Going into a stock market bubble

[merkhet]

2. SIRI is doing about ~1b in FCF compared to >4b in debt. Also, if you believe the economy is going to fall then auto sales will slow which would be negative for SIRI. I think SIRI definitely has a lot vol/ST price movement risk given the debt and that it's tied to a cyclical industry.

 

I know you probably don't care too much and trust Malone. It's not an investment that makes too much sense to me given your outlook and the fact you are positioning yourself around that outlook.

 

Jay,

for what I can see that $1 billion in fcf is growing quickly and steadily. EBITDA is higher: I think SIRI long term debt is circa 3 times EBITDA (maybe a bit more), which is not too aggressive imo.

 

Furthermore, we are at a S&P500 Shiller PE of 27, while I said I would call a bubble when it reaches 29-30… I am not positioning my whole portfolio as if a crash would be just around the next corner!... I must be prepared to see a S&P500 Shiller PE of 32-33, because you never know when a bubble is going to finally burst, right? Another year… Maybe even two… Who really knows?

 

And given how it is priced today, I think LMCA might perform very well during the next two years… If the bubble doesn’t burst!

 

Later, LMCA might have become something completely different… Maybe SIRI will have been acquired and spun-off… And Malone might be onto something completely different!

 

My point is this: if the S&P500 Shiller PE goes from 27 to 32, before the bubble finally burst, I need something to keep making money: cash won’t be useful, Fairfax might be, but with obvious limitations we all know… BH and LMCA must really do the job! ;)

 

Gio

 

Siri's churn rates are impressively low, so that even if they don't end up growing as fast as expected (unlikely, IMO) they will be perfectly fine to service the 4x FCF of debt that they have.

 

That said -- I don't know how useful it is to try and predict bubbles. It's pretty easy to see that there's froth in certain parts of the technology industry, but it's less clear in other parts of the market.

[giofranchi]

That said -- I don't know how useful it is to try and predict bubbles. It's pretty easy to see that there's froth in certain parts of the technology industry, but it's less clear in other parts of the market.

 

My point of view is very simple and straightforward: in the last 100 years the Shiller PE of the S&P500 has reached 30 only twice, and both times with dreadful consequences… If you don’t play it safe with a S&P500 Shiller PE of 30, imo you will never play it safe… Nothing wrong with that, of course! It is just not a style I am comfortable with.

 

Gio

 

[jay21]

 

Siri's churn rates are impressively low, so that even if they don't end up growing as fast as expected (unlikely, IMO) they will be perfectly fine to service the 4x FCF of debt that they have.

 

That said -- I don't know how useful it is to try and predict bubbles. It's pretty easy to see that there's froth in certain parts of the technology industry, but it's less clear in other parts of the market.

 

Forward churn will be higher as they try to get a deeper penetration which will come from less affluent buyers.

 

My point isn't debt service (I think they will be fine), my point/speculation is they will go down potentially faster than the market in a downturn.

[vinod1]

gio, don't you think the various Malone securities and BH will get slaughtered in a downturn? Both got slaughtered more than the market in 2008 (granted, I don't believe Biglari was in full control at the time).

 

That’s why I hold lots of cash! ;)

 

Anyway, I don’t know of anyone better than Malone at taking advantage of any market crash that might await us. I will be much more willing to double down in the Liberty family of businesses than in any other company, because I know Malone is working on some incredible bargain. And don’t forget LMCA today is almost debt free! In 2008 it was not so, and that could be a great advantage this time around.

 

As far as Biglari is concerned, the fast food industry generally behaves much better than the general market in a downturn. Furthermore, he hold lots of cash, which could be deployed opportunistically. And he surely knows how to do that!

 

Last but not least, both LMCA and BH are among the cheapest stocks I know today (at least in the North American stock market).

 

Gio

 

I have an investment in LMCA as well. This is a small investment for me at this time as I am quite not comfortable with the valuation primarily because this is not an industry that I spent time on. It is more of a smart owner operator/capital allocator in an industry with good economics that is undergoing change.

 

Could you please share your thoughts on how you are valuing LMCA?

