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This Time Itís Value Traps

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  • This Time Itís Value Traps

    This Time It’s Value Traps

    by John Rubino

    June 13, 2007

    Most financial bubbles are pretty easy to spot: An asset class climbs way beyond what old-fashioned valuation measures used to define as reasonable, market participants start acting like idiots, and pundits rationalize the madness with learned “new era” theories. Think late-90s tech stocks or California houses in 2005 or today’s Shanghai stock market. This kind of bubble announces itself loudly, making it easy to ridicule and/or bet against.

    But today’s U.S. stock market is a different, trickier, far more dangerous kind of bubble, because the stocks that are wildly overvalued actually look pretty cheap by traditional measures: Banks and brokerage houses at 12 times earnings, homebuilders at 1.5 times book, retailers at 1 times sales. In terms of historical trading ranges, there seems to be nothing here to get excited about.

    But look a little closer and you see that these are classic “value traps,” stocks that seem cheap but are actually wildly overvalued because their underlying earnings, book value, dividend yield or whatever are artificially inflated. Value traps are common at the end of long expansions, when corporate earnings have spiked because of supply constraints, but stocks haven’t, as investors begin to suspect—rightly—that demand is about to slow, thus compressing profit margins and sending earnings off a cliff. Hence the juicy-looking valuations.

    A few weeks ago I interviewed Bill Laggner and Kevin Duffy, principals of Houston-based hedge fund Bearing Fund LP, for a magazine article. Great interview, much of which, as is always the case with magazines, ended up on the cutting room floor because of space constraints. But their thoughts on value traps are so timely that I’ve asked their permission to post more of the interview here:

    Bill Laggner: Today the faith is clearly in central bankers, that they’ve got things totally under control and have engineered a synchronized global boom. If you’re not participating in this global boom you just don’t get it. It’s not just faith in the Fed but in all the central banks. A good example of this thinking is BusinessWeek’s recent cover story ‘It’s a Low, Low, Low Rate World.’ The idea is that foreign central banks will continue to finance our excesses, they always have and always will, and as a result interest rates will remain low.

    Kevin Duffy: This time around the inflation has been the good kind, like home values and stock prices, rather than the things we buy at the grocery store. That was a common theme with Japan in the late 80s and the U.S. in the late 1990s. It’s exactly the same script. Back in the late 1990s all the talk was ‘hey, we don’t have any inflation.’ Today we have a little more, but it’s not enough to worry people.

    The last bubble was in valuation, with all the hot money flowing into technology. This time around it’s value traps, primarily financial companies. 45% of corporate profits come from financing. Financial stocks account for 23% of the S&P 500’s market cap. Add in the GMs and GEs [which earn most of their profits through financing] and it goes even higher . How many people said “we’ve got to buy New Century because it’s trading at book value and the dividend yield is so high?”

    BL: Bloomberg just ran an article on how everyone is looking at financials and saying ‘gee, based on valuations, financials are the cheapest they’ve been since 1996.’ Easy credit has created this gain-on-sale love-fest and they’ve extrapolated it like in any bubble.

    Ken Fisher and a lot of other money managers have been telling people to buy the homebuilders because based on price/earnings and price/book this is one of the cheapest sectors in the marketplace. But book value is misleading because land values are highly inflated. Most of the big builders were constantly acquiring land and other builders, assuming interest rates would never go up and we’d have this mass influx of people and the demand for housing would keep increasing. Now they’re writing down their land, which is an impairment to book and could go on for the next three or four years.

