Premium (~2 min)

Stocks represent ownership in company profits, a residual left after deducting all other claims. To value stocks, we discount uncertain future cash flows back to today (present value) using a discount rate. The simplest possible cost of equity discount rate adds:

(1) “Risk-free” long-term government bond rate in the relevant currency, to compensate for the time value of money. Currently, rising government bond interest rates are increasing this cost of equity. This mechanically lowers valuation multiples.

(2) Equity Risk Premium (ERP), to compensate for all other equity risks. The following chart, by Callum Thomas’ paid publication Topdown Charts, points out how ERPs have not yet really increased to the elevated levels seen around recent decade bear market index trough levels:

“The current level of the ERP is not particularly attractive for US equities. Even the rest of the world, while boasting a higher ERP vs the USA, still hasn’t moved up to previous major buying opportunity levels at this point.”

— Callum Thomas, Head of Research and Founder of Topdown Charts

Mr. Thomas also publishes the free The Weekly S&P500 #ChartStorm, a PiggyBack Recommendation:

The Weekly S&P500 #ChartStorm

Weekly charts: macro, technicals, valuations, and more -- a good and easy way to stay on top of the market outlook!

By Callum Thomas

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

Back PiggyBack(!)

Your Analyst sincerely hopes all readers enjoy and get inspiration and value investing ideas from PiggyBack. If so, consider sharing PiggyBack with friends and colleagues:

Share PiggyBack

Only with the help of early readers will this publication reach a sustainable scale for free, independent insights. Many thanks to all PiggyBackers!

Johan Eklund, CFA
PiggyBack

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In our new link section PiggyBack’s Value Elsewhere, we highlight an interesting holding company discount read.

Your Analyst,

Johan Eklund, CFA
PiggyBack

Beware Of Undercurrents

August 2022. A treacherous calm has set in on the global stock market’s surface after a summer recovery rally. Sentiment- and macro-wise, this may look/walk/talk/smell like a bear market rally. So market strategists and traders suggest tactically reducing risk exposure as the sensible thing in the short run.

If they are wrong? A “pain trade” for short-term market timers would be "recovery" to new levels of low-interest rate market craziness. Fear Of Missing Out (FOMO) all over.

We are not in the business of making or trading these shorter-term market calls. PiggyBack is in the business of making long-term fundamental risk-reward calls.

Strategically, there are a few important stock market undercurrents to beware of today. Fundamental forces that will affect the long-term investor's expected returns. Beyond the next month/quarter/year leg price move in the markets.

Photo by Francisco Kemeny on Unsplash

Medium Term Risk: The Inflation Problem

Let’s say inflation does not come down fast with increased interest hikes into a global recession. Then we have a stagflation problem. (As we discussed here.) Here it is better to be safe than sorry in equity portfolio risk management.

But playing safe does not need to mean market timing, in terms of selling everything in hope of being able to buy back cheaper. As long-term investors, we can also express the inflation risk in our security selection.

Until the inflation shock is under control there is a clear risk of lower equity valuations:

If central banks fight inflation credibly with (much, much) higher interest rates, those interest rates mean higher discount rates and lower valuation multiples on stocks. Here the highest valuation multiple, “glamour” stocks are most susceptible to return headwinds. They get crushed via falling share prices, the classic valuation multiple compression. Especially if their businesses are cash-flow negative and rely on issuing new equity to keep their doors open. Like many recent year unprofitable growth tech darlings and SPAC IPOs. Falling share prices here means worsening dilution of existing shareholders, with each new round of capital needs.

Lower earnings/asset quality business stocks may face severe headwinds if higher interest rates deepen a recession. Even risks of being impaired in a restructuring/bankruptcy if cyclical customer demand drops to where it no longer supports fixed costs or debt loads.

And if central banks capitulate and let inflation run to “save” the economy, the same lower earnings/asset quality stocks may still destroy capital, only more slowly but steadily. Here the problem is lacking pricing power, to compensate for long-term cost inflation on inputs and reinvestment.

Note that low quality businesses include low quality value stocks. If shareholders do not demand strategic asset sales, mergers or liquidation in time, their initial asset discounts are like melting ice cubes.

So where to hide in stocks?

One can try to position in at least some stocks with built-in inflation protection, or even inflation upside. Think commodities, energy, infrastructure, utilities, staples, and well-positioned suppliers to such industries.

Another option are strong pricing power asset-light “quality” businesses with non-cyclical demand. Easier said than done to buy these at discount valuations, but bear markets present some such opportunities.

Related to inflation-fighting via higher interest rates are risks of tighter financing conditions. Given the levels of debt that have been propped up by near-zero interest rates and central bank purchases, expect some things to break if inflation interest rates continue higher.

While the timing, chain of events, and collateral damage in terms of regions and sectors are uncertain, major stress events to the global financial system are a recurring phenomenon after long periods of credit expansion. It is prudent to plan for short-term credit to tighten or dry up:

1. Refinance for longer maturities and fewer covenants on any well-motivated financial, business, and personal debt leverage.

2. The same goes for stock-picking. Avoid firms that depend on highly levered, short term debt profiles to produce meaningful shareholder returns.

3. A positive leverage case can be found in firms that lock in attractive long-term debt against some convincing long-term investment plans. While not without risk, properly used leverage can create long-term printing presses. Debt creates the opportunity to build real equity as inflation reduces the debt’s real payback value. Debt also provides a cash tax shield, so that more current income can be reinvested or distributed.

Long Term Risk: The U.S. Valuation Problem

Geographically, the U.S. stock market is still historically expensive. See for example Research Affiliates’ excellent cyclically adjusted P/E (CAPE) summary.

The basic fundamentals: U.S. stocks price in low interest rates and near-record profit margins. In the long run. Nothing new here, but still time to reconsider. If we are to make a macro bet, do U.S. equity valuations provide worthwhile “bang for the buck” (risk reward)? Your Analyst doubts it, more broadly speaking. A market that is not a good value will still have its pockets of value though.

Long-Term Opportunity: Global Value

Let's end on a positive note. Research Affiliates' data also highlights an aspect overlooked by today’s U.S.-focused equities bears:

Many regions around are already getting more reasonably priced, or even cheap. Both from historical and fundamental valuation perspectives.

Global diversification we have already discussed. An active, long-term investor making use of that opportunity should currently have no lack of value stocks to pick apart. And PiggyBack.

Affiliate Marketing: This article section contains affiliate marketing links, labeled “(paid link)".

PiggyBack Promotes: TIKR Terminal

Supercharge your single stock investing with a powerful, yet light Equity Research terminal. TIKR Terminal provides professional and do-it-yourself investors with global, well-laid-out fundamental company overviews. In a fast, easy-to-use, and reasonably priced web app. Think of it as your 24/7, first-look analyst.

The TIKR Terminal (paid link)

PiggyBack’s Value Elsewhere

Free value investing content and other recently enjoyed curiosities with “shelf-life”.

Listen:

The Wolf in Cashmere’s Conglomerate (~53 min)

Ever wondered about the origins and playbook of global luxury conglomerate LVMH? (Moët Hennessy Louis Vuitton, Euronext Paris ticker: MC)

Mr. Christian Billinger, CFA, a Swedish investor operating the private family holding company Billinger Förvaltnings AB, breaks it all down. Get great insight into the economics and practical realities of investing in true luxury. Hint: Quite different from performance-focused premium brands. Host: Zack Fuss for Business Breakdowns

Reads:

BEEPING Holding Company Discounts (~10 min read, ~2 min comment)

“For various reasons, holding company discounts are evident across the world. Most management teams shrug their shoulders when the right thing to do for shareholders is to just spin off their holdings. However, a corporate manager’s natural compulsion is to preside over the largest possible empire rather than a smaller one.”

— David Eborall, CFA portfolio manager SaltLight SNN Worldwide Flexible Fund

SaltLight SNN Worldwide Flexible Fund, managed by South Africa’s Saltlight Capital, published an interesting investor update this summer. Portfolio manager David Eborall’s topic was holding company discounts. Specifically, the value that insiders and major shareholders can unlock from big discounts.

SaltLight’s example was extreme: the Amsterdam/Johannesburg-listed holding company Prosus (ticker PRX for both, and U.S. ADR PROSY). Prosus's main asset is a long-term stake in the Chinese Internet giant Tencent (Hong Kong-ticker HKG: 0700, U.S. ADR TCEHY). Earlier this year, the market value of Prosus’s Tencent stake was around twice Prosus’s total market value.

This means the market was so pessimistic that one could buy Prosus shares to:

1. Get indirect Tencent exposure for only half price.

2. And get the rest of Prosus “for free”. (This remaining portfolio at the time had got a low accounting book value, compared to the Tencent stake.)

Professional speculators: One could also buy Prosus while short-selling Tencent. This creates a purer bet on a narrowing Prosus discount. More or less isolated from Tencent’s short-term share price movements.

Your Analyst has nothing intelligent to add about Tencent’s valuation at this moment. Most of our readers should however sense the bargain opportunity. PiggyBack will hopefully get to offer readers a fair share of digging deeper into holding discounts.

Charts:

Chart of the Week - Global Equity (Population) Growth (~2 min)

An easy-to-forget demographic challenge for the world economy: population growth is stalling to a near halt in Developed Markets, and to very low levels in Emerging.

Combine with populations that generally (1) are getting older and (2) already have seen women joining the workforce. This means that the Developed and Emerging world will have to do without the historical tailwind of a steadily growing labor supply.

Optimists look to Frontier Markets for more predictable demographic tailwinds. S&P Global Ratings have highlighted Sub-Saharan Africa in particular.

Chart by Callum Thomas’ paid publication Topdown Charts. Mr. Thomas also publishes the free The Weekly S&P500 #ChartStorm, a PiggyBack Recommendation:

The Weekly S&P500 #ChartStorm

Weekly charts: macro, technicals, valuations, and more -- a good and easy way to stay on top of the market outlook!

By Callum Thomas

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

Back PiggyBack(!)

Your Analyst sincerely hopes all readers enjoy and get inspiration and value investing ideas from PiggyBack. If so, consider sharing PiggyBack with friends and colleagues:

Share This Post

Share PiggyBack

Only with the help of early readers will this publication reach a sustainable scale for free, independent insights. Many thanks to all PiggyBackers!

Johan Eklund, CFA
PiggyBack

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Your Analyst,

Johan Eklund, CFA
PiggyBack

An Original PiggyBack Investor

“Knowing when other full-time investors are likely to outperform your own part-time efforts may be the most fundamental of all value insights.”

— On Robert Heilbrunn in Value Investing: From Graham to Buffett and Beyond, 1st ed. (2001), by Bruce Greenwald, Judd Kahn, Paul Sonkin, Michael van Biema

For this publication's “piggyback investing”, the above quote is a key lesson reminder:

With experience, "IQ-intelligent", curious investors can gain above-average current market knowledge. With some luck being at the right place and time, such investors find early success and outperform.

