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Ben Graham's Best Lecture Ever: Securities in an insecure world!


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Ben Graham ranked the threats to the financial world: nuclear war, inflation in 1963. How applicable they are still today!

 

Weapons of mass destruction in fool hands is the biggest single threat that I can think of over the long haul. It will not matter that much how much Fairfax and Berkshire will be worth if we'll always being affraid of being killed by them. Just my opinion.

 

 

 

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A previously lost lecture unearthed by Jason Zweig!

http://bit.ly/cJS2hr

 

Awesome-  based on this, dow FV is 12,000.

 

BG's original method of inflation-adjusted 10 year average earnings divided by 2x corporate bonds gets to a dow FV of about 8,000 now.

 

However, he says in here that the numbers upon which he based his original formula on were from 1871-1954, and markets had matured since then, and safety nets were added to reduce systematic risk (i.e. unemployment insurance reduces corp earnings vol), so he said an arbitrary increase of 50% of the original model was warranted.

 

Based on this 50% increase to 8,000, this would imply dow 12,000 is the current FV.

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A previously lost lecture unearthed by Jason Zweig!

http://bit.ly/cJS2hr

 

Awesome-  based on this, dow FV is 12,000.

 

BG's original method of inflation-adjusted 10 year average earnings divided by 2x corporate bonds gets to a dow FV of about 8,000 now.

 

However, he says in here that the numbers upon which he based his original formula on were from 1871-1954, and markets had matured since then, and safety nets were added to reduce systematic risk (i.e. unemployment insurance reduces corp earnings vol), so he said an arbitrary increase of 50% of the original model was warranted.

 

Based on this 50% increase to 8,000, this would imply dow 12,000 is the current FV.

 

Also, another way to estimate stock FV me and my coworkers were discussing:

 

Damadoran, valuation expert from NYU, professes stocks are 1.5x more volatile then bonds, and therefore should have an equity risk premium of 1.5x bonds.  BBB bonds trade at a credit spread of 165 right now, which with a rfr of 3.21% implies stocks have a required rate of return of 5.68%.  With 3% assumed growth, this would imply a 37x PE multiple for FV!

 

Invert the formula, and our current PE of 13.9 implies bonds should have a credit spread of 429 bps (or about 2.5x current levels)....

 

So...according to Damadoran's studies, stocks/bonds are not trading in sync, and people should long stocks and short bonds.

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I wouldn't put much stock in Dam's volatility based method. It just doesn't make much sense to me, except on paper. I also wouldn't base any macro valuation off the Dow index, as so few companies make up that index.

 

I've always used Shiller's method to find a range i think S&P fair value should be. It's quick and simple, and makes sense to me. One thing it doesn't factor in much is balance sheet strength or weakness at any given time period. By my approximations, and based on the macro risks out there, i think the fair value for the S&P is about 900-950.

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I'm not necessarily advocating damodaran or BG as right or wrong, I just think it can be interesting to think about different tools and framework people have to estimate FV. 

 

Either way, my gut tells me that the "model answer" that damodaran's model gives us is right (the bond market implies stocks are undervalued and the stock market implies bonds are overvalued).  This is my gut based on the fact that both the real risk free rate, expected inflation, and corporate bond spreads are very low.  However, you have stock indices trading at a 7.19% earnings yield at the trough (using year end 09 earnings). 

 

Other inconsistencies exist in the market too right now too...look at gold.  If someone really wanted to "hedge" inflation, why would they not just enter a 30-year, fixed for float swap, trading at 3.8% the other day?  For 30 years, pay fixed 3.8% and receive a floating LIBOR payment.  Seems to me like that is a much better direct hedge against inflation than buying gold at 1200.  Point is, the bond market has extremely low rates right now, indicating a very low expected inflation rate.  However, gold keeps going up because of inflation fears (or geopolitical fears translated into inflation fears).

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I'm not necessarily advocating damodaran or BG as right or wrong, I just think it can be interesting to think about different tools and framework people have to estimate FV.  