    Hovnanian [a leading homebuilder] has taken earnings estimates down twice in the last 40 days. They posted a loss before impairments, so on an operating basis they’re losing money. This is an example of people catching falling knives like tech sell-off of 2000-2002. ‘We’re gonna buy these things because they’re cheap,’ but they can get a lot cheaper.
    MBIA, the municipal bond insurer, looks cheap at 11x earnings and 1.4 x book value, but when you look at the balance sheet, which very few people look at today, you see that it’s levered 94 to 1. The statutory capital that they keep on hand is 3.5 basis points of their bond guarantees. Compare that to Citigroup, which has almost 9.5 basis points of reserves. Ten years ago just 14% of MBIA’s business came from structured finance guarantees on asset backed securities. Today that number is 32%. Of course the structured finance world is all based on numerous assumptions, including stable interest rates and low default rates. We would say that those are very generous assumptions.

    On the pure bank side there are a few, primarily in California, like First Federal and Downy Savings & Loan where 75%-80% percent of their book is negative amortization mortgages. Most of these borrowers are not even making the minimum payments, so the principal grows—and these banks are booking that as income. They can do it until the borrower’s principal gets to 110% or 120% of the original loan, which might be a couple of years after the origination. This is a classic case of nonperforming loans not being categorized as nonperforming loans.

    KD: I was at a conference in Boston in 1998, right before LTCM [Long Term Capital Management’s implosion]. David Dreman [a prominent value investor] was speaking at this conference, and I asked him how you avoid value traps. And his answer was ‘that’s kind of the risk in what we do; we’re just not very good at that.’ I find it interesting that today Dreman is one of those people saying you should buy the brokerage stocks. Ken Heebner [manager of the CGM Realty Fund] was smart enough to see the housing stocks as value traps but he’s now buying the brokerage stocks. These are two guys with stellar reputations now staking those reputations on brokerage stocks.

    Everyone is saying subprime is contained, the brokers make money on the unwinding of subprime, they make money in any direction, they’re the smartest guys in the room and all the rest of it. There’s just a tremendous amount of optimism about the brokers. The estimates for the big five, Goldman, Merrill, Lehman, Morgan and Bear have them at a P/E of 10.6 and price/book of 2.29. In the mid-80s we were buying brokers like Legg Mason at book value. That book was a lot more real than what we’re looking at today.

    So many things are done off-balance sheet today that it would be very difficult to get a real book value for the brokers. Today they’re leveraged something like 25 times total assets to tangible equity, and we don’t know about the games being played off balance sheet, or how much the over-the-counter derivatives are being inflated by mark-to-model pricing. Also, the big five have at last count total assets of $3.9 trillion, and in the first quarter they were growing at a rate of 34 percent. There’s practically no limit to how much they can borrow.

    BL: They’re posting smaller reserves for these various assets, and this is just the leverage we know about and doesn’t take into consideration the leverage we don’t know about. For example, some of the big brokers don’t even report their swap exposure.

    KD: The brokers are really at the epicenter of all the big bubbles: private equity, commercial real estate, and hedge funds. They’ve got a tremendous amount of exposure and litigation risk. They’re not just brokers in the traditional sense. They’re risking their own capital now, more than they ever have. Goldman for example gets 65% of its net revenues from trading and investing. Some of this is skill, some is just leveraging asset inflation, some is writing insurance, and some is cheating. We’re starting to see that there’s a lot that going on. A boom hides a multitude of sins, and the bust exposes them. Also, in retrospect, I’m sure that we’ll see that there were all kinds of conflicts out there.

    This credit bubble has morphed over the last several years. It was focused initially on residential real estate – amateur hour. The housing bubble obviously hit the wall in July, 2005 yet the stock market is up over 20%. What’s going on? It’s a credit bubble, not a housing bubble, and as the air has gone out of that balloon the torch has been passed to the professional speculator who shows up in commercial real estate, hedge funds, and private equity. It’s amazing how this bubble has changed its spots over the past few years. It also makes it more dangerous, because we have a new bubble on top of the older bubble. The new bubble has masked the damage of the older bubble, so we’ll end up with both deflating at the same time, which could be quite spectacular.