But increasing technical expertise often builds egos. Curiosity fades. Such investors will find out they lack market wisdom. Markets will ruthlessly compete away most current outperformance abilities (edges). It is a matter of time. Stubborn "expert" investors may double down as they are risking not just capital, but also misplaced overconfidence. The market never cares and now has a new playbook.

Adaptive investors recognize that many edges are likely outside their current investing competence. Many times, talented and resourceful contemporaries may offer us greater learning and investing opportunities. U.S. businessman and value investor Robert H. Heilbrunn embodied such wisdom.

Who Was Robert Heilbrunn?

While leaving a philanthropic legacy, there are no great lengths written on Robert Heilbrunn (1908–2001) the value investor. He is often mentioned briefly as a supporting character in the value investing lore around Benjamin Graham (1894–1976). Graham is, more often than not, mentioned as an early role model for his student, later associate, Warren Buffett’s (1930–) investing success.

Depression-Era Lessons From Ben Graham

His short Value Investing: From Graham to Buffett and Beyond chapter starts with a young Heilbrunn inheriting his father in 1929. At the Great Depression’s onset. This included responsibility for the family's leather trade and a stock and bond portfolio.

The leather business, like many others, crumbled. Heilbrunn decided to liquidate it in his first two years. The rest of the family fortune saw a more exciting future. 1929 was one of modern history’s worst times to start managing U.S. securities. And Heilbrunn lacked experience. Heilbrunn’s father had however mentioned one investment advisor to trust: Ben Graham.

"At first he seemed very cold. After all, people were jumping out of windows and selling apples in the street and I think he was afraid I was going to ask him for a loan. When he found out that all I wanted was investment advice, he agreed to help me."

— Robert Heilbrunn on approaching Benjamin Graham to become his investment advisor

Source: Columbia University speech in 1993

The book continues how Graham and Heilbrunn early in the Depression could sell some of Heilbrunn's father’s better bonds. At near par (near 100% of principal value). Only to start reinvesting in deeply distressed, even bankrupt, corporate bonds.

• Today this would have been called a crash course in deep value or distressed debt. Graham’s Great Depression operations are interesting since few investors were willing, or even able, to pick up any securities. The investing public at the time generally wanted or had to liquidate, to reduce leverage and make ends meet. Buying more illiquid and distressed securities was a very contrarian move.

Later in the 1930s, when Heilbrunn had value investing experience he took Graham’s investing class. Unlike Walter Schloss, and later Warren Buffett, Heilbrunn was never employed by Graham at Graham-Newman. But he got to operate as an independent research contractor for the group. His Graham-Newman investment legwork included the insurer GEICO (a later major acquisition of Buffett’s Berkshire Hathaway).

Among Early Value Quants

With growing value investing expertise, Heilbrunn wrote some articles in his name. A Practical Approach to Common Stock Valuation, in a May 1958 issue of The Financial Analyst’s Journal (paywall link), was a case study on the improved returns from purchasing U.S. Steel stock in less expensive parts of its trailing valuation range. Metrics studied included Price/Earnings (P/E) and dividend yield.

• Conceptually, this is not that far from today’s factor investors. It just lacked the scale and statistical validation help of databases and computers.

Early Grahamites, such as Heilbrunn, operated in less efficient markets. Lacking access to high-quality data, they would still be willing buyers based on common sense analysis. But at more conservative, deeper discounts than we commonly find today.

Still, the human urge to chase bull market story stocks was about as a hard inner battle then, as it was in the recent 2021 roaring bull market:

“The experienced investor as well as the neophyte is influenced in varying degree by the tremendous quantity of bullish sentiment in the form of newspaper and magazine articles, speeches, reports, analyses and the like, which emanate from the financial district... It is especially important and very difficult in such times not to be influenced by these pressures from sticking to fundamentals and continuing to make decisions strictly on the basis of the facts.”

— Robert Heilbrunn

Source: Robert Heilbrunn (1958). A Practical Approach to Common Stock Valuation, Financial Analysts Journal, 14:2, p. 49–51.

Assessing the Abilities of Others, Including Warren Buffett

Eventually, the more lasting result of Heilbrunn's value investing experiences, with Graham and on his own, became his ability to recognize the long-term investor potential in some of his peers.

“He put money into Buffett’s partnership a year or so after it started, and he also entrusted some funds to Schloss after initially deciding against it. In later years he added other prominent value investors to his portfolio of managers. These decisions paid off handsomely, and Heilbrunn was able to retire, more or less, from direct active investing.”

— On Robert Heilbrunn in Value Investing: From Graham to Buffett and Beyond, 1st ed. (2001), by Bruce Greenwald, Judd Kahn, Paul Sonkin, Michael van Biema

PiggyBack Takeaways

With experience, we may realize how little we know what others know. Then we may start seeing some of our peers, role models, and competitors as great investing opportunities.

This does not mean that we have to become fully passive, fund investors. Think of it more as expanding our current abilities. By allocating capital with or in the spirit of unique investors and entrepreneurs, we can get in on:

• More attractive fundamental setups (that we might not have found ourselves)

• Hard-to-access or exclusive term deals

• Superior investment execution

If available in public markets, as minority investors we can piggyback with liquidity.

So lose some of that active investor ego. Like Robert Heilbrunn, we should be on the lookout for our hard-to-copy investing superiors.

Heilbrunn’s Legacy

Robert Heilbrunn passed away in 2001, but his legacy in the value investing community lives on. Donations from the Heilbrunn and Lerner families helped fund The Heilbrunn Center for Graham & Dodd Investing at Columbia Business School. This center is important for practitioner-relevant, value investing research.

• PiggyBack recommends the Value Investing With Legends podcast. It offers enjoyable learning from some of today’s value investors on the center’s radar.

Affiliate Marketing: This article section contains affiliate marketing links, labeled “(paid link)".

PiggyBack Promotes: TIKR Terminal

Supercharge your single stock investing with a powerful, yet light Equity Research terminal. TIKR Terminal provides professional and do-it-yourself investors with global, well-laid-out fundamental company overviews. In a fast, easy-to-use, and reasonably priced web app. Think of it as your 24/7, first-look analyst.

The TIKR Terminal (paid link)

PiggyBack’s Value Elsewhere

Selected free value investing content and other recently enjoyed curiosities.

Listen:

I Beg to Differ (~47 min)

“I believe most investors have their eye on the wrong ball. One quarter’s or one year’s performance is meaningless at best and a harmful distraction at worst.”

Howard Marks, Co-Chairman of Oaktree Capital, goes back to key principles on why investing outperformance requires long-term, contrarian thinking (Recommendation).

The Bear Has Arrived (~1h 22 min)

Jeremy Grantham, co-founder & Chief Investment Strategist of GMO, on the pandemic hangover. Trey Lockerbie hosts for TIP Network (Recommendation).
(Yes, still multi-year relevant. The summer bear market rally did not improve a poor fundamental return outlook for U.S. stocks. It brought back a valuation headwind.)

Will Thorndike: The Power of Long Holding Periods (~59 min)

William Thorndike, investor and author of capital allocation case bible The Outsiders, has launched a new podcast called 50X on a long-term compounding research project. Here, Thorndike serves a great introduction to 50X’s deep dives into Transdigm’s () capital allocation. Hosting the host: Patrick O'Shaughnessy of Invest Like the Best (a colleague in 50X's pod network).

Reads:

I Beg to Differ (~20 min)

Farnam Street Investments: July 2022 Client Letter (~10 min)

Pattern recognition on how investments in publicly listed businesses with strong microeconomics are not victims of periods of tanking stock prices, but potential great long-term beneficiaries. (Hint: disciplined, valuation-driven capital allocation.) Via Jake Taylor, CEO Farnam Street Investments. Autozone () serves as example.

Understanding Jane Street (~20 min)

Interesting analysis on competitive dynamics and technical mechanics in play at proprietary trading shop Jane Street. By The Diff’s Byrne Hobart (Recommendation).

Charts:

Off-Topic ChartStorm: Valuations in Focus (~5 min)

Reminders that global stocks remain less stretched than U.S. and that U.S. small-caps are breaking. Via Callum Thomas Weekly S&P500 #ChartStorm (Recommendation).

Is Everyone Out There Cray-Cray? (~1 min)

Clifford Asness, co-founder of AQR Capital Management, provides a (rhetorical?) question. The below chart shows the global relative cheapness of the “value” factor. In simple terms, the statistically lowest valuation multiple stocks trade at near modern history record discounts, to the highest multiple “glamour” ones.

In hindsight, the bursting and aftermath of the first Internet Bubble was a decent time to be picking up “old economy” value stocks. Eventually, the more robust shiny tech stuff muddled through and could be had at “low conviction” prices.

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

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Where next?

1. From August PBL is back.

2. When ready, we will launch PiggyBack's premium, actionable, equity research paid edition. PiggyBack Letter readers will get samples and ongoing, selected insights from this upgrade. For free.

Look forward to this!

Your Analyst,

Johan Eklund, CFA
PiggyBack

The Foreign Investor's Advantage

“Sweden accounts for approximately 1 percent of the world economy. A rational investor in the United States or Japan would invest about 1 percent of his assets in Swedish stocks. Can it make sense for Swedish investors to invest 48 times more?”

— Richard H. Thaler and Cass R. Sunstein in Nudge: Improving Decisions About Health, Wealth, and Happiness (2009, p.153)

Thaler and Sunstein’s question above is on how Swedes* chose their equity allocation when offered to make an active choice of mutual funds. The takeaway? An extreme home bias effect, at least initially. Investors who make active choices tend to over-allocate equities in their “home” market.

This experiment constituted a small part of Sweden's state-run pension system. Most Swedes of working age have at least some allocation. The pension system default, non-choice “nudge” is more globally diversified. For good reason, as we will learn.

In its defense, Swedish equity indices contain a handful of multinational industrial champions. But still: whether investing in passive products or buying insignificant active stakes one should not put half of one's stocks in such a small "home" market. Equities are a too major asset class with good global access not to diversify.

A similar critique, but less extreme would be Americans putting most of their wealth in the S&P 500 Index. Despite this Large/Mega cap index having a good share of multinational U.S. companies.

Some readers might protest. The U.S. currently makes up almost 60% of global equities market capitalization. In the MSCI ACWI + Frontier Markets All Cap Index, covering 99% of world capitalization. But any investor, including those whose "home" markets dominate the global market cap, can have a too narrow universe. Let us piggyback on global diversification.

(* Sweden is PiggyBack’s home country. A small, open economy in the Northernmost EU. Easy to confuse with our non-EU Switzerland friends down in the Alps.)

The Global Free Lunch

A lot of portfolio theory rests on the assumption of market cap-weighting. This means we accept the market as efficient, at all times (and not just most of the time).

Want the market average risk-adjusted return (minus low fees and taxation)? Then be a passive investor by just buying cheap, well-executed market index products. This let-markets-do-their-dance has historically beaten the average, active investor in the same universe. This "wisdom of the crowd" is well-known by most investors nowadays.