 

Vinod

[giofranchi]

my point/speculation is they will go down potentially faster than the market in a downturn.

 

Maybe! But with LMCA today we already have a 12% discount, right? Not bad! ;)

 

Gio

 

[giofranchi]

Could you please share your thoughts on how you are valuing LMCA?

 

Hi Vinod,

please take a look at the slide in attachment.

Of course, if you think SIRI is wildly overvalued, that won’t be of great help to you… Anyway, buybacks at SIRI just keep going on (share repurchases year-to-date at the end of 2014Q3 totalled nearly $2.1 billion), and Malone is not someone who likes buybacks if he thinks the price of the shares is overvalued! ;)

 

Gio

[merkhet]

That said -- I don't know how useful it is to try and predict bubbles. It's pretty easy to see that there's froth in certain parts of the technology industry, but it's less clear in other parts of the market.

 

My point of view is very simple and straightforward: in the last 100 years the Shiller PE of the S&P500 has reached 30 only twice, and both times with dreadful consequences… If you don’t play it safe with a S&P500 Shiller PE of 30, imo you will never play it safe… Nothing wrong with that, of course! It is just not a style I am comfortable with.

 

Gio

 

And herein lies the rub -- this is an experiment with no control group.

 

 

Siri's churn rates are impressively low, so that even if they don't end up growing as fast as expected (unlikely, IMO) they will be perfectly fine to service the 4x FCF of debt that they have.

 

That said -- I don't know how useful it is to try and predict bubbles. It's pretty easy to see that there's froth in certain parts of the technology industry, but it's less clear in other parts of the market.

 

Forward churn will be higher as they try to get a deeper penetration which will come from less affluent buyers.

 

My point isn't debt service (I think they will be fine), my point/speculation is they will go down potentially faster than the market in a downturn.

 

Maybe, but I'm assuming that's because you think of the Siri multiple as a function of growth, right? What if, instead, you look at the Siri cash flows as a function of yield?

 

Assume you have a box you bought for $100 that spits out $10 a year like clockwork. That's a 10x multiple that you paid -- is it worth a 10x multiple even if I told you that there's no possible variation and/or change to the cash flows? I would think not. It's basically a U.S. Treasury at that point, and, thus, the box is worth maybe a 6% long-term Treasury yield or 16x the yearly free cash flow.

 

If you then plot Siri somewhere on the continuum from unstable to stable free cash flows, figure out the yield on the free cash flow and then translate it into a FCF multiple, then Siri is not necessarily all the expensive -- and with the possible growth, could even be cheap.

 

Of course, this says nothing about where the stock price will go if there's a downturn in the market, but I've found that anticipating stock prices is usually a fruitless endeavor. Newton once lamented that he couldn't chart "the madness of men," and if he can't do it, I haven't a shot at it.

[vinod1]

Could you please share your thoughts on how you are valuing LMCA?

 

Hi Vinod,

please take a look at the slide in attachment.

Of course, if you think SIRI is wildly overvalued, that won’t be of great help to you… Anyway, buybacks at SIRI just keep going on (share repurchases year-to-date at the end of 2014Q3 totalled nearly $2.1 billion), and Malone is not someone who likes buybacks if he thinks the price of the shares is overvalued! ;)

 

Gio

 

Hi Gio,

 

Thank you! I agree, just do not have enough confidence in the extent of the undervaluation to increase the position size.

 

I think as with Leucadia's previous owners, it would not be possible to predict the value created by looking at just the existing individual parts.

 

Vinod

[giofranchi]

Newton once lamented that he couldn't chart "the madness of men," and if he can't do it, I haven't a shot at it.

 

Newton suffered from something we all have instead spent lots of time thinking about: he ventured outside his circle of competence! ;)

 

Gio

 

[yadayada]

Having good capital allocators in charge is a really nice hedge against market downturns. If the value is not impaired, they can take advantage of the situation by buying back stock. So in that case, down turns of the stock market are actually a positive for long term holders, as it will enhance your long term returns.

