Protect your Investments in a Deflation

The 'D' word has started to rear its ugly head. Greg Zuckerman at the Wall Street Journal recently reported that some of world's leading investors (Bill Gross, Jeremy Grantham, and David Tepper) are becoming worried about deflation and re-shaping their portfolios to prepare for a possible period of falling prices. Even though value investors don’t invest based on macro forecasts, it is a grave mistake to totally ignore the macro environment, especially by the experts at PIMCO.

I am not a macro economist or have any forecasting abilities. I have zero opinion on whether the environment will be inflationary or deflationary going forward, but in this article, I highlight points by notable investors, Seth Klarman at Baupost Group and Steven Romnick at FPA Crescent, that value investors need to be cognizant about  on how to protect against a possible deflation when selecting individual securities.

Seth Klarman points to the complexity and variability of business valuation in various macro environments in his rare and out-of-print book that sells for $2000 on Amazon, ‘Margin of Safety, Risk-Averse Investing for the Thoughtful Investor’. Here is what he has to say about assessing business value in a deflationary environment:

“In a deflationary environment assets tend to decline in value. Buying a dollar’s worth of assets for fifty cents may not be a bargain if the asset value is dropping. Historically, investors have found attractive opportunities in companies with substantial “hidden assets”, such as an overfunded pension fund, real estate carried on the balance sheet below market value, or a profitable finance subsidiary that could be sold at a significant gain. Amidst, a broad-based decline in business and asset-values, however, some hidden assets become less valuable and in some cases may become hidden liabilities. A decline in the stock market will reduce the value of pension assets; previously overfunded plans may become underfunded. Real estate, carried on companies’ balance sheets at historical cost may no longer be; and undervalued subsidiaries that were once hidden jewels may lose their luster.”

“The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investing approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient? Should investors worry about the possibility that business value may decline? Absolutely.”

He recommends three responses to protect against the degradation of asset values in a deflation.

“First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all.”

Further, in his recent lecture at the Ben Graham Center for Value Investing, he gives a specific example of how to evaluate asset values to protect against a “depression-type” environment:

“We have looked at the debt of auto finance companies. They are captive and their equity does not trade. Right now (2008-2009) the default rates on auto loans have not gone up much. These companies are running an annual loss rate of 2%-4%. That is less than the default rates on houses in many markets and less than high credit card defaults. We don’t have a very good reason for why its so but we suspect it is because (i) very few loans are subprime, (ii) people have a tendency to hold onto their cars if they paid into their loan for a few years, (iii) it is (currently) hard to get new car loans, people don’t have the money, so they don’t let go off their old cars easily, (iv) and, if one has to get to job, they need the car to drive to the job. So, we have reasons to believe that car loans will continue to perform, but we are modeling it to get worse from here on. We ask ourselves what would be a really bad scenario – a base case scenario is for the annual car loan loss rate to quadruple. So, what would happen if it quadruples. The bonds we are buying are fifty cents on a dollar will be still worth ninety to par. Now lets assume that the loan losses go up eight fold, which is armageddon. We would have 40% loss rate over the life of a car loan, 40% loss over the life of a lease, 40% loss on the new cars sitting in dealer showrooms, all of which these companies lend to, but our bonds are still worth sixty to par compared to a our purchase price of fifty. I don’t know how many things you can buy that are worth 20% more than the purchase price even in an armageddon and this is the closest to armageddon we can get. There is no historical precedent to anything close to that ever happening.”

“That is how we are modeling everything. When we look at home residential properties in a housing market that has corrected massively, we assume 20% down in 2009 and 2010 and 10% down in 2011. That will get you down to home price levels in California to 1979 prices, and way past any affordability metric, and will get to mid to high-teens current yields on renting. When you can buy mortgage securities to earn a high return to that assumption, that is the kind of armageddon scenario that makes us excited about investing. You cannot apply that kind of stress test to any bank and buy it. Every bank in the country would be wiped out in those scenarios, though I don’t think it will happen. But, that is the degree of comfort we like and we think we can get in this market, and still buy things to yield high returns.”

Further on, Seth comments on how requiring a larger than usual margin-of-safety causes him to sit on the sidelines in such an environment until it meets his standards of “cheapness”:

“Consider Las Vegas casinos or Hilton hotels. Revenues are down 20% year-over-year. What makes investing in these businesses difficult is that it is hard to tell if revenue are going to be flat one year from now, or if the revenue will be up 15-20%, or worse, if the revenue will drop another 15-20%. When you have that kind of wild disparity, you need to buy to a deteriorating scenario and still get a good return. Its much harder to make those assumptions in certain businesses than in others. Will the volume in Kleenex go down 20% from here on. No, it wont. But, could the revenue at a gambling casino go down another 20%. They could because people don’t have to be at a gambling casino if they don’t want to. So, we try to be really careful, and sometimes its just easy for us to say that we don’t really have an opinion on what may happen. There are other opportunities we could look at, and we’ll just pass on this one.”

Steven Romnick at FPA Crescent commented at the recent quarterly conference call on the large-cap stocks that are considered to be very cheap by many investors -Jeremy Grantham and Bill Miller to name a few.