An important aspect is often missed in practice. This market portfolio should be global to capture all diversification benefits. In the 2019 report, Geographic Diversification Can Be a Lifesaver, Yet Most Portfolios Are Highly Geographically Concentrated, the hedge fund manager Bridgewater provides an excellent summary of 20th and early 21st-century support for global diversification. The charts are great (and copyrighted) so please go to the above link to study the report. Our highlights:

1900–early 2019 Excess Returns*

* Excess return = return above cash risk-free interest rates in this report.

Individual country excess returns

Bridgewater looks at passive, buy-and-hold investing in equities of the big five powers at the start of the 20th century. Germany, France, Russia, the U.K., and the U.S.

• Most of us know that the 1900- period that followed was the best for U.S. stocks. The U.S. won great success with its economic model and capital markets. Plus its domestic economy was better isolated from two world wars.

• Public equity investors in Russia were wiped out in the revolution.

• German equity investors lost decades around the two world wars. Interestingly, German post-war capitalism has been very successful. So successful that German excess returns including the wars have already surpassed France’s and almost caught up with the U.K.’s. Both were on the “winning” side in both world wars that Germany lost. (Some argue that war has no real winners.)

“Global” excess returns

Bridgewater compares with a passive, equal-weighted “global” strategy of 20% each in Germany, France, Russia, the U.K., and the U.S. Bridgewater rebalanced this allocation every year. This means selling down the previous year’s winning countries to buy more of the losers.

• This simple mechanical strategy showed excess returns of almost as much as the U.S. from 1900. Despite allocating 20% to Russia and 20% to Germany.

1900-early 2019 Draw-downs

As long-term fundamental investors, a risk we care about is permanent loss of capital. The first step to permanent loss is experiencing long-lasting and deep portfolio-level draw-downs. A draw-down is just a period of cumulative negative returns. More concretely, a percentage loss from a portfolio's peak value to its following trough.

Individual country versus global draw-downs

Here Bridgewater’s comparison gets even more interesting.

• The equal-weight five-country “global” portfolio’s worst excess return draw-down? -66% in USD, during the 1929–1932 global Great Depression. Within 13 years this was recovered and the global strategy advanced higher (post-WWII).

The big five 1900 countries all did worse, in terms of worst draw-down:

• Russia of course lost all. A terminal -100%.

• Germany from WWI lost -99% during a draw-down that lasted for 47 years(!).

• The U.S. lost -85% during the Great Depression, which took 16 years to recover. So compared to the global strategy’s worst drawdown, U.S.-only investors would see their equities drop an extra more than half. Compared to an allocation with both WWI & WWII Germany and the Russian revolution.

• France’s worst -83% started towards the end of WWII. Recovery took 15 years.

• The U.K. fared “best” and still lost -72% during the 1970s inflation.

Bridgewater then expands the data by including more major country stock markets, as they become available for each decade.

• Since 1900 no single major stock market has yet shown a milder worst drawn down than the global equal-weight portfolio. Switzerland, with data from 1966, was closest with a 51% draw-down during the 2007–2009 Global Financial crisis. The global strategy’s worst was -49% during the same period.

PiggyBack Takeaways

Stock markets are conduits for allocating capital and public investment access. This was true in very different times and places during the 20th and early 21st centuries.

Bridgewater’s study highlights how national stock markets see very different fates. Some geographic economic and political outlooks are reasonably predictable near term. Most are very unpredictable far out into the future. By diversifying across regions and countries, investors reduce the impact of macro uncertainties. Without sacrificing much, if anything, in long-term expected returns.

An extreme, yet not uncommon example would be major wars or political revolutions:

• Around such events, some investor groups risk getting labeled “enemies”. Of a state, the revolution, or some other political interest group. Right or wrong, this opens up asset confiscation.

• The practical reality is that someone’s investment can be withheld or handed over to someone else permanently. Then stock index averages no longer reflect that first investor’s experience. By diversifying, we reduce this and other binary “terminal zero” risks down the road. However unlikely they may seem today.

We should not assume our future in the 21st century as an extrapolation of the last decades, or the 20th century. History is full of civilizations once successful in trade, science, innovation, or politics. Most eventually lose track and waste their advantages.

One-way bets on a single dominant or emerging world power at the start of the 20th century had a foolish risk-reward. The same is true today.

To balance, diversifying to every geography might be infeasible or inadvisable. Most investors have constraints on where they are allowed, or willing, to invest:

• Some constraints are self-imposed. We may reason that we lack enough insight into regional, national, or local affairs. Or that we believe to understand an unattractive risk-reward of a specific market. For example, a lack of accounting transparency, weak minority protection, widespread insider graft, or politically controlled companies. Investors’ personal beliefs against political regimes can put whole stock markets out of the question. (With merit some would argue.)

• In other cases, we lack access to invest at reasonable terms. This could be due to a lack of resources or regulatory hurdles. For example, foreign controls or punitive taxation make international investing impractical or unattractive. Such issues may involve both the investment destination if we are foreigners. But also our home country, if we are unlucky.

• Managing the money of others usually comes with formal mandate restrictions.

Investing under constraints is like fishing in a smaller pond. Nothing wrong with this, since we should know “our” pond better for the time being. But we should be aware that we are missing out on the free lunch of global diversification.

The Global Stock-Picker

OK, so we should diversify globally within our constraints if investing passively. What does that have to do with active value investing? (For primer see Value Investing 101.)

As active investors, we by definition tilt away from our benchmark. We think that we are smarter than “lazy” passive market cap-weights (which is harder in practice than it sounds). Smarter than the discussed simple trick of equal-weights (even harder).

So we start picking the best stocks using our fundamental value-investing methods. Wouldn’t we then want to explore the widest possible universe of investable stocks? One that we could at least partly understand if we are willing to study a little?

John Templeton

One investor who did just that was the U.S.-born British mutual fund manager John Templeton (1912–2008). His specific methodologies we have to return to, as they cover several case studies. In meantime, see this overview by Broken Leg Investing.

For this article, we will only showcase Templeton as an early pioneer in using his mutual funds to explore equity markets far outside any U.S. home bias. He invested in some at the time very exotic equity markets. Like post-war Japan in the 1950s. Imagine investing in one of your home country’s top war enemies within a decade or so. Takes some forward-looking perspective.

So Templeton had this contrarian, exploratory global investing streak. But he went even more contrarian in adding the value-investing mindset that we are piggybacking.

Skilled in both stock picking and portfolio management this contrarian global value style allowed Templeton Growth Fund (ticker TEPLX) to widely outpace the “home” U.S. market. When Templeton managed this fund from 1954 to 1992 he compounded investor returns at more than 15% after fees. An exceptional, long track record.

PiggyBack Takeaways

Within our investment constraints, we may search for attractive opportunities in new waters. With an open mind we may ask ourselves:

1. After hearing just a little about some “exotic” investment, does it make common sense to us?

2. Can we understand and accept the practical reality of the terms under which we invest? (Which may be very different from what we are used to “at home”.)

3. Does valuation support the idea? We may compensate for our limited geographical knowledge by requiring a larger margin of safety. (Deeper discount between entry price and valuation, or more conservative assumptions.)

The result may be good risk-reward investments where we learn more about the world. Seemingly “scary” macro may sometimes be more a function of our bias, prejudice, and lack of knowledge, than a reflection of reality. And even correctly judged macro risks will, to some extent, cancel out if the countries and regions selected are not tightly connected.

It takes experience to learn new rules of the game. So start. Opportunities await.

Disclaimer: This publication and related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, see the following link.

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“We can expect to see more use of disguised payout reductions as business struggles with the problem of real capital accumulation. But throttling back shareholders somewhat will not entirely solve the problem. A combination of 7 percent inflation and 12 percent returns will reduce the stream of corporate capital available to finance real growth.”

— Warren Buffett, “How Inflation Swindles the Equity Investor”, Fortune, May 1977

The above 1977 quote from U.S. value investor and businessman Warren Buffett is relevant again today, June 2022:

1. For 10+ USD billion market capitalization stocks the current global median trailing Return on Common Equity (ROE) is around 13%. According to TIKR.

2. Official consumer price inflation (CPI) is running hot. Above 9% for the OECD countries in the trailing data as of April 2022. (Or above 6%, if we exclude food and energy. For people who do not eat, transport, power/heat/cool or produce.)

Western central banks' decade of aggressive money printing created strong asset price inflation. Add handout checks and tax relief (fiscal stimulus) and supply issues in the recent pandemic. Inflation has now found its way into real economy prices and wages. With a recession long overdue, Western economies now face threats of stagflation.

Stagflation

When price inflation (expectations) rises at the same time as economic growth (real GDP) slows. Often accompanied by recession and increased unemployment. Especially if central banks raise interest rates to regain inflation control.

Selected stagflation effects

1 Consumption: With stagflation real (after-inflation) disposable (after-tax) household income can stagnate or shrink. Living expenses simply rise faster than income from working. Discretionary spending is postponed when job security and access to credit become more insecure.

2 Corporate investment: Demand is reduced and input costs rise. Companies respond by cutting costs and raising prices. Capacity investments are postponed. Shoring up liquidity and keeping access to credit is the priority.

3 Bond investments: Extended periods of stagflation means lost purchasing power for fixed-coupon bonds. Coupons and repayments over such bonds' holding periods will buy less future consumption. To add, higher interest rates cause immediate (mark-to-market) losses on long-maturity* bonds.

4 Stock investments: For most stocks, stagflation is also bad:

• Reinvestment costs: Operating companies face reinvestment cost increases. For most of them, these increases can not be covered fully by raising prices (without losing sales volumes). Accounting profit margins may still look OK, especially if the companies postpone reinvestment. But wear-and-tear forces businesses to eventually replace assets at inflated prices.

• Valuation headwind: Cost of capital soars with rising interest rates. This means lower earnings multiples. Like long-duration bonds, the highest valuation stocks face more mark-to-market loss risk on interest rate increases.

• Distress risk: Low margin, reinvestment needs, poor pricing power, and a lot of short-term debt. Such businesses quickly face serious credit risks in a stagflation scenario. If not priced at a discount, the equity risk-reward is poor.

(* Technically long duration, a measure for how long into the future we expect the bulk of an investment’s future cash-flows to arrive.

Where now?

How about (1) low-multiple stocks? In (2) trading and financing centers for (3) commodities, (4) goods, and (5) infrastructure? Not a bad combination for trying to keep up with stagflation.

In this week’s first PiggyBack Letter (PBL) we piggyback Warren Buffett’s insurance conglomerate, Berkshire Hathaway. From Berkshire’s Omaha, Nebraska across the Pacific. We study Japanese trading houses, a niche industry theme still in play.

Where next?

1. At the end of this week, there will be another PBL.

2. During July Your Analyst provides summer reading-type posts.

3. In August we are back with PBL while preparing actionable research.

Summer greetings from Sweden to all Piggyback readers!