[giofranchi]

Having good capital allocators in charge is a really nice hedge against market downturns. If the value is not impaired, they can take advantage of the situation by buying back stock. So in that case, down turns of the stock market are actually a positive for long term holders, as it will enhance your long term returns.

 

Of course, I fully agree! :)

 

Gio

[petec]

If you look at schiller's PE, you are basicly saying that history will repeat itself. Which is not a bad argument. But you can also easily argue that this time is different. Competitive dynamic could be different (higher profit margins due to consolidation), and more conglomerates. Also Asia, and the rapid rise of the middle class world wide. We are not just selling most goods in Europe and the US now, but also various asian and south american countries.

 

In the last 60 years, there has not been a case where over a billion people are working their ass off to get to the middle class and higher. They were mostly held back by opressive regimes and communism.

 

I don't think there will be another lost decade.

 

None of this changes the fact that competition, either from new businesses or existing ones, should erode profit margins from record levels unless the required return on equity rises.

[petec]

 

If Japan can beautifully delever (ie no precipitous fall in its currency or bonds) at 260% debt to GDP, taking in only something like 12% of GDP in taxes and spending double that currently - I'll shit myself.

 

+1

 

This is possibly my all time favourite COBF post.

[yadayada]

If you look at schiller's PE, you are basicly saying that history will repeat itself. Which is not a bad argument. But you can also easily argue that this time is different. Competitive dynamic could be different (higher profit margins due to consolidation), and more conglomerates. Also Asia, and the rapid rise of the middle class world wide. We are not just selling most goods in Europe and the US now, but also various asian and south american countries.

 

In the last 60 years, there has not been a case where over a billion people are working their ass off to get to the middle class and higher. They were mostly held back by opressive regimes and communism.

 

I don't think there will be another lost decade.

 

None of this changes the fact that competition, either from new businesses or existing ones, should erode profit margins from record levels unless the required return on equity rises.

That is not how oligopoly's and duopoly's work. Just look at companies like micron or western digital. Sometimes fiercely competitive industries evolve into not so competitive industries. This is because there used to be some weak players. And the strong players were preying on the weak ones with price wars. But as soon as the weak ones are gobbled up, there is no incentive to continue price wars. A little bit of market share might be gained, but at a huge cost. Sometimes this evolutionairy process can take decades. My reasoning is that we are seeing more and more of this.

 

Barriers of entry for new players and the fact that everyone loses with price wars increases profit margins. Only thing that can disturb this is if some new technology comes in from the outside that is not bought out.

[petec]

If you look at schiller's PE, you are basicly saying that history will repeat itself. Which is not a bad argument. But you can also easily argue that this time is different. Competitive dynamic could be different (higher profit margins due to consolidation), and more conglomerates. Also Asia, and the rapid rise of the middle class world wide. We are not just selling most goods in Europe and the US now, but also various asian and south american countries.

 

In the last 60 years, there has not been a case where over a billion people are working their ass off to get to the middle class and higher. They were mostly held back by opressive regimes and communism.

 

I don't think there will be another lost decade.

 

None of this changes the fact that competition, either from new businesses or existing ones, should erode profit margins from record levels unless the required return on equity rises.

That is not how oligopoly's and duopoly's work. Just look at companies like micron or western digital. Sometimes fiercely competitive industries evolve into not so competitive industries. This is because there used to be some weak players. And the strong players were preying on the weak ones with price wars. But as soon as the weak ones are gobbled up, there is no incentive to continue price wars. A little bit of market share might be gained, but at a huge cost. Sometimes this evolutionairy process can take decades. My reasoning is that we are seeing more and more of this.

 

Barriers of entry for new players and the fact that everyone loses with price wars increases profit margins. Only thing that can disturb this is if some new technology comes in from the outside that is not bought out.

 

My point is that it would be very very hard to prove (to the level that I would want to base investments on) that the same dynamics have not existed in the past.  Every era has had its untouchable companies (many no longer exist) and its consolidating industries (many of which became so uncompetitive that they attracted, er, competition, because that's what high ROCE does in a free market). 