“Why is the fund sitting on cash instead of investing in high quality large cap stocks that are cheap and have relatively high yields?”

To this, Mr. Romnick responded that the large caps are cheap relative to their historical 10 year averages, but assume that these companies can continue to maintain their margins going forward. This may not be true in a higher than usual inflationary environment or in my opinion a deflationary environment. Cash can be more useful in the future when markets are under distress than to be fully invested in these high quality large caps.

I have looked at the large caps in the past (PG, JNJ, Pfizer, Walmart) and own a long position in Coca Cola and Pepsi, but I do not have an opinion yet on how these companies are priced to various margin compression scenarios. I plan to revisit my position and the other large caps to stress-test for these scenarios.

In conclusion, the important point of this article is that value investors should test individual securities when they are under examination for various stress-case scenarios (like inflationary and deflationary environment, higher than usual margin compression, higher than usual revenue drops etc), and buy only when there is acceptable return to these scenarios. Beware that buying securities by simply looking at historical 10-year data may lead to regret later.

Resources:

• PIMCO August 1, 2010, "Privates Eye”, William Gross
• WSJ August 1, 2010, “Big Investors Fear Deflation”, Gregory Zukerman
• Margin of Safety: Risk-Averse Investing for the Thoughtful Investor, Seth Klarman
• March 17, 2009, Seth Klarman, Ben Graham Center for Value Investing.
• July 29, 2010, Quarterly Briefing, FPA Crescent.

Disclosure: The author has his family invested in FPA Crescent. The author has a long position in KO and PEP.

A Risk-Averse Approach to Emerging Markets

The folks at Tweedy Browne have a solid reputation as value investors. Its history traces back to a brokerage house started in the 1920s that counted Graham and, later, Warren Buffet as some of its primary customers. In 1975, the firm became an investment advisory managing separate accounts and in 1993 it started the Value Fund as a vehicle to bring Graham’s value investing principals to retail investors. They have had an admirable record for their funds over the last 10 and 15 year periods. Also, their letter to shareholders are among the best written ones around and are a must read for all value investors.

In this article, I would like to highlight their approach to investing in the emerging markets. This topic is very relevant today in the light of massive inflows of funds into emerging markets. On Friday, Aug 6 2010, the Wall Street Journal reported that in July 2010 $1.5 billion poured into BlackRock's iShares Emerging Markets ETF (EEM) and $2 billion into Vanguard's Emerging Market ETF (VWO). Now compare this to the fact that Vanguard’s next largest ETF, a fund that invests all over the world except the US, has a mere $5.6 billion in total. Below are some excerpts from their 2009 semi-annual report and 2010 annual report that throw light on how they think about investing in the emerging markets

High profile investors such as Bill Gross and his fellow portfolio manager, Mohamed El-Erian, at PIMCO have opined frequently of late that as deleveraging in the US continues, growth will slow in the West but continue to increase in Asia. Investment capital has again been flowing aggressively back into the emerging markets, driving some valuations in those equity markets to levels that do not make sense to most value oriented investors.

Over the last year (2009), emerging market equities have once again become the darlings of the equity investment world. While mutual fund flows have overwhelmingly been in the direction of bond funds over the last couple of years, the money that has been invested in equity funds has gone largely into international funds, with the vast majority invested in emerging market funds. According to Morningstar, $67.3 billion poured into emerging market equity funds all over the world for the year through January 31 2010. In the US alone, in 2009, a little over $17 billion found its way into diversified emerging market funds which is 40% higher than the flows in any of the last ten years into this category including the high performance years of 2005 through 2007. This flood of new money has had somewhat of a self-fulfilling effect on the performance of these markets with the BRIC index (Brazil, Russia, India and China) up over 85% in US dollars for the year ending March 31, 2010. The Brazilian, Russian and Indian markets are up over 100% during the same period. Investors appear to be not only chasing performance, but also the faster growth in GDP that they feel is relatively assured in these markets. In our opinion, valuations of companies in these markets are now full-to-high and discount extremely optimistic projections of future growth, ignoring the cyclical nature of their most dominant companies and industries. Record inflows and high valuations should raise red flags for investors.

While we love growth and would agree that the economic prospects for a number of these lesser developed countries are quite promising, we simply refuse to pay up for the hope of growth. We will continue to search for value on a company by company basis, and will only commit our shareholders’ capital when we are being afforded a satisfactory “margin of safety,” based on current fundamentals. From our point of view, the prospects for attractive returns continue to be dependent in large part on the price we pay. In a recent article in The Wall Street Journal, Peter Tasker cited an academic study by Jay Ritter of the University of Florida that analyzed 100 years of data from 16 countries that showed that there was no positive correlation between GDP growth and stock market returns – if anything, the correlation was slightly negative. Again, we believe that faster growing countries simply do not offer attractive long-term investment opportunities unless valuations are compelling. Tasker goes on to explain that the companies that end up winning the struggle for survival in the emerging economies may not even exist yet, and cites the fact that there were over 100 different motorcycle companies during the Japanese miracle of the 1950s. “The market leader, Tohatsu, was driven out of business by the cut-throat pricing of a flaky upstart called Honda.”