    John Rubino is co-author, with GoldMoney’s James Turk, of The Coming Collapse of the Dollar and How to Profit From It (Doubleday, December 2004), and author of How to Profit from the Coming Real Estate Bust (Rodale, 2003) and Main Street, Not Wall Street (Morrow, 1998). After earning a Finance MBA from New York University, he spent the 1980s on Wall Street, as a Eurodollar trader, equity analyst and junk bond analyst. During the 1990s he was a featured columnist with and a frequent contributor to Individual Investor, Online Investor, and Consumers Digest, among many other publications. He now writes for Fidelity Magazine and CFA. His web site is

    See also The Modern Depression.

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    Last edited by FRED; 06-15-07, 09:37 AM.

  • #2
    Re: This Time Itís Value Traps

    The housing bubble obviously hit the wall in July, 2005 yet the stock market is up over 20%. Whatís going on? Itís a credit bubble, not a housing bubble, and as the air has gone out of that balloon the torch has been passed to the professional speculator who shows up in commercial real estate, hedge funds, and private equity. Itís amazing how this bubble has changed its spots over the past few years. It also makes it more dangerous, because we have a new bubble on top of the older bubble. The new bubble has masked the damage of the older bubble, so weíll end up with both deflating at the same time, which could be quite spectacular.
    Yeah that's one way to put it.

    Considering the declining value of the dollar relative to other currencies and "stuff", I would venture to say anything denominated in dollars is a value trap. I'm not sophisticated enough to effectively avoid this, yet aware it is happening, which makes me feel a little.... well, trapped.


    • #3
      Re: This Time Itís Value Traps

      The situation has fundamentally changed since the last stocks upturn - and with fundamentally I mean the basics of how enterprises are financed and what they are doing nowadays compared to roughly 15 years ago. Let us start with the basics and this is always the enterprise who wants to turn the money of the shareholder into a product or service to sell and to return MORE money back to the shareholders. Of course the less money they need for he same operations from the same shareholders, the more the shareholders get back in relation. Now let us consider the two sides of the balance sheet: Assets and liabilities.

      On assets the following trend happened to lower the number of shares and reduce capital to drive earnings per share:

      1. Sale and Leaseback of key assets (plant, asset, machinery) - therefore increasing the lease payments into the future
      2. Outsourcing of processes to make the story leaner.
      3. Lean production, no inventory etc.

      Both has its justification yet at the same time the expense must be paid by operating income/revenues, we usually call this cost. This is one of the reasons why earnings grew but margins have shrunk.

      On the liabilties side, the trend was similar:
      1. Lower capital requirement by having less assets, overall
      2. Reshift capital away from share instruments to debt instruments (bond, loans)
      3. Don't pay your suppliers until you get it from your clients (reverse DSO!)

      All this is also good but also puts the following risks.

      1. If revenues go up the net profits (EPS) go up often faster as many of the operating costs have become fixed items like recurring lease payments for plant, credit etc.
      2. If revenues go DOWN the net profits disappear like water in the desert - they simply get swallowed by the current payments.

      As a consequence, the valuations of once an asset-rich economy like "PE of 12 is ok for manufacturing" has become simply a risky one on an asset-poor economy, means: where all assets belong to someone else and have to be paid through financing costs or through outsourcing. Both are the same . Where one can compare it is on a PC = Price Cashflow ratio, a very rarely used ratio nowadays. With almost no depreciation (as everything is financed!!!), the PC ratio has moved up to be very near the PE ratio- debt payments.
      As a result, a good PC of 5-6 (sic!) is now out of reach for most companies, even though their PE still looks quite good. Consequence: Higher risk of huge losses invisible to most stock valuation techniques who compare 10-15 year old ratios to nowadays.

      Good hint: with the current PE ratios, just double them to see the reality and compare it with the old days!!!