 

My feeling is that margins will fall either because demand decreases or because demand rises (prompting companies to invest and compete more).  I don't think the current situation, in which demand is enough to sustain margins but not enough to incentivise investment, is sustainable over the very long term.

 

P

[tytthus]

Anyone debating around Shiller CAPE should read this guys work:

 

http://www.philosophicaleconomics.com/2014/11/dilution-index-evolution-and-the-shiller-cape-anatomy-of-a-post-crisis-value-trap/

 

Basic conclusion: CAPE should be used with caution for any country exposed to boom/bust in credit....which is, of course, every country in the world.

[AzCactus]

Gio,

 

I am surprised you have no Berkshire in your portfolio especially since Berkshire tends to make opportunistic purchases of both stocks and wholly owned businesses in a recessionary environment.  If we listen to what Howard Marks and others have said it sounds like we are towards the end of the game (bottom of the 7th according to Marks)but it isn't over. 

 

Personally, there are two issues that I believe are essential: investing time horizon and tolerance for volatility.  To a large extent they are functions of one another (E.g. the longer time horizon you would expect a greater tolerance for volatility), however that is not always the case.  While using a metric like Shiller PE is good it will provide some guidance but isn't the end all indicator. 

 

Ultimately, if someone thinks that stocks are too high then cash really seems smart because it cushions the downside and provides the opportunity to allow for buys in market turmoil.  I am currently around 20% cash, however that figure is likely to rise over the next 3-6 months if stocks continue their run.

 

David   

[original mungerville]

Anyone debating around Shiller CAPE should read this guys work:

 

http://www.philosophicaleconomics.com/2014/11/dilution-index-evolution-and-the-shiller-cape-anatomy-of-a-post-crisis-value-trap/

 

Basic conclusion: CAPE should be used with caution for any country exposed to boom/bust in credit....which is, of course, every country in the world.

 

I absolutely agree - this is a fabulous article critiquing the CAPE which has major issues when applied to a discontinuous boom/bust scenario as we have had over the last 10 years. The CAPE works, however, to smooth the normal business cycles over a decade. Just excellent, I recommend everyone read it - the shortcomings are clear and obvious once you read it. This is really important for international investing and deciding what country to focus on at this point - essentially the take-away is don't use it.

[cobafdek]

Anyone debating around Shiller CAPE should read this guys work:

 

http://www.philosophicaleconomics.com/2014/11/dilution-index-evolution-and-the-shiller-cape-anatomy-of-a-post-crisis-value-trap/

 

Basic conclusion: CAPE should be used with caution for any country exposed to boom/bust in credit....which is, of course, every country in the world.

 

I absolutely agree - this is a fabulous article critiquing the CAPE which has major issues when applied to a discontinuous boom/bust scenario as we have had over the last 10 years. The CAPE works, however, to smooth the normal business cycles over a decade. Just excellent, I recommend everyone read it - the shortcomings are clear and obvious once you read it. This is really important for international investing and deciding what country to focus on at this point - essentially the take-away is don't use it.

 

I'm an avid reader of philosophicaleconomics.com, one of the most thoughtful blogs around.  (Psst . . . Anyone know who's behind the pseudonym Jesse Livermore?)

 

To be fair to Gio (the OP), he wasn't citing the Shiller CAPE as a rationale to diversify into lower-Shiller-CAPE countries, and his portfolio construction and cash position is arguably sensible under any market scenario.

 

The US market is high, and the more relevant philosophicaleconomics.com blogpost was in August, in which Jesse deconstructs the Shiller CAPE for the U.S., pointing out the drivers that might account for why it is higher than TTM PE.  http://www.philosophicaleconomics.com/2014/08/capehigh/  Interestingly, at that time, he ended that blogpost with this:

 

"An investor’s best bet, in my view, would be to underweight U.S. equity markets in favor of more attractively priced alternatives in Europe, Japan, and the Emerging Markets."

 

[original mungerville]

Anyone debating around Shiller CAPE should read this guys work:

 

http://www.philosophicaleconomics.com/2014/11/dilution-index-evolution-and-the-shiller-cape-anatomy-of-a-post-crisis-value-trap/

 

Basic conclusion: CAPE should be used with caution for any country exposed to boom/bust in credit....which is, of course, every country in the world.

