On Birds and Bushes

The intrinsic value of a stock, i.e. its “true” value, is the summation of all future cash flows discounted back to the present from their respective periods. It is not a Price-to-Earnings ratio nor is it a Price-to-Book Value ratio nor is it an EV-to-EBITDA ratio nor is it even a Discounted Cash Flow analysis. Indeed, it is nothing that can be funneled into a formula.

It is an unknowable figure because it is always changing, being impacted every day by a myriad of decisions ranging from a salesman calling in sick to the Central Bank governors sitting around a mahogany table pondering interest rate policy. What the aforementioned ratios give are only rough approximations of that mystical unicorn known as intrinsic value.

Buffett once used Aesop's classic aphorism to illustrate the idea. Is a bird in the hand indeed worth two in the bush? Because, consider also: How sure are you that there are two birds in the bush, and how long will it take to get them out? That's intrinsic value in a nutshell.

Mispriced securities either underestimate the value of the bird in the hand or the potential of the birds in the bush. Let me draw a couple of examples of this kind of thinking in action.

We exited our multi-year investment in PMT this past quarter. PennyMac was founded by ex-Countrywide Mortgage executives in 2009 to invest in all the distressed mortgages left from the savage wake of the housing bust. They also harbored aspirations of becoming a major independent mortgage originator as their founders all possessed experience and industry know-how from their prior employer.

We initiated our position around $18 back in 2011. At the time, even though PMT was earning a near 20% ROE on its distressed investments and paying it out to the tune of a 10% dividend yield, few investors had the appetite to invest in anything related to the mortgage industry. PennyMac couldn’t put capital to work fast enough, evaluating a torrent of loans that banks were incentivized to unload due to post-crisis regulation. In this case, we had a situation where there was both a bird in the hand (fat dividends), and more in the bush (a vast multi-billion market of distressed mortgages needing to be worked out).

Fast-forwarding to 2014, much of the stigma has faded. Mortgages are no longer toxic in the eyes of investors. The pool of distressed mortgages have become shallower, and the persistent low interest rate environment has spawned numerous competitors willing to bid more aggressively and accept a lower ROE. Now, we still have the bird in the hand (the fat dividend has increased by 45% over the past three years), but the birds in the bush are more uncertain. Considering the risks and other opportunities, I closed our position, generally satisfied with our overall IRR, inclusive of dividends, in the mid-teens.

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Now, consider the example of one of our current positions: General Motors (GM). At first blush, it may seem like GM and PMT have nothing in common. But consider the backdrop. GM, once upon a time the mightiest company in America, fell into bankruptcy and required a bailout by the government. Then, a few short years after exiting bankruptcy, just when it seemed like they were getting their act together, a scandal involving covering up faulty ignition switches in several models of their older cars which caused multiple injuries and deaths was uncovered.

GM, like PMT, has become a pariah on sentiment alone. It has become “un-investible” for many simply because the story has a past history of unpleasantness. But what are the facts? The facts are that the scandal and recall and the likely billion plus dollar legal in costs have not damaged their brand in any significant way if measured by cars sold. On the back of a multi-year replacement cycle for autos, GM has posted record sales two years in a row, selling over 9.9 million cars in 2014. GM’s newest mid-size truck, the Chevrolet Colorado, won Motor Trend’s prestigious truck of the year award. This timely award has coincided with the plummet in oil and gas prices and are thus driving sales of not just their trucks, but also their SUVs, both which happen to be the highest margin products in their portfolio.

Qualitatively, the scandal and recall may just be what the doctor ordered to drive true cultural change in as big a company as GM. New CEO Mary Barra has told its employees at a townhall meeting that, “I never want to put this behind us. I want to put this painful experience permanently in our collective memories.”¹ Capital allocation, once a secondary consideration behind the amorphous (and oftentimes unprofitable) goal of being The World’s Biggest Carmaker, has become front and center, with management committing to aggressive share buybacks and increasing dividends. Return On Invested Capital (ROIC) has recently become a reported metric, bringing transparency and accountability to the company who now instead strives to become The World’s Most Valued Carmaker.

By my calculations, GM is trading at a valuation that suggests the company ought to be worthless in ten years. To put it more precisely, using conservative assumptions of no growth and no margin improvement, the sum of the cash they generate over a ten year span, discounted at 10%, equals their entire market value. An investor buying shares of GM today are paying nothing for the cash flows GM will generate ten years hence.

With GM, investors believe the bird in the hand is as good as it gets and there are just a smattering of birds in the bush. I, to the contrary, believe there are plenty of birds left in the bush and they’ll happily emerge with a mere song. And if you think Tesla (TSLA) or Apple will come out with some kind of miracle disruptive car that eat up the entire automotive pie, I have a bridge to sell you. Tesla’s goal is to sell 55,000 cars in 2015, or, 0.5% of what GM delivered last year. Investors in TSLA, on the contrary, have no bird in the hand (they have never posted an annual profit) and are betting there is a veritable flock of birds in a bush that will take ten years to hike to².

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¹ “It was clearly the right message, but was jaw-dropping at GM. Retired executive Steve Harris, who started at GM in 1967, observes, ‘Her remarks at that meeting were unlike anything any previous GM CEO has ever said.’” (Source: http://fortune.com/2014/09/18/mary-barra-general-motors/)

² Morgan Stanley’s valuation model appraises 80% of TSLA’s value from cash flows beyond 2025. (Source: http://www.wsj.com/articles/tesla-targets-pull-away-from-profits-1429889005)

Holding Period as a Consideration With Regards To Common Risk Metrics

There is something about the nature of stock markets that attract speculators and traders who do not care about intrinsic value as opposed to investors who do. Correspondingly, much of risk management has focused on short-term volatility that cater to those security slingers. Standard Deviation has become the de facto number to brag about or manage around. Somehow, somewhere along the line, most investors have been brainwashed to believe a low Standard Deviation is as valuable as a high absolute return.

Pzena Investment Management, a respected shop adhering to a classic value-oriented approach, who put the theory through the wringer (http://www.pzena.com/investment-analysis-3q14-2). Unsurprisingly, they found: “Much of the daily or monthly volatility of a portfolio disappears as the vagaries of short term price movements offset each other in the long term and the frequency of loss decreases substantially.”  In other words, Standard Deviation draws an inaccurate picture for long-term investors when focused on daily or monthly timeframes. Zoom out, and what do we find?

On a month-to-month basis, stocks fluctuate, and for the S&P 500, 40% of the time, it will be lower than it was the previous month. But by zooming out, five-year periods exhibit less relative fluctuation and less loss. The trend of lower volatility and shrinking losses is even more pronounced for ten-year periods.

Okay, great, so we know stocks go up in the long term. Not exactly breaking news. But... why don’t most hedge funds seem to know this?

Here, most hedge funds, although they have a lower monthly Standard Deviation than World Equities (stocks), actually have a higher five year Standard Deviation.

And the kicker is they do not have definitively superior performance over the long term! Stocks generally go up in the long-term. Hedge funds? Not as certain.

The explanation is that most active funds cannot help but micro-manage their short-term volatility. Those Masters of the Universe sell themselves by touting an ability to achieve equity-like returns without equity-like risks. In the short-term, they can make a case for being successful. But longer term, it is a miserable strategy that offers subpar returns with higher risks.

Moreover, it is nonsensical. Equities are, almost by definition, a long duration asset class. Managing short-term volatility for an asset intended as long duration is like zig-zagging a ship across the ocean in a vain attempt to avoid waves. It’ll take twice as long to get to your destination and there is simply no way to guarantee there will be no waves along the way.