Johan Eklund, CFA
PiggyBack

Disclosure: At the time of publication the author or associated entities held long positions in common shares of Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo.

Affiliate Marketing: This article section contains affiliate marketing links, labeled “(paid link)".

Berkshire's 2019– Bet On Japan Inc

The Trade

It was August 31, 2020. U.S. value investor and businessman Warren Buffett’s insurance conglomerate Berkshire Hathaway [U.S. ticker NYSE: BRK BRKA BRK.A BRKB BRK.B] sent out a press release. The heading may have surprised U.S.-focused Berkshire-watchers:

“Berkshire Hathaway acquires 5% passive stakes in each of five leading Japanese trading companies”

The concise release went on:

1. Berkshire had acquired stakes in Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo. Via regular share purchases on the Tokyo Stock Exchange over “approximately” 12 months.

2. The slightly over 5% outstanding shares stakes were “long-term”.

3. Berkshire may increase its holdings up to a maximum of 9.9% of shares in any of the five houses. Buffett pledged to seek board approval from the trading houses before purchases beyond 9.9%.

“I am delighted to have Berkshire Hathaway participate in the future of Japan and the five companies we have chosen for investment. The five major trading companies have many joint ventures throughout the world and are likely to have more of these partnerships. I hope that in the future there may be opportunities of mutual benefit.”

— Warren Buffett, chairman and CEO of Berkshire Hathaway, in a short comment to the August 31, 2020 press release on Berkshire’s share purchases in five Japanese trading houses Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo

The trading houses' stock returns before Berkshire’s release were weak. In early 1992 the Japanese bubble economy was deflating after the 1980s. From then the shares produced mean and median total returns of 3% per year (CAGR) over the nearly three decades until August 2020. Even in a low inflation, Japanese yen world such low returns do not compensate for equity risk.

Fundamentals

Now securities returns and fundamentals can be very different, even over decades.

Sogo Shosha = General Trading House

Japan’s export-led modern economy has historically relied heavily on trading houses. These traders set up and managed ever-growing portfolios of international export-import relationships for the Japanese business and government economy. In doing so they ended up becoming power centers in large, interconnected industrial groups.
(For background, see for example Robert W. Dziubla, International Trading Companies: Building on the Japanese Model, 4 Nw. J. Int'l L. & Bus. 422 (1982))

Sogo shosha are larger, more diversified trading houses. Gradually they are adding more trading, logistics, project financing, and investments far outside Japan.

Note: Japanese Cross-Ownership

Large Japanese keiretsu business groups share brands, such as Mitsubishi. There can be multiple parent, subsidiary, and affiliated companies that are interlocked but still have independent listings on stock exchanges.

1. Always consider how the group’s cross-shareholdings and ownership control structures can benefit or disadvantage the specific company being analyzed.

2. Be careful not to mix up companies when looking up stock tickers.

A brief intro to the “big five” that Berkshire invested in, in alphabetical order:

1 Itochu [Tokyo ticker TYO:8001, U.S. OTC ADR*: ITOCY]

Itochu dates back to 1858 (incorporated 1949) and currently operates in 60+ countries. Its concise business description of current trading and financing activities:

“ITOCHU is involved in domestic trading, import/export, and overseas trading of various products such as textile, machinery, metals, minerals, energy, chemicals, food, general products, realty, information and communications technology, and finance, as well as business investment in Japan and overseas.”

2 Marubeni Corporation [TYO:8002, U.S. OTC ADR*: MARUY]

Marubeni spun out of Itochu in the early 1900s, recombined with Itochu during WWII, and returned as a separate trading company again in 1949. Like Itochu, the group is active in 60+ countries with extremely diversified activities:

“Marubeni… conduct importing and exporting (including third country trading), as well as domestic business, … across wide-ranging fields including lifestyle, ICT business & logistics, food, agri business, forest products, chemicals, metals & mineral resources, energy, power, infrastructure project, aerospace & ship, finance, leasing & real estate business, construction, industrial machinery & mobility, next generation business development and next generation corporate development. Additionally, the Marubeni Group offers a variety of services, makes internal and external investments, and is involved in resource development.”

3 Mitsubishi Corporation [TYO:8058, U.S. OTC ADR*: MTSUY]

One of three large listed parent companies in the Mitsubishi industrial group, dating back to the 1860s. The others include Mitsubishi Heavy Industries, which controls the Mitsubishi Motors car brand. And Mitsubishi UFJ Financial Group, Japan’s largest banking group.

As a trading house Mitsubishi Corporation (“Mitsubishi”) is active in around 90 countries. It runs a wide range of activities:

“Natural Gas, Industrial Materials, Petroleum & Chemicals Solution, Mineral Resources, Industrial Infrastructure, Automotive & Mobility, Food Industry, Consumer Industry, Power Solution and Urban Development… MC’s current activities have expanded far beyond its traditional trading operations to include project development, production and manufacturing operations.”

4 Mitsui & Co [TYO:8031, U.S. OTC ADR*: MITSY]

The large Mitsui industrial group’s origins date back to the 1600s. After WWII Mitsui & Co (“Mitsui”) was incorporated in 1947 as the major trading house of the group. Mitsui is active in over 60 countries and, as readers expect by now, diversified:

“We are multilaterally pursuing business that ranges from product sales, worldwide logistics and financing, through to the development of major international infrastructure and other projects in the following fields: Mineral & Metal Resources, Energy, Infrastructure Projects, Mobility, Chemicals, Iron & Steel Products, Food, Food & Retail Management, Wellness, IT & Communication Business, Corporate Development Business.”

5 Sumitomo Corporation [TYO:8053, U.S. OTC ADR*: SSUMY]

The Sumitomo industrial group’s origins date back to the 1600s as well. Sumitomo Corporation (“Sumitomo”) was incorporated in 1919 and is active in 60+ countries.

Sumitomo currently has six “Business Fields”:

1. Metal Products

2. Transportation & Construction Systems

3. Infrastructure

4. Media & Digital

5. Living Related & Real Estate

6. Mineral Resources, Energy, Chemical & Electronics

Plus one “Next-Generation Business” in Energy Innovation.

(* Liquidity for ADRs varies, all readers should do their due diligence.)

Shareholder Value Creation

As businesses, trading houses are very exposed to the physical trading of commodities and goods. This makes them cyclical.

The next chart shows Return on Common Equity (ROE). Trading houses generated mid-teens % median ROE in the early 2000s commodities bull market. Despite structural issues in Japan’s economy. In the 2010s commodity bear market, profitability dropped. Most trading houses were pressured to a low single-digit % ROE trough in 2016. Berkshire bought after a 2017–2018 recovery, into the 2020 global pandemic.

Under the hood of the ROE, a promising trend is that the trading houses have deleveraged. In the 15 or so years before Berkshire bought shares, the Equity-to-Assets (E/A) more than doubled. From 16% median E/A in 2005 to 34% median 2020.

What is happening is a shift of focus. From the asset-intensive, high competition, lower margin physical trading the trading houses are reinvesting more in higher-return, higher-risk investing. To balance the investment risks the trading houses are decreasing their debt loads. Instead, investments can use more external project financing and partner capital**. This increases the capital efficiency of the trading houses. If investment returns and risk management work out.
(** Infrastructure can be financed with long-term, secured project debt. The lenders tend not to get recourse beyond the investment asset. This helps investors diversify over high-risk projects with controlled downside risk.)

The after-tax Return on Total Assets (ROA) remains low and shows cyclicality with commodities. If the investment strategies succeed, the ROA should increase over time.

Berkshire’s Opportunistic Value Timing

So the underlying value creation seems OK and is possibly changing for the better. What about the stock market valuation?

The next chart shows Price-to-Tangible Book Value (P/TBV) multiples. Trading houses traded at median premiums of more than double tangible book value (P/TBV > 2) in the early 2000s. The last big commodity bull market.

The mid-2010s commodities bear market pushed median P/TBV down to P/TBV 0.6–0.7x. A one-third discount on tangible book value. While Berkshire started buying at smaller 2019 discounts, the 2020 pandemic cheapened the price for part of its stake.

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Performance to Date

So how has Buffett & Co's signal done so far, one year and ten months after Berkshire's positions were disclosed?

1. Stock Returns: Not bad, with above 25% median and mean total returns per year (CAGR). See chart below.

2. Fundamentals: More important, the trading houses have benefited as expected from pandemic supply constraints and initial waves of commodities inflation. The deleveraging has continued. See Charts 3 and 4.

3. Valuation: A quick revaluation to tangible book premiums followed Buffett's investment in 2021. As of June 2022, the median trading house is now back to trading around tangible book value. So the investor gets any “hidden” longer-term values in these power centers “for free”. See Chart 5.

   (And for a Background on value metrics, see PiggyBack’s Shades of Value).

PiggyBack Takeaways

Our piggybacking of Warren Buffett’s Berkshire Hathaway into Japanese trading houses can teach us many things.

From a general value investor perspective:

1 Commodity Inflation Tollbooths

Trading businesses take a percentage toll on economic activity. This is less inflation-sensitive than production. A trading operation enjoying enough competitive advantage should be able to protect its gross margin. It also has less maintenance reinvestment to cover at inflated costs.

In this case, much of the trading is in physical commodities and other necessary input goods. Here we move beyond inflation insensitive, to inflation protection. Or even to inflation-winner positions. Inflation gains for any commodity segment are unpredictably lumpy, like call options. Trading houses own portfolios of options.

2 Infrastructure Private Equity

Japanese sogo shoshas are not only powerful traders. They also mobilize large amounts of risk capital into long-term physical project investments. From a Western perspective, this makes their equities a private equity investment hybrid.

3 Global Diversification

Some of us might be even more U.S.-focused than the global stock market indices. With the trading houses, Buffett got domestic Japanese and global diversification to “home” market macro risks, in Berkshire’s case the U.S.

Major regional stock markets, like Tokyo, may also widen our opportunity set. The U.S. stock market of 2019–2020 may not have offered large-scale, low-valuation opportunities in similar businesses.

In addition, Berkshire has their own, investor-specific benefits from this position:

1 Macro Bet/Hedge

Berkshire has raised bonds in Japanese yen. A lot of them. As of Q1 2022, the conglomerate had 7.5 USD billion equivalent of JPY bonds outstanding. With maturities 2023–2060 and weighted average interest rates of only 0.6%.

Recall that long-duration bonds are likely inflation losers for an investor (the creditor). As a borrower (the debtor) Berkshire profits if inflation reduces the real value of future bond payments. Use bonds to finance potential inflation-winner stocks. Result? Inflation profit potential, on both the balance sheet’s asset and liability sides.

Currency-wise, the stock position also hedges JPY exposure. Borrowing JPY, by issuing bonds, to reinvest in JPY stocks limits the net exposure to JPY.