 

I absolutely agree - this is a fabulous article critiquing the CAPE which has major issues when applied to a discontinuous boom/bust scenario as we have had over the last 10 years. The CAPE works, however, to smooth the normal business cycles over a decade. Just excellent, I recommend everyone read it - the shortcomings are clear and obvious once you read it. This is really important for international investing and deciding what country to focus on at this point - essentially the take-away is don't use it.

 

I'm an avid reader of philosophicaleconomics.com, one of the most thoughtful blogs around.  (Psst . . . Anyone know who's behind the pseudonym Jesse Livermore?)

 

To be fair to Gio (the OP), he wasn't citing the Shiller CAPE as a rationale to diversify into lower-Shiller-CAPE countries, and his portfolio construction and cash position is arguably sensible under any market scenario.

 

The US market is high, and the more relevant philosophicaleconomics.com blogpost was in August, in which Jesse deconstructs the Shiller CAPE for the U.S., pointing out the drivers that might account for why it is higher than TTM PE.  http://www.philosophicaleconomics.com/2014/08/capehigh/  Interestingly, at that time, he ended that blogpost with this:

 

"An investor’s best bet, in my view, would be to underweight U.S. equity markets in favor of more attractively priced alternatives in Europe, Japan, and the Emerging Markets."

 

He also had another great one on the possible problems with using Buffett's 1999/2000 favorite yardstick for valuations of US equities - ie corporate earnings relative to GDP. Recently, Buffett maybe, but at least Munger, seemed to note that that old yardstick may not fully apply right now. Munger said something like: just because Warren put up a chart 15 years ago doesn't mean...I forget, but basically Munger was kind of dismissing that. Buffett then said  they would talk about that over lunch. Don't know where they ended up on that one!

 

I think the blog did not mention Buffett...but the focus was on how QE and government deficits meant that the "E" in the market's P/E may stay high for a long time relative to GDP...

[giofranchi]

essentially the take-away is don't use it.

 

original mungerville,

 

This is what Hussman had to say in his latest weekly commentary:

 

As a side note, the reason I emphasize that the effect of QE is psychological is that one can calculate the impact that a given period of zero interest rates should have on the discounted value of future cash flows. I’ll say this again – if historically normal equity valuations and prospective returns are associated with short-term rates averaging, say, 4%, one can show with straightforward discounting arithmetic that the expectation of zero interest rates for 3-4 years will result in a justified 12-16% increase in valuations over and above historical norms. On valuation measures that are best correlated with actual subsequent S&P 500 total returns (and many popular measures are quite weak on that record), we presently estimate that the S&P 500 is about 115% above historical valuation norms.

 

Put another way, we estimate nominal total returns of less than 1.4% annually for the S&P 500 over the coming decade, with negative total returns over the next 8 years. So if one believes that zero interest rates are likely to persist for another 8 years, and that stocks should be priced with zero return or premium for risk, stocks are probably fairly valued. If one believes that zero interest rates are likely to persist for another three decades, but stocks should be priced with normal historical risk premiums over and above risk-free rates, stocks are also probably fairly valued. In every other universe, stocks are about double historically normal valuations, even adjusting for the likelihood of several more years of zero short-term rates.

 

Which is basically what the Shiller PE of the S&P500 is telling us right now.

 

Of course you might answer Hussman is not a good investor, he has not made any money for his shareholders in a while, etc. … And I might even agree with you … This doesn’t change the fact than when it comes to general market valuation no one that I know of, and I repeat: no one!, has done a more accurate, thoroughly researched, and convincing work than Hussman. Period. Anyone who doesn’t read his weekly commentary should start doing so.

 

If the Shiller PE of the S&P500 truly gets to 30, valuations will be even more stretched!

 

Furthermore, just look at the ups and downs of the markets in the 20s’ and 30s’: those were two decades of unbelievable booms and busts! And, although the Shiller PE might not have been very useful in the midst of those booms and busts, surely it acquired meaningfulness at the extremes! It never got lower than 6… and it never got higher than 30! If it approaches 30 again, I strongly believe you should take notice.