 

Yeah, i know. Just throwing my opinion in the mix.

 

On the whole inflation/deflation thing, it is a bit perplexing. Every economic sign (gold aside), especially excess capacity, yields, and consumer debt, points to deflation to me. However, i think the response (in a multitude of ways) thus far has been, and will continue to be, that deflation won't be allowed. This policy of avoidance of deflation at all costs we seem to be in suggests that we will have quite an inflationary period in the future, as it is very likely to be overdone. That is my macro prediction. I just don't know the time frames in which i think both scenarios play out. It may still be too early to invest for an inflationary environment. Though my macro predictions are often wrong. Another wildcard that will effect the macro environment is the China effect, in which i am in the camp that thinks it is overheating. Though it can continue to overheat for years to come.

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On the whole inflation/deflation thing, it is a bit perplexing. Every economic sign (gold aside), especially excess capacity, yields, and consumer debt, points to deflation to me. However, i think the response (in a multitude of ways) thus far has been, and will continue to be, that deflation won't be allowed. This policy of avoidance of deflation at all costs we seem to be in suggests that we will have quite an inflationary period in the future, as it is very likely to be overdone.

 

That is my feeling exactly...recognizing these macro factors are extremely difficult to predict.  Have you watched the debate between Rosenburg and Grant?  Jim Grant argues inflation, Rosenburg argues deflation.  I follow both (get breakfast w/ dave emails, and have subscription to grants at work).  VERY interesting, though I was still confused afterwards.

 

Generally I agree with you: there are more factors that point towards deflation, but I find it hard to believe policy makers will not respond with too strong a response to avoid deflation therefore stemming significant inflation.

 

That being said, if that is the case, bonds right now are very overvalued relative to stocks, as inflation will destroy bonds (to my earlier point).  Equities in firms with lots of real assets and lots of debt will outperform (assets go up w/ inflation, debt is fixed).  Think stocks like oil tankers, deep water drillers, certain real estate operators.  There are even companies that own and lease construction equipment such as cranes, and operate similar to a REIT (just own assets, no real operations).  I have to believe these are better bets for inflation than gold!

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On the whole inflation/deflation thing, it is a bit perplexing. Every economic sign (gold aside), especially excess capacity, yields, and consumer debt, points to deflation to me. However, i think the response (in a multitude of ways) thus far has been, and will continue to be, that deflation won't be allowed. This policy of avoidance of deflation at all costs we seem to be in suggests that we will have quite an inflationary period in the future, as it is very likely to be overdone.

 

That is my feeling exactly...recognizing these macro factors are extremely difficult to predict.  Have you watched the debate between Rosenburg and Grant?  Jim Grant argues inflation, Rosenburg argues deflation.  I follow both (get breakfast w/ dave emails, and have subscription to grants at work).  VERY interesting, though I was still confused afterwards.

 

Generally I agree with you: there are more factors that point towards deflation, but I find it hard to believe policy makers will not respond with too strong a response to avoid deflation therefore stemming significant inflation.

 

That being said, if that is the case, bonds right now are very overvalued relative to stocks, as inflation will destroy bonds (to my earlier point).  Equities in firms with lots of real assets and lots of debt will outperform (assets go up w/ inflation, debt is fixed).  Think stocks like oil tankers, deep water drillers, certain real estate operators.  There are even companies that own and lease construction equipment such as cranes, and operate similar to a REIT (just own assets, no real operations).  I have to believe these are better bets for inflation than gold!

 

I have breakfast with Rosie everyday. I have also been following Grant to a lesser extent recently. I don't have access to Grant's letters, so i just get snips here and there. They are a great read to balance thoughts. I also like Hoisington and Granthams' macro views for additional perspectives. The only thing i worry about is that minor deflation sits with us for a while longer (maybe even a few years), before policy effects kick in, just as a "real" recovery begins. I have a feeling it is still too early to pursue top-down investing (or hedging) for an inflationary environment. That is my hunch anyway.