2 Future Collaborations(?)

Buffett hints at potential future collaborations in the trading house press release. His U.S. insurance conglomerate and the Japanese trading house conglomerates. Shared aspects include (1) permanent capital, (2) international investing, and (3) industry expertise. Examples of the latter would include energy and infrastructure. While not yet concrete, Berkshire’s shareholdings could give a seat at the table for future deals.

To Be Continued

PiggyBack's future, premium research may offer opportunistic stock coverage on selected Japanese trading houses.

The business of moving, trading, and financing physical stuff is not going away soon.

Disclaimer: This publication and related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, see the following link.

Back PiggyBack(!)

Your Analyst sincerely hopes all readers enjoy and get inspiration and value investing ideas from PiggyBack. If so, consider sharing PiggyBack with friends and colleagues:

Share This Post

Share PiggyBack

Only with the help of early readers will this publication reach a sustainable scale for free, independent insights. Many thanks to all PiggyBackers!

Johan Eklund, CFA
PiggyBack

PS: Feel very free to (1) follow 📻, (2) share/tag 📢, and (3) discuss 💬 PiggyBack content, with us and others in relevant threads/groups/hashtags on these platforms:

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Readers new to value investing are recommended to also read the Value Investing 101 Background. Followed by Piggyback Investing (PBL #0 2022).

Your Analyst,

Johan Eklund, CFA
PiggyBack

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An Equity Value Toolbox

Equity = Assets - Liabilities

But what asset and liability values are we going to use? The answer as always: it depends on what we are going to use it for.

Below is a map of how different equity value metrics apply in different value situations. (If the chart becomes too tiny on a smartphone: Try flipping the screen to horizontal. Or revisit the article on a desktop or reading pad.)

Here is a summary of the equity metrics, listed from the most conservative:

Price/”Net-Net” Working Capital (P/NNWC)

“At their low price, these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.”
— Benjamin Graham and David L. Dodd on “net-net” stocks in Security Analysis (6th Edition, The McGraw-Hill Companies, 2009, p.570)

The “net-net” metric, as popularized by Benjamin Graham and David L. Dodd is a conservative liquidation value estimate. It is a quick way to ensure that we buy stocks for what is likely only a part of their value if they go into liquidation soon. And for much less than business value, if their businesses continue (as going concerns).

The net-net formula is straight-forward, but it comes with assumptions and conditions:

P/NNWC
= Market Capitalization / [[Cash + Short-Term Investments + Discount% x [Accounts Receivable + Inventory]] - [Total Liabilities*]]
= Share Price / [NNWC / # Shares Outstanding]

Assumptions: Only a few current assets are accepted as liquidity. Further, we are advised to set conservative discounts on accounts receivables and inventory values. Graham and Dodd used 0.75x receivables and 0.5x inventory for general situations.

Conditions: Graham and Dodd (Security Analysis, 6th Edition, p.570), required two more characteristics of the companies:

1. Cannot be at “apparent” risk of consuming (“dissipating”) these assets.

2. Must have “formerly shown a large earning power on the market price”. In other words, must have a history of profitability.

Pro: A diversified portfolio of net-nets is a good, aggressive mean reversion strategy offering some fundamental** downside protection in the liquidation value.
(** Not to mix up with price risk, or volatility, measures. See e.g. Alpha Architect for a critical review of the evidence.)

Con: The main issue is that there are few investable net-net:s in today’s more efficient markets. Mechanical screening may end up with many “melting ice cubes”, with cash-burn or contingencies that fail the quality conditions above. To find a set of decent-quality ones, we have to accept other risks. For example, investing in smaller market capitalization and/or in less efficient geographies. That makes net-nets a difficult main strategy for larger or restricted portfolios.

Price/Net Current Asset Value (P/NCAV)

P/NCAV
= Market Capitalization / [Current Assets - Total Liabilities*]
= Share Price / [NCAV / # Shares Outstanding]

A simpler but much less conservative liquidation proxy. In short: Your Analyst would advise against using NCAV as a standalone metric. Graham and Dodd described screening for (2/3) x NCAV stocks, but that is an arbitrary workaround.

Pro: Very fast and easy to calculate and use in screening.

Con: Not all current assets are likely worth 100% of their accounting book values in a liquidation. NCAV will include intangible current asset accounting items, such as prepaid expenses. These are most likely not worth their book values if operations are shut down suddenly. So not a good liquidation estimate. Nor is NCAV a good “asset play” metric, as it ignores marketable long-term assets, regardless of quality.

Price/Tangible Book (P/TBV)

P/TBV
= Market Capitalization / [[Total Assets - Intangible Assets] - Total Liabilities*]
= Share Price / [TBV / # Shares Outstanding]

Among widely available, unadjusted book value measures PiggyBack prefers P/TBV for quick screening of potential asset play-type stocks to analyze further.

Pro: Very fast and easy to calculate. Supported in many screeners. By ignoring intangible assets, TBV offers a partial solution to reality-distorting goodwill***.

Con: Susceptible to distortion by choice of accounting policies and accounting assumptions (other than goodwill).

Price/Book (P/B or P/BV)

P/B
= Market Capitalization / [Total Assets - Total Liabilities*]
= Share Price / [BV / # Shares Outstanding]

As discussed in Below Book - Part 1: Pull To Average (PBL #1 2022), P/B is the go-to equity book value in academic literature.

Pro: Very fast and easy to calculate and use in screening. Widely available in not only equity databases but also longer-term historical data series. Easy to relate to accounting earnings multiples (P/E) and popular valuation models.

Con: Very susceptible to distortion by accounting rules, including goodwill***.

Accounting sets rules-based records, not maps of reason

Accounting provides rules-based and backward-looking records. As equity investors, we make great use of this information as model input. Often accounting analysis may also provide early hints of significant risks or opportunities.

But accountants do not help us in assessing an investment's economic returns. That is a return above the investment's cost of capital. Neither do accounting book values offer precise estimates of intrinsic value.

To move beyond screening, we must collect more information and make forward-looking assessments. In other words, draw useful maps of what is likely to happen next. In future analysis, PiggyBack will combine historical data checks with forward-looking assumptions. We do so to become more confident of the intrinsic value on balance sheets, but also from earnings power and franchise growth value beyond this.

The distinction of screening versus valuation is made much more clear by Aswath Damodaran, Professor of Finance in a recent Aswath Damodaran - Making Sense of the Market episode on the Invest Like The Best podcast:

“When is the last time you actually valued a company? And don’t tell me you buy companies at low P/E ratios and high dividends or whatever it is. That is not valuing the company, that’s just running screens. Maybe one in a hundred actually values companies… They say they don’t value companies because they don’t like to make assumptions. What? Investing is a set of assumptions. The fact that you are using past data does not mean you are not making assumptions, it just means you are not making assumptions explicitly.”

— Aswath Damodaran, Professor of Finance, in the recent episode Aswath Damodaran - Making Sense of the Market on the Invest Like The Best podcast

Read Musings on Markets: PiggyBack views Mr. Damodaran as a great teacher, thinker, and resource in the world of valuation and markets. Follow some of Damodaran’s great work on his (still underfollowed) Substack at:

Price / Reproduction Value

Reproduction values/costs attempt to explain the cost for competitors to hypothetically recreate a company's current assets in place.

Usually, this assessment is a matter of collecting reasonable market valuation price points. Like appraisals or recent market transactions for the assets in question. It may also be abstract, like imagining an invisible Research and Development (R&D) “asset” based on R&D expense. (Technically: capitalizing R&D on the balance sheet.)

From our equity investor perspective, reproduction values may involve liability adjustments as well. (As the value of liabilities affects our residual equity value.) For example, the reproduction values of debt-levered companies are extra sensitive to the market value of debt. If interest rates or the credit market (credit risk premiums) change significantly, we can adjust the value of debt.

Pro: In complex capital structures, reproduction values may highlight “hidden” values.

Con: Compared to accounting metrics, this process may require considerable effort in sourcing data. Despite this, reproduction values are not complete fundamental valuation frameworks. They lack forward-looking assumptions and important return on capital to cost of capital links. So for operating businesses, consider using some NAV valuation framework instead. (For complex structures Sum Of The Parts, SOTP, can combine reproduction values with forward-looking assumptions.)

Price/Net Asset Value (NAV)

NAV:s are the outputs of doing a complete valuation with some explicit assumptions.

The Net Asset Value (NAV) is the output of fundamental valuation models that:

1. Use forward-looking assumptions to forecast fundamentals such as cash flows, dividends, or investment returns.

2. Discount the forecast fundamentals' Net Present Value, NPV, using some appropriate cost of capital.

3. Add/deduct NPV:s of relevant balance sheet items not captured by the forecast NPV. Arrive at the NAV.

Pro: Combine a consistent valuation framework with reasonable assumptions that capture risk-reward. Then NAV is our intrinsic value estimate for the investment.

Con: Valuation work is a much more time- and resource-consuming process than pricing stocks based on relative criteria. Nor is it just applying some quantitative filter (like a P/TBV discount screen). So investors must focus their valuation efforts or their acquisition of research. Preferably to situations or themes that they (1) have reason to believe are mispriced, (2) already have committed to, or (3) wish to learn more about.

“It is better to be vaguely right than exactly wrong.” — Carveth Read

Caveat 1: Valuation does not necessarily mean extremely complex or large models. Nor does it mean including the most information or establishing the closest insider access. What such factors will produce is a highly detailed analysis. But beware that if it lacks common sense and probabilistic thinking, it may also be a very biased analysis.

Caveat 2: Without reasonable assumptions, a valuation model is just a mechanical framework. It can be corrupted to arrive at basically any NAV “needed”. If we notice serious conflicts of interest and a lack of research independence, we can still study such analysis. But we do so for business or sector insights. Not for using its valuations.

Beyond Value

Ventures

Venture investments are an interesting special category of high-flying investments. In stock markets, they tend to be found among micro and small caps and in technological industries. This technology- or business innovation-driven investments are usually early-stage and explosive growth. They have some low-probability shot at becoming competitive future industry leaders. At least that is the story they all must tell to raise their capital needs.

Ventures are more like innovative equity options than operating businesses. We do not use our value-investing tools here. Instead, we need venture financing analysis, with more focus on entrepreneurs and innovation. Few value investors specialize in this. But we will find ventures on the books of listed corporations and holding companies. So it is good to understand that they have their playbook and that they may, possibly, be worth more than the average extremely high multiple stocks.

“Fair” Market Folly

Market prices for liquid securities are set where demand meets supply for the day. This pricing has nothing to do with long-term fundamentals or valuation.

Pricing is the basis for the accounting concept of fair market value, as long as the parties are knowledgeable and not forced traders. Appraisal in for example real estate is asset-based market pricing. Neither reflects intrinsic value, in taking into account the cost of capital versus forward-looking assumptions.

Pricing without valuation also means that we allow any level of short-run overvaluation. Eventually, we can no longer value an investment based on common-sense fundamental assumptions. By then, most participants chase price momentum or throw around loose relative multiples. (The “my-laser-eyed-golden-skin-ape-picture-is-worth-at-least-twice-your-diamond-skin-ape-picture” type of reasoning.)