 

I simply repeat this: In 1929 the Shiller PE of the S&P500 reached 30… a market crash of more than 80% followed… If the Shiller PE of the S&P500 gets to 30 again, and you don’t become defensive… you will never be.

 

Gio

wmc141124.pdf

[giofranchi]

Gio,

 

I am surprised you have no Berkshire in your portfolio especially since Berkshire tends to make opportunistic purchases of both stocks and wholly owned businesses in a recessionary environment. 

 

David,

Malone is 10 years younger than Buffett and Liberty Media is much smaller than Berkshire; Watsa is 20 years younger than Buffett and Fairfax is very much smaller than Berkshire; Biglari is 47 years younger than Buffett and BH is very very (add as many “very” as you want) much smaller than Berkshire. ;)

 

Anyway, I agree: if the price of LMCA and/or BH gets too high in a market bubble, I will sell them and redeploy the proceeds into Berkshire! :)

 

Gio

 

[anders]

My point of view is very simple and straightforward: in the last 100 years the Shiller PE of the S&P500 has reached 30 only twice, and both times with dreadful consequences… If you don’t play it safe with a S&P500 Shiller PE of 30, imo you will never play it safe… Nothing wrong with that, of course! It is just not a style I am comfortable with.

 

This point might be simple but in my opinion dangerous thinking and a disservice to investors. This means that in practical terms to base a strategic decision on capital allocation, based on what might happen tomorrow in the market, that we are in bubble territory, because CAPE almost reached 30.

 

To illustrate this, lets go back in history to november 1996.

 

During this time we were at about same level of CAPE as today and, the subsequent years CAPE kept on climbing upwards. If you would have chosen to act on same principles in nov-96 - to allocate 70% in three vehicles and 30% cash - then you would have had to wait approximately 5 years to may 2002 until CAPE came down back to the 28-level.

After that, CAPE bottomed at around 21,5 in march-03. I can only imagine those that during this period of time, really thought that CAPE would continue downwards but what instead happened was that it started to climb up! and 9 months later, we were back at the 28 level once again. Then from jan 2004-dec 2007, CAPE fluctuated a bit between 28 and 26 until the market started to go down in 2008 financial crisis reaching a low in march 2009.

 

Why im writing this is to illustrate that anyone that made a strategic decision based on CAPE trading high in nov 1996, I think would have been very surprised over the price action over the coming years and would had to wait more than 10 years! before the dreadful consequenses that you talked about actually materialized and then could buy on the argument - CAPE is trading low.

 

I have tried and failed miserably at trying to predict market, lost a lot of money on trying to make hedges based on CAPE etc, which has led me to the point that my only focus today is to find wonderful companies at a fair price regardless of overall price in market. I just sincerely hope you are much better than I am in seeing whats coming,

 

Best Regards,

[giofranchi]

During this time we were at about same level of CAPE as today and, the subsequent years CAPE kept on climbing upwards. If you would have chosen to act on same principles in nov-96 - to allocate 70% in three vehicles and 30% cash - then you would have had to wait approximately 5 years to may 2002 until CAPE came down back to the 28-level.

 

anders,

as I have already said, I think I am quite prepared to see the Shiller PE of the S&P500 go well beyond 30… And if that happens, I am sure I will make a lot of money! ;)

 

In my experience every time I failed to make money cash was never the culprit… Instead my investments were, simply because they didn’t perform as I expected!

 

You still want to be 100% invested when the Shiller PE of the S&P500 gets above 30? Well, as I have already said, then you will always find some rationale to be fully invested, and you will never hold cash. Period. Maybe you’ll do fine… But it is just not my style!

 

Gio

 

[anders]

In my experience every time I failed to make money cash was never the culprit… Instead my investments were, simply because they didn’t perform as I expected!

 

Agree!

 

My problem today is rising cash level, I simply cant find anything that meets my criterias. (Except maybe IBM  :) reading the AR,s, I think I finally start to understand why WB is bought it after 50 years of waiting, its a wonderful company with a bright future ahead)