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Another possible scenario is modest inflation with high real interest rates once the gov't stops supporting the market.  The assets that will continue to decline in value are of two types: 1) sectors financed by gov't subsidies (education, housing) and 2) highly competitive/commodity fields (energy, technology).  With high real rates, I think debt may still crush some firms and in the sectors mentioned above it could be deadly.  I still see many firms with alot of debt that I think will restructure when even with the recovery they will not be able to start reducing principle with free cash flow. 

 

I agree stocks are priced better than bonds on the whole but I think you need to be do bottoms up analysis to make the real interpretation.  Right now there are some income-type investments who have delay/deferred dividend payments that are great deals like SSW.  An about in $3.00 in FCF once all the ships are delivered and cash flowing with LT fixed contracts.  Right not its sells for just over $10.

 

Packer 

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I agree stocks are priced better than bonds on the whole but I think you need to be do bottoms up analysis to make the real interpretation.  Right now there are some income-type investments who have delay/deferred dividend payments that are great deals like SSW.  An about in $3.00 in FCF once all the ships are delivered and cash flowing with LT fixed contracts.  Right not its sells for just over $10.

 

Packer   

 

SSW looks cheap - interesting.  How do SSW's contracts work - I invested in a few oil tankers in 2003-2006 and am somewhat familiar with their time charters - they had a guaranteed fixed amount and a portion that floated.  Do SSW's have any upside or is it all fixed? If it is all fixed, could increases in costs (i.e. oil & labor) due to inflation eat away at their margins?  Do you know what currency the fixed payments are denominated in? 

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"On the whole inflation/deflation thing, it is a bit perplexing. Every economic sign (gold aside), especially excess capacity, yields, and consumer debt, points to deflation to me. However, i think the response (in a multitude of ways) thus far has been, and will continue to be, that deflation won't be allowed. This policy of avoidance of deflation at all costs we seem to be in suggests that we will have quite an inflationary period in the future, as it is very likely to be overdone."

 

I think we may some deflation at first, then a lot of inflation.

 

It is not in the government's best interest to pay back all their debt with dollars worth more than they are today.

 

I think we may have some deflation (decreased prices of real assets) initially,then once economy starts to grow + gain momentum we will have a lot of inflation.

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Guys - I was thinking about bonds vs stocks with a colleague. He's trying to think of it from the perspective of a widow, say with a 50:50 usual equity:bond split.

 

There are some good companies with attractive earnings yields and dividends, so the divi brings the duration down abit, makes everything a little more bond like. For taxes the divi is better here in Canada too.

 

Volatility is up, but if it costs about 3%/yr to buy slightly out-of-the-money puts, would you attempt to do the stocks vs bonds arb by selling the govies and corporates, plowing it into conservative, well-run, undervalued companies, and paying maybe 1.5%/yr to hedge half that portfolio, or the portion that is no longer in bonds???

 

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SSW has fixed charter rates but also fixed costs provided by the manager.  The manager has an incentive fee based upon the dividend paid.  So for the $3.00 FCF if 90% is paid out the dividend would be $2.70 pre-incentive and $2.57 post incentive fee.  See their 20-F for details.  In essence this is a shipping triple-net lease operation.

 

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SSW has fixed charter rates but also fixed costs provided by the manager.  The manager has an incentive fee based upon the dividend paid.  So for the $3.00 FCF if 90% is paid out the dividend would be $2.70 pre-incentive and $2.57 post incentive fee.  See their 20-F for details.  In essence this is a shipping triple-net lease operation.

 

Packer

 

So does that mean every time charter has a corresponding contract with the manager that fixes the costs over the life of the contract?

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The contracts are negotiated every 3 years so there is some re-pricing risk if the costs go up.  However, given the commodity nature of the tasks, I think the inflation risk is small.  This is consistent with my overall assessment of low inflation given the high value added components (i.e. labor) are in surplus.

 

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