You might be surprised to learn that our Funds have significant exposure to these faster growing markets. Much of it is indirect and at valuation levels that we believe are more attractive than the majority of opportunities available from most direct investments in these markets. As of September 30 (2009), approximately 10% of the assets in the Tweedy, Browne Global Value Fund were directly invested in what we would describe as the more developed of the emerging markets, (particularly Mexico, South Korea and Croatia) in companies such as Coca-Cola Femsa, Korea Exchange Bank, SK Telecom, and Adris Grupa, among others. Our criteria for direct investment in countries are rather straightforward. We want a political environment with which we are comfortable; we want a fairly well-developed system of contract law with a court system that would allow us to enforce our property rights and seek redress, if necessary; we need reliable financial reporting so that we can value businesses; we would like a forward market in foreign exchange so that we can hedge our currency exposure if we choose to; and finally, we need some mispriced stocks. Absent these basic requirements, from our point of view one is speculating, not investing.

We also have significant indirect exposure to the emerging markets, even those we would be somewhat hesitant to invest in directly. Companies such as Nestle, Unilever, Coca-Cola, Heineken, Diageo, Kone, 3M, and Emerson Electric, among a host of others, derive a surprising amount of their revenue and profits from these faster growing markets. For example, it might surprise you to learn that Heineken has made more money over the last year or so in Africa and the Middle East than it has in the United States where its beer brand is ubiquitous. Its African and Middle Eastern businesses now account for 25% of Heineken’s earnings before interest and taxes (EBIT), second only to the European region, which accounts for 36% of EBIT. Over 50% of 3M and Emerson Electric’s sales occur outside the US today, and approximately 28% and 30%, respectively, comes from emerging markets. 3M’s emerging market segment of its business is growing at a compound annual growth rate of 14%. Diageo, the world leader in premium spirits, generates approximately 35% of its sales from emerging markets. In June, Coca-Cola opened its 37th bottling plant in China, where today Coca-Cola has 52% of the carbonated soft drink market, including the top soda brand, Sprite. Nestle produces over 100 different products that are aggressively sold to the emerging market countries. In 2008, Nestle’s food and beverage sales in the emerging markets achieved over 15% organic growth and accounted for over 30% of its overall sales, or 35 billion Swiss francs. Phillip Morris International, which was spun off from Altria in early 2008, sells cigarettes and other tobacco products in over 160 countries with the bulk of its unit growth today coming from the emerging markets. Its Eastern European, Middle Eastern and African Regions increased its net revenues by 18.2% to reach $7.5 billion in 2008. It has a 41.4% market share in the cigarette market in Turkey, a 35.2% share in the Ukraine, a 29.5% share in Indonesia, 12.3% in Korea, 71% in Argentina, 67.7% in Mexico, 37.6% in Poland, and 39.2% in the Czech Republic. Kone, our long time Finnish elevator company holding, is reported to be the fourth largest player in the Chinese elevator market, which has been growing reportedly at 20% a year for years, and now represents a third of the global elevator market. In addition, there are a number of other companies in our portfolios that derive a substantial amount of their sales from Asian markets, including Jardine Strategic, Unilever, Richemont, and Sika. And the list goes on and on.

In our view, the valuations of these companies remain quite reasonable and are largely free of corporate governance issues, which can plague local emerging market companies. For example, the US-based conglomerate 3M, which we own in the Tweedy, Browne Value Fund, has a publicly traded subsidiary in India called 3M India Ltd., which trades today at approximately 23x earnings before interest, taxes, depreciation and amortization (“EBITDA”), 26x earnings before interest and taxes (“EBIT”), and 40x earnings. This compares to the US-domiciled parent company’s valuation of 17x earnings, 9x EBITDA, and 11x EBIT. From our point of view, the parent company today is practically fully valued despite trading at less than half the multiple levels of its Indian subsidiary. Investing indirectly is often simply a cheaper and safer way to participate in these rapidly growing emerging markets.

Setting aside corporate governance issues for the moment, as we have mentioned in past reports, a bet on these markets is often a highly concentrated bet. The top 5 companies in terms  of market cap in the constituent indices of each of the BRIC countries account for between 31% and 58% of the market cap of the index, and, as previously mentioned, these companies are often cyclical in nature, i.e., banks, oil companies, mining businesses, etc.

Despite these challenges, we remain interested in many of these markets, and we regularly screen for opportunities in those markets. Today, approximately 10% of the net assets of the Tweedy, Browne Global Value Fund is invested in what we would describe as the more developed of the emerging markets, primarily South Korea and Mexico. We are actively screening in Brazil and India today, but uncovering very little value.

Resources:

• 2009 Semi-annual report, Tweedy Browne, LLC.
• 2010 Annual report, Tweedy Browne, LLC.
• Aug 6 2010, Emerging Market Inflows Offer Warning to Financial Advisors, WSJ

Disclosure: The author is a shareholder of Tweedy Browne Global Value Fund (TBGVX).