Other practitioners and promoters will still use valuation, like a discounted cash flow model. But study those “valuations” carefully, as they often rely on very aggressive implicit key assumptions.

Sometimes we are proven wrong. Some speculative investment themes materialize into strong fundamentals, that grow into their prices. But as we have discussed before, the highest valuation "glamour" part of the stock market tends to underperform over cycles. Markets get overconfident and overvalue shiny, popular objects of their day.

Multiples of hundreds of times earnings, or worse revenue, call for extreme success. This should not be accepted as likely based on just “this time is different” storytelling. Then we are just speculating to sell even higher to some Greater Fool, a very different game from valuing speculative investments.

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* Technical Note: Exclude Other Equity

When we calculate common equity to the shareholders of a parent company we also exclude:

1. Preferred Equity and other equity-classified instruments that are senior to the common equity.

2. Minority Interest in the common equity.

*** Technical Note: Goodwill

One accounting concept that makes financial statements difficult to accept at face value today is goodwill.

Major frameworks like IFRS (International Financial Reporting Standards) and various national GAAP (Generally Accepted Accounting Principles) treat goodwill weirdly.

The core of the problem: major intangible values that are built up in businesses over time. For example brands and customer loyalty do not show up on the balance sheet. Instead, we notice them as some businesses stay more competitive in their industry.

While goodwill is linked to such intangibles in theory, it is not in practice. What the instead is limited to doing (and distorting) is mergers and acquisitions. Here is an example:

1. Say acquiring company A today buys another target company T for 100 units of currency in cash.

2. A then has its accountants revalue all the (identifiable) assets and liabilities on T’s balance sheet. Only to find that the equity value purchased was only 50 units of currency.

3. A’s remaining 50 units of acquisition payment that the accountants would not allow to be covered by acquired T assets is then balanced. This is done by just adding an imaginary “goodwill” asset of 50 units of value on acquirer A’s balance sheet.

4. For 100 units of cash paid acquirer A got T’s business with assets valued at 50 units plus 50 units of made-up goodwill. Goodwill is then rolled forward by A. This continues as long as A’s accountants regularly sign off on the assumption that the goodwill is intact (usually the case right until it is painfully evident that an acquisition strategy has destroyed value).

The result: Acquisition strategy companies will over time get balance sheets where the book value gets more dominated by goodwill. This distorts many financial ratios based on the balance sheet. In the years there are write-downs it also distorts accounting earnings and their input into financial ratios.

For fairer comparisons across companies and cleaner metrics over time, the easiest quick fix is to exclude goodwill as needed.

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

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At a glance, this large-cap stock trades at a Price-to-Tangible Book Value (P/TBV) of around 0.6x (a discount of 40%). While having a decent backward-looking Return on Common Equity (ROE) of around 9.5%.

So we are looking at some sort of likely asset value play, that the market has lost its forward-looking belief in. In this “dot’s” U.S. home equity market most other large/mega-caps from various sectors trade at major premiums to TBV. (Or have negative accounting equity.)

Now, what if this “dot” is the most recent major new stock buy of the world’s most famous and followed value investor. And what if this investor happens to have invested with success for decades in the “dot’s” sector. Coincidence?

The “C” NYSE stock ticker represents the banking heavyweight Citigroup [U.S. ticker NYSE: ]. The very proven capital allocator who bought in is the insurance conglomerate Berkshire Hathaway [U.S. ticker NYSE: BRK BRKA BRK.A BRKB BRK.B], led by U.S. investor Warren Buffett.

Berkshire discloses its public shares positions with some delay. With Citigroup, this was around three weeks ago. During the first quarter, Berkshire bought 2.8% of all shares outstanding in Citigroup. This represents becoming the banking group’s fourth-largest owner on file. It also represents around 0.8% of Berkshire’s equity portfolio, according to TIKR Terminal.

Affiliate Marketing: This article contains affiliate marketing links, labeled “(paid link)".

Studying Buffett Does Not Make Us Berkshire

Berkshire is likely to make its significant stock picks in the S&P 500 large/mega-cap universe. This is natural for a U.S.-based insurance behemoth in need of writing large investment checks for the long run.

For our small band of PiggyBackers, the average capital we invest is not yet as prohibitive in size as Mr. Buffett’s. Nor are we all U.S.-focused. We all have our different biases, preferences, and mandates when it comes to geographies and sectors.

That said, Citigroup and other large-cap U.S. Financials* could very well offer attractive current risk rewards. Even from a global, non-constrained perspective. Those of us who have not already done should so should consider analyzing the space. (* The alert reader may have noticed: a majority of Chart 2's TBV discounts in the S&P 500 are well-known U.S. financial names.)

Where now?

The recent Part 1 of our introduction to “cheap” asset discount value stocks focused on how and why simple book value discount stocks (0 < P/B < 1) get a statistical edge.

This Part 2 of 2 is less economics and more practical, as we practically show how to quickly screen out asset discount candidate lists for further research.

Where next?

We will shortly follow up with a Background overview of commonly used equity metrics. Further introducing our newer investor readers to more value investing concepts and terminology makes PiggyBack and similar publications easier to follow. The Background also includes a conceptual map of the types of cases that PiggyBack’s future single-stock research will feature.

Greetings from the West Coast of Sweden and thanks for reading!

Johan Eklund, CFA
PiggyBack

PiggyBack Promotes: TIKR Terminal

Supercharge your single stock investing with a powerful, yet light Equity Research terminal. TIKR Terminal provides professional and do-it-yourself investors with global, well-laid-out fundamental company overviews. In a fast, easy-to-use, and reasonably priced web app. Think of it as your 24/7, first-look analyst.

The TIKR Terminal (paid link)

Screening For Global Asset Discounts (June 2022)

Screening filters a broader investment universe down to a specific characteristic subset. Think of this as choosing and traveling to a promising fishing site. We do so based on previous experience, some new ideas, and our trusted equipment. The actual "fishing" is the analysis and valuation of found investments that follow.

We quickly screen asset discount value candidates using fundamental stock databases. Preferably the ones with high-quality data, broad coverage, and clear presentation. Breadth can be both the number and types of markets and investments supported. But it may also be in the mix of useful data points and metrics per investment.

For this exercise, PiggyBack employs TIKR Terminal (paid link), a high-quality, global-coverage, easy-to-use fundamental screener. To make the process clear we add filters in steps.

Filter 1 - Discount Valuation Metric

Say we want to explore the current, June 15, 2022, asset discount universe. Then we start with an asset discount valuation metric.

Based on the accounting Book Value discount (0 < P/B < 1), discussed in Part 1, TIKR currently shows 13,700 such stocks*. This is 20% of its global coverage of 67,500 securities.
(* = We exclude two primary exchanges “ARCA” and “NasdaqGM” to exclude exchange-traded funds, ETF:s. We also exclude stocks with market capitalization below 5 USD million, as these are less investable and may have less reliable data.)

We color highlight Table 2 to make a point. If only looking at the green-marked P/B (“Trailing P/BVPS LTM”), we see a non-skewed distribution (mean average is close to median) of asset discount stocks. While technically correct, there is a major accounting input problem with the P/B:s: goodwill.

The rightmost, stricter “P/Tangible BVPS LTM” (P/TBV) tangible book value leaves out goodwill. It shows a similar median value, but heavy skew to the upside. No need for detailed statistics: The yellow-marked mean P/TBV is at a 50% premium while the mean P/B is at a 40% discount. And there are negative TBV stocks in the P/B discount set (with no tangible equity on their balance sheets).

The Background on value metrics will make this clearer to all readers. Here is only a short motivation why P/TBV discounts are more useful screens than P/B discounts:

Tangible Book Values strips out all intangible assets from the accounting equity book value. The main benefit of this is that modern goodwill accounting does create a lot of thin air in the books of acquisition-focused companies. We do not accept paying up for goodwill as a fundamental asset.

Other types of accounting intangible asset book values (for example for capitalized development) will seldom be accurate market value proxies. Neither are they as common as the "goodwill problem". So when early screening for value cases, we can accept such assets as “included for free”. These are sometimes patents, copyrights, and brands that could be sold off or licensed for royalties. Our following analysis could catch some of these more rare cases.

So we re-screen using tangible book discounts (0 < P/TBV < 1):

The P/TBV discounts have a similar, non-skewed distribution (mean close to the median). There are 11,800 P/TBV discount stocks, or over 17% of the global universe, only slighter smaller than the P/B version. More important, it is more conservative and useful for screening asset play-type value cases (and even the odd liquidation).

Filter 2A - Geography & Size

Geography and market capitalization “size” are practical and behavioral constraints to many, if not most, investors. So let's use that as our next set of filters.

A series of geography and size combination screens can quickly map out where we currently find the almost 12,000 global discount stock candidates:

Depending on the quality of the above situations, including accounting, all regions offer bargain-hunting opportunities. As expected, the number of tangible book value discount opportunities increases as we go down in market cap size (due to generally higher cost of capital for smaller companies).

Number of opportunities

Asia / Pacific markets offer the most P/TBV discount stocks currently, followed by Europe, then the United States & Canada. In the "Large" market cap segment, the U.S. & Canada discount opportunity set is tiny compared to Asia's, and considerably smaller than Europe's.

Latin America & Caribbean and Africa Middle / Middle East (Other) may have more emerging or frontier market type macro risks. But for our readers with decent access and willingness, these smaller sets of discount stocks are worth checking out.

Level of TBV discount and recent ROE

The median Return on Common Equity (ROE) is generally falling with size, as there are more loss-making smaller firms. This is clear in the low median ROEs of the “Micro” cap segment globally, and the "Small" market caps for Asia / Pacific and U.S. / Canada. Above those segments, the median ROEs are decent for most regions and segments.

The United States & Canada show a wide spread in discount stock ROE with size. The "Large" cap TBV discount stocks show a respectable 15%+ median ROE, and the "Mid's" a not bad 10%+. At the same time, the median U.S. / Canada "Micro" cap TBV discount stock is unprofitable.

Note:

• These are medians, so half of the discount stocks will be above and half below these ROE numbers.

• The ROEs are also backward-looking (TTM = trailing twelve months) for only the most recent period. Cyclicality shows up by studying a full economic cycle decade-long series (or similar).

• ROE is a function of both operations and financing. Further analysis is needed to control differences in earnings quality and risk (for example debt leverage).

• (Technical: Theoretically, we should adjust the ROEs somewhat higher for this dataset, as we look at tangible equity only with TBV. Return on Tangible Common Equity or similar would be more appropriate.)

Filter 2B - Sector

Another popular high-level screen is sectors or even specific industries. This ensures that stocks with somewhat similar economics are compared. Very useful, both for specialists and generalists.

Number of opportunities

The more or less cyclical Financials, Industrials, Consumer Discretionary, and Materials sectors offer the highest number of discount stocks globally.