      So let us do another piece of math to understand how this basic risk then translates if you take an "oldstyle" company and use "creative financing" and other "lean methods" to bring "earnigns magic" to the table: A typical company once had a debt / equity ratio of maybe 60% to 40%, so 1 1/2 times the debt of equity and this was already the maximum. Now the debt to equity ratio might be at 70% to 30%, but besides this the rest has been hidded through kai-zen (lean management), outsourcing, reverse DSO and S&LB. Which means, the "real debt" service is probably again 60% higher, so we talk about a 85% to 15% of leverage, so in other words a leverage of 1 to 6 compared to a former leverage of 1 to 1 1/2. Maybe I do exaggerate but this is the net of it.

      Unfortunately this is not the end of the story. This company might be bought off by a hedge fund.

      This hedge fund again is leveraged by a factor of 1 to 3, and maybe, as hedge funds alone are all that dangerous for retail investors, the hedge fund is being bought by a Fund of Fund with again a similar leverage, as otherwise noone would justify the high fees, if not from an excessive delta between debt service interest payments and capital gains. So again 1 to 3 maybe. And maybe a sophisticated retail investor (=sucker) bought half of the fund of fund by debt, so again the leverage is 1 to 2

      So we are now ending with the following ratio:

      Old situation pre hedge fund: ** Debt / Equity ratio of 1 to 1 1/2 - Somebody buys the stock directly: Leverage 1 to 1 1/2

      Now the "new" situation: ** Leveraged company with a "real" new DE ratio of 1 to 6 bought through the funds of hedge funds with leverage: Leverage 6 times 3 times 3 times 2: equals on every real dollar there are a whopping 108 !!! Do I exaggerate??? Unfortunately. not.

      Now let us drive this exercise to the next level:

      With the leverage, the profits ratio of course is also leverage - up and down

      Profits increase because of more revenue: Revenue go up by 10%, therefore profits go up by 30%, share price goes up 30% as PE might stay the same... ok. everything is fine, and after all fees, the retail investor gets a whopping 40% of capital gains delivered. Good!!! It's all good, and a verrry a sweet deal!

      Profits decrease: Revenues go down by 10%, therefore unfortunately profits also go down by 30%, and the share price goes down by 30% as well, as the PE stays the same... no problems for the retail investor. Maybe in the old days with a 10% revenue decrease the profits would have gone down the same ratio or so... but ok 30% is ok because:

      Already the hedge fund had to exit sale the share immeditely or the total capital gained with a leverage of 1 to 3 would have been whiped out (margin call by the bank), the fund of funds already had an exposure on this hedge fund's exposure, and therefore also might have been affected and if this all goes down at the same time along with the market, the retail investor even with a leverage of 1:2 stays there with NOTHING BUT DEBT.

      Unforatunately somebody eventually has to pay all this and there are two sides: Goods importing countries (from an exporter - guess which country is NOT a net exporter???) - the retail customers, also known as consumers or the ivestors, in that case the sucker retail investor who has bought the share through a fund of fund to diversify the risk...

      Last edited by Christoph von Gamm; 06-15-07, 02:23 PM. Reason: bad grammar
      Christoph von Gamm - with Queer-O-Pinion!


      • #4
        Re: This Time Itís Value Traps

        The last three LVW [Long Valuation Wave] peaks rolled through in 1929, 1966, and 2000. They averaged general-market P/E ratios of a staggering 34x earnings. This is considerably in excess of the twice-fair-value 28x level that marks classic bubbles. While the latest 2000 valuation peak looks a lot like the 1929 peak in symmetry terms, 2000 was at a far larger scale. General-stock valuations soared to 44x in early 2000, a bubble unprecedented in US history. This most-recent valuation peak dwarfed the one witnessed in the late 1920s.

        This yields a provocative point to ponder. If the long-term average stock-market valuation is 14x earnings, but the late-1990s boom pushed valuations up to never-before-witnessed extremes, then the coming LVW trough will need to be lower and/or longer than usual to restore balance to the long-term valuation averages. Stock investors need to be aware of this ominous possibility in this receding LVW.
        Valuations have already been roughly cut in half since 2000, so there is no doubt we are in the secular-bear phase of the current wave.