Preceding analysis, expect quite a few “inflation-proof” businesses to show up in the Financials, Materials, Real Estate, and Energy spaces. On the downside, the brewing global recession creates shorter-term risks to both financial balance sheets and commodity market demand. A risk-reward balance is best sorted out on a segment-by-segment, stock-by-stock basis.

Level of TBV discount and recent ROE

Median discounts are somewhat deeper in the already mentioned Consumer Discretionary (median P/TBV 0.57x), but also in the more defensive Utilities sector (median P/TBV 0.56x).

The negative outlier is Healthcare, with somewhat lower median discounts despite showing considerable median losses on equity (median ROE -17%). Further analysis would confirm that the sector’s discount stocks are dominated by unprofitable, smaller pharma and biotech. These cash-burn, venture option businesses often* require a specialist analytical skill-set.
(* Some odd rare small pharmas/biotechs become “cash boxes” or royalty-holding companies, after winding-down in-house scientific research.)

Picking Our Pond(s)

By extending with more and more specific filters in an appropriate database, we can start our research with a candidate list that captures fundamental themes.

• Too wide and we probably lose focus, if the end goal is active value investing in specific ideas. That is studying businesses and financing, not just playing a quantitative fundamentals factor game (no shame in that).

• Too narrow and we risk not seeing the forest for the trees. We might catch random blips but miss strong general trends. We also risk missing nearby candidates with a bit less attractive standard metric optics. Some of those missed candidates would show to be better-positioned businesses by just a glance at the latest annual report or a Google search.

As value investors, we tend to relate fundamental characteristics—good, bad, or ugly—to valuation metrics.

At times those valuation metrics will become unattractive across whole markets. Then it becomes a matter of waiting or looking for better ponds.

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

Back PiggyBack(!)

Your Analyst sincerely hopes all readers enjoy and get inspiration and value investing ideas from PiggyBack. If so, consider sharing PiggyBack with friends and colleagues:

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Share PiggyBack

Only with the help of early readers will this publication reach a sustainable scale for free, independent insights. Many thanks to all PiggyBackers!

Johan Eklund, CFA
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After a long period of strong returns, the start of 2022 has been more turbulent for global stock markets. Around 20% of the stocks in TIKR Terminal's global universe are now trading for a book value discount:

Affiliate Marketing: This article contains affiliate marketing links, labeled “(paid link)".

Now buying “low” on a single valuation metric may seem like a too simple or outdated road to stock profits. Yet, investors in modern times before ours did well doing so, and for some good reasons.

This PiggyBack Letter (PBL) is first in a two-part intro to asset value discounts:

• In this Part 1, we focus on statistical, economic, and behavioral aspects. How and why can simple book value discount investing offer return outperformance? And what does this tell us about average investor and company behavior?

• Part 2 gets more practical. We will discuss some considerations when screening for asset discount cases to further research.

With this initial focus on conservative value, we are “piggybacking” on the modern value investing tradition as pioneered by Benjamin Graham and David L. Dodd. (Visit The Heilbrunn Center for Graham & Dodd Investing for more background.)

Your Analyst,

Johan Eklund, CFA
PiggyBack

PiggyBack Promotes: TIKR Terminal

Supercharge your single stock investing with a powerful, yet light Equity Research terminal. TIKR Terminal provides professional and do-it-yourself investors with global, well-laid-out fundamental company overviews. In a fast, easy-to-use, and reasonably priced web app. Think of it as your 24/7, first-look analyst.

The TIKR Terminal (paid link)

As easy as P/B < 1?

Deduct the value of liabilities from the value of assets and equity is what remains (the residual). A company's book value of equity, "B", is the latest accounting value of equity we can look up on its balance sheet. And a book value discount is simply when a listed stock price, "P", offers us to buy at a Price-to-Book multiple, P/B, below 1.

• In short notation: P/B < 1 or more correctly 0 < P/B < 1 (the left part filters out negative equity firms).

• Chart 1 below provides a basic illustration of a 50% book value discount.

Now, despite the simplicity, low P/B stocks have proven to be a positive return factor. We can get such factors by 1) sorting the stock market by rising P/B and 2) cutting it into equal size slices (quantiles).

Without getting all academic, returns are above the market average for the lowest P/B stocks. They are also below average for the highest P/B stocks. Buying the lowest and avoiding the highest P/B slices has been an outperforming strategy. Over a century of data supports this outperformance for U.S. stocks (1). For many other Western stock markets, there are several decades of support (2).

Note that P/B discounts are a special case of such low P/B stocks, in that we set an absolute upper bound of P/B 1. So if the relatively lowest P/B slices of the market drift "too high" in P/B, we will no longer invest in those stocks. In demanding some P/B discount, we make sure to only buy "cheap" stocks (in absolute terms).

Figure 13 of this 2016 article by Starcapital’s Norbert Keimling shows what returns followed after investing at various P/B:s. Large return outperformance (upward sloping dots, left) followed investing at P/B discounts (“cheap” stocks):

• The P/B discount local currency returns were 14% per year in real terms for the article's sample. So investors got these real returns plus the consumer price index (CPI) inflation.

• This finding was for stock positions held over long, 10-15 year, periods. The data covered Western stock markets over the years 1980 to early 2015.

(Interested readers should read the full article. Besides P/B, it focuses on cyclically-adjusted P/E-ratios, CAPE, a concept we may revisit.)

So in recent decades, a simple book value strategy produced twice the historical 6–7% real returns for U.S. stocks (see e.g. Straehl & Ibbotson (2017)).

Today, we look back at a decade of zero interest rates, rising valuations, and record corporate margins for many Western stock markets. It will not get much better than that for stocks. As fundamentals-aware practitioners, we should expect lower than historical returns going forward. See for example GMO (2022).

Now, for book value discounts and other value strategies the outlook is different. The most important thing to understand is that a margin of safety to fundamentals is its own long-term valuation tailwind. The macro risks to cyclical demand, interest rates, and inflation will vary case by case.

Why do book value discounts work?

“If you buy companies that are depressed because people don’t like them for various reasons, and things turn a little in your favor, you get a good deal of leverage.” — Walter Schloss (Forbes, August 15, 1973)

A former student and employee of Benjamin Graham, Walter Schloss later ran an investment partnership together with his son Edwin Schloss.

The Schlosses managed a diversified (and quite passive) strategy of statistically cheap U.S.-focused stocks. This compounded after-tax returns of almost 16% per year over 45 years for their investors. U.S. Large Cap stocks (the S&P 500 Index) compounded at 11% per year over the same period. Source: 47 Year Results of Walter and Edwin Schloss Associates, obtained via walterschloss.com

In PiggyBack’s recent background post we noted that value investors must make uncertain assumptions about the future. Without assumptions, we cannot value stocks.

In this letter, we have already hinted we can earn “value” factor returns by mere exposure to low backward-looking P/B multiples. Yet, this is not a paradox. We still commit capital to uncertain, long-term valuation assumptions. But we make those assumptions implicitly and smooth them by buying baskets of low P/B stocks.

Why this simple, low P/B “value” strategy works even as time changes is a matter of economics and human behavior.

Profitable is not always economical

To understand the investment economics of stocks, we can look to economic returns:

1. Shareholders are the owners of equity and profits of businesses. Thus they expect public companies to eventually start earning profits. Profits can be paid out as dividends now or reinvested to grow the equity (and be paid out in the future).

   • The accounting ratio of net profits over equity is the Return on Equity, ROE.

2. Shareholders as a group will seek to earn an economic return on their stocks. Economic returns are accounting returns minus a cost of capital. The latter compensates investors for exposing their capital to investment risks.

   • In the case of equity valuation, the cost of equity is the cost of capital that we compare to the ROE. This cost of equity is an invisible mix of the time value of money (interest) and risk premia. We set it by assumption or studies of the general stock market, and adjust it for business specifics.

   • So we express economic returns for equity as [ROE - Cost of Equity] spreads.

The pull to average

Now, for readers short on time, let’s ignore a lot of details and just trust us on this one:

1. Valuation theory justifies higher P/B multiples for higher future economic returns. Higher ROE drives higher P/B:s (cost of capital, reinvestment, and many factors inside the ROE matter as well).

2. The stock market tends to set higher P/B:s to reward companies with higher recent ROE:s. Recent lower ROE:s tend to get discounted with lower P/B:s. This naive extrapolation gets more extreme when the market gets joyful or gloomy.

3. The problem? High or low recent company ROE levels are generally not "sticky" trends that continue far out into the future. Quite the opposite, data and competitive reasons support that we should expect more extreme ROE:s to mean revert to more average (mean) levels. We should also expect investors to make more “mistakes” when P/B:s reach more extreme high or low levels. So P/B:s will also mean revert.

Readers who want a quick mean reversion take may glance at Chart 2. It sums it all up with “COMPETITION” as the big, invisible magnet that pulls to average:

ROE mean reversion: Competing for business returns

In theory, free competitive forces drive economic returns toward zero in the long run. We call this perfect competition and normal returns.

From the companies capital allocation perspective, competition for returns will:

1. Lower high ROE:s towards the cost of equity (from above). This happens when too much company investment chases similar high return potential opportunities. An ever-growing supply of capital may no longer find good enough new projects to earn high returns. Competition for limited demand may lower the return from existing projects. On average, the industry’s ROE falls. If competition is fierce it may compete away the industry’s economic returns to zero (or lower).

   • Caveat: Some businesses may have competitive advantages that prove both strong and sustainable. Such “moats” can defend a high return on larger pools of capital for longer, but it is an exception to the above rule.

2. Increase low ROE:s so that they approach the cost of equity (from below). Reinvesting at an ROE below the cost of equity is not long-term sustainable**. Whole sectors may find themselves struggling for profitability. For example, due to overcapacity. The long-term solution is often that the least competitive players get either shut down or bought up. Company-specific issues may require an appropriate turnaround plan. Usually, this involves improved operations and/or financing. Sometimes there are changes to corporate governance as well. In all these restructuring cases it is again competition that is the main driver. Only now, it is a competition for surviving for better times. Eventually, the restructured industry or company could see its ROE rise, as long as demand stabilizes. So the competition will also pull too low ROE:s toward recovery and cost of capital.

   • Caveat: Full return recovery to the cost of capital is far from certain. There may be structural issues that make an industry a poor allocator of capital. For example, if players receive investment funding, bailouts, or guarantees at non-market terms. Here mean reversion in ROE could be “too little, too late”. We can still pick better than industry stocks at depressed valuations, but the industry economics would stay poor.

   • ** Exception: In some cases, net profits, and thus ROE, do not reflect the underlying earnings. In these cases, we can look at some mix of cash flows, operating profits, and adjustments.

P/B mean reversion: Competing for stock returns

In stock markets, the competitive force is the flowing of global capital to the highest expected risk-adjusted returns. In doing so the stock market sets current stock valuations that look far into the future. (Each trading participant need not be aware of this as long as other participants are willing to profit from their mistakes.)

While this pricing process is somewhat efficient on average, it is messy and more prone to valuation errors in the lower and higher P/B ranges:

1. The reason why high P/B “glamour” stocks underperform statistically is that they, as a group, tend to get overvalued. The stock market increases P/B:s across stocks related to promising opportunities. Several human biases will make investors tend to exaggerate the potential and downplay the risks of such situations. And it usually gets worse the higher the valuations go. Eventually, more and more investors will realize the stock is overvalued. Overvalued here means trading (very far) above intrinsic value (where the intrinsic value corresponds to some lower P/B range). This implies that this stock's forward-looking risk-adjusted returns are lower than the stock market's. As more sellers seek to get out at lower prices than there are new buyers to support, P/B revalues lower. This continues until investors see the stock's risk-adjusted return as competitive again. Return to sanity if you will.

   • Caveat: The stock market will often get things right. High P/B:s will often correctly forecast risk-adjusted returns that are at least as good as the stock market. But statistically, the valuation errors will be to the downside. This means that we can improve our returns by just staying out of the highest P/B stocks, which is what many value investors do. (While one can establish an investment edge in the highest valuation stocks this requires some very different mindset and toolsets.)

2. Low P/B “value” stocks outperform as a group because they tend to get undervalued. Firms get punished hard by the stock market for cyclical industry downturns, temporary execution problems, financing problems, or non-business reasons. Sometimes stock market pricing gets dislocated* for non-fundamental reasons. We find such stocks among the low P/B stocks. Here investors have behavioral biases that tend to err more and more on the pessimistic side the lower the valuation goes. Near-term risks are exaggerated or extrapolated indefinitely. Potential is overlooked or neglected. At some point, investors may get confident that one of these stocks is undervalued. This means that its intrinsic value is in a higher P/B range and that its expected risk-adjusted returns are higher than for the market. As more investors get willing to buy at higher prices than there are sellers left, the P/B rises. Eventually, the P/B may reach intrinsic value (or higher with some price momentum).

   • Caveat: The stock market will again often get things right. Low P/B:s will often turn out to have been “cheap for a reason” as shareholders are wiped out in bankruptcies or get caught with sub-par returns. This does not invalidate the statistical edge of low P/B investing. But it highlights the need for diversification and for assessing the risk-reward of each such situation.

* Technical note: Market dislocations

Stock markets experience recurring hiccups and crises (market dislocations). Then low price multiples are not only the resulting consensus of willing parties agreeing in orderly trades. Instead, they may be a function of short-term supply and demand disruptions. In such times we may see:

1. Unwilling "forced" sellers liquidate assets at almost any price.

2. Absence of otherwise willing and able buyers. Some investor types may get blocked from buying a troubled asset class. For example, institutions facing new restrictions or changes to regulations.

3. If a crisis goes on far enough there may even be unwilling holders. For example, if many defaulting or restructuring major debtors give up assets or issue new securities to their creditors. The receivers may have rules or incentives to sell out as soon as the assets or securities become liquid. This may be long before valuations reflect more long-term characteristics again.

This may be obvious to some, but... dislocations can offer great value investing opportunities.

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

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“The intelligent investor is a realist who sells to optimists and buys from pessimists.”

― Benjamin Graham, The Intelligent Investor

The value investing philosophy that PiggyBack follows comes in many flavors. Its simple essence is trying to buy investments at valuation discounts. Its purpose is to earn higher returns and/or to lower our risk.

This post introduces value investing to PiggyBack readers who are not already familiar.

Happy value investing!

Your Analyst,

Johan Eklund, CFA
PiggyBack

The Value Investing Process

Here is PiggyBack's informal introduction to a typical value investing process:

1. Idea

Find an interesting investment or investment theme to research. Its fundamental value must be possible to appraise using some valuation model.

2. Inputs

Gather relevant background facts and reasonable forward-looking assumptions about the investment’s fundamentals.

Set reasonable capital market assumptions (cost of capital for making similar investments).

Use these inputs in an appropriate valuation model.

3. Intrinsic value

The chosen valuation model outputs (ranges of) “intrinsic value” estimates. This is our current idea of what the investment could be worth further down the road if sold to some other buyer.

Depending on valuation approaches, this buyer could be offering future securities market prices. Or they may be a strategic acquirer, who offers to buy all the units of our investment.

4. Buy

As value investors, we buy investments at market price discounts to intrinsic value.

If we are conservative in our analysis these discounts offer us a "margin of safety". A margin of safety offers some "protection"* from our own valuation mistakes and bad luck.

5. Holding period

We hope prices and intrinsic values will converge (move closer to each other) within some time. If so we may receive the market return for similar risk investments plus some excess return.

The main source of the "extra" returns in value investments tends to be revaluation, from closing the valuation gap, but oftentimes better than expected profit growth adds value as well. Some value investments offer excess returns from above-market dividend yields.

From a risk perspective, a value investment can also mean lower risk for similar returns.

6. Sell

One reason to sell is if we find more attractive alternative investments. Another reason is if the investment becomes overvalued or too complex for us to value. After learning more we may also discover that we made a mistake by investing in the first place.

Value investors with concentrated portfolios of high-quality, predictable businesses ("compounders") are reluctant sellers.

Other value investors buy baskets of lower-quality stocks at deep statistical discounts. Such strategies can call for replacing stocks quickly if valuations and fundamentals change.

* Value Investing Caveats

Single-stock value investing comes with its own set of risks. Here are a few caveats to understand and be comfortable with before value investing:

1. Stocks are (highly) uncertain

The future for the single company, industries, the economy, and the market risk appetite are all uncertain variables. Moving further out into the future tends to increase these uncertainties. Over the life of our investments, these uncertainties multiply to give a range of likely outcomes.

So even if we buy at attractive entry conditions we expect our single investment outcomes to be very different. Especially if we only made a few investments.

To smooth out some of these swings in "luck" and to soften some of the blows from our mistakes we should diversify. Appropriate portfolio diversification means holding more investments and more types of investments (reducing correlation risks).

2. Investing skills are noisy

Diversification also allows us to get more investment experience under our belts. It increases our confidence in the scope and limits of our abilities faster.

Beyond common sense confidence, there is also statistical confidence. As active investors, we invest to beat the market. To do so over the long run we need repeatable advantages, a so-called “edge”. For smaller numbers of investments, the problem is that return and risk outcomes become very noisy. These metrics blend the signal of our edge (if any) with noise from wide swings of good or bad luck.

Increasing our number of investments with a given strategy cancels out some of this luck. And extending our measurements to at least full market cycles we get more certain of how the strategies hold up in the long run. (The real "stress test" for stock strategies is how they hold up in bear markets.) We get more certain of whether our measured return is support for investing with an edge, or not.

3. When not to try

When practicing active value investing in somewhat efficient markets it can be hard to accept that we may lack an edge for extended periods. If short on attractive risk-reward single stock ideas, we may be in a market that we are less likely to outsmart.

Now if we find the market as a whole overvalued we can still protect our capital. We may stay out in cash, or consider investing in oth

er asset classes that we are comfortable with.

If the market has sound fundamentals and valuation, we may stay exposed via indexing. We can also invest with other investors whose capital allocation strategies make more sense for the time being.

PiggyBack's "piggyback investing" approach falls somewhere between. We learn from proven and promising active investors in public markets. And we make active judgment calls on when and how to invest alongside or in the spirit of their strategies.

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

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Piggyback

“To use something that someone else has made or done in order to get an advantage.”

—  Cambridge Dictionary

The most promising ideas we can think of are usually already set in motion by smarter, more resourceful, or better-connected people. Our superiors may turn out to be neighbors down the same street if the idea is very crowded. Or if we got early to the party, they may be niche players on the other side of the world. Tough luck, but learn to be happy with competition for good ideas as a fact in life.

Now, as investors – in particular as minority investors in public stock markets – we have the opportunity to invest in our superiors. And we can afford to wait until we get confident that these superiors are stacking odds in our favor.

This marks the launch of the PiggyBack Letter (PBL), a free weekly stock market newsletter. PBL brings you free opportunities to learn capital allocation from proven and promising active investors – via their present, past, and potential future public stock market investments.

We will select and analyze “our” capital allocators and investment situations from a value investing lens. For all readers interested to be able to follow, we have provided a separate background post on value investing.

This first PBL post introduces "piggyback investing", a concept specific to PiggyBack.

Your Analyst,

Johan Eklund, CFA
Founder PiggyBack

What is Piggyback Investing?

Piggyback investing

“To gain knowledge or resource advantages from active investors by studying or investing in their public securities positions.”

— Johan Eklund, CFA, PiggyBack

As minority investors, the public stock market records offer us vast hunting grounds. These records contain tracks of where and how proven and promising investors actually invest their capital. With selective tracking we can try to identify:

1. Past investments

Where and when an active investor revealed some of their unique knowledge or strategy. We can study strategies employed, mistakes made and successes achieved in these events. The insights and techniques we pick up may improve our own investing.

2. Current investments

Specifically, active investments where the investors may use their resources for our benefit. The presence of the “right” active investor may signal interesting investments to further research. Add the right incentives and the investor may also act as a catalyst to improve the investment case. For example, by demanding improved and more long-term capital allocation from its investments.

3. Future potential investments

As we pick up strategies and traits from many allocators we may start selecting “similar” stocks. The allocators may not agree, and likely never will set foot in these specific copycat investments. But we gain experience with our growing set of borrowed ideas and behaviors. We start to internalize. Over time competition drives us to "our" strategies, suited for our times and markets. We evolve.

In all these cases, we are climbing onto the backs of “giants” to improve our public stock market investing. With PiggyBack, we call this “piggyback investing”.

Capital Allocator Traits

Our investor “giants” reveal themselves by leaving tracks that convince us of at least two attributes:

1. Superior investing skills

We search for sound strategies, high-quality investment processes, and good execution. If the strategies employed involve hard-to-copy investor resources that is preferable.

• Caveat: Never confuse investing skills with short-term investment outcomes. In a single bull market and ignoring risks, many “lucky fool” strategies produce "impressive" returns. The skillful are easier to separate from the fools after full business cycles. (For many Western stock markets we would argue there were no full cycles in the 2010s and early 2020s. Remember that quantitative easing and zero-interest-rate episode anyone?)

2. Decent minority treatment

A track record of repeatedly profiting at the expense of minority investors is a big red flag. So is maintaining close business relationships with entities that do. In general, we want to piggyback investors who show good character.

• Exception: Investing is seldom black or white. If we are comfortable, it can make sense to partner with skillful allocators despite predatory tendencies. Especially if the situation offers us a deep valuation discount or protective terms. But we should not fool ourselves to enter a predator's cage without a clear idea of who is next for lunch.

DISCLAIMER: This publication and all related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, available at the following link.

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Spreading the word really helps(!) in growing PiggyBack’s readership. Working together, this publication can reach a sustainable scale for free, independent insights.

Many thanks to all PiggyBackers!

Johan Eklund, CFA
PiggyBack

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