Prem Watsa interview

[Sea Island]

Parsad, Have companies really deleveraged or is it pretend and extend?

 

 

From Zero hedge:

 

It is not surprising that nearly 50% of cash was generated from operating cash flow ($1 trillion) while $600 billion came from new debt issuance (the rest from asset disposition). Yet despite consistent claims that companies have massive deleveraged, just $635 billion of debt was repaid, meaning only $35 billion of debt was actually retired!

 

http://www.zerohedge.com/article/sp-500-full-year-sources-and-uses-cash

[Guest Bronco]

Please keep in mind everyone that much of the cash (piles of cash) are parked overseas and CANNOT be brought back to the US (assumption here is a US headquartered multinational).  This is bad for North America and specifically the U.S.  Instead of giving incentive to bring cash back as we saw in the mid-2000's, we (US Govt) are making it harder! 

 

So most investments are parked in treasuries, or capital is being allocated to overseas expansion and investment. Then people scratch their head on CNBC wondering why companies don't hire.  This world is a crazy place.

[Cardboard]

The pile of cash waiting to be invested argument is a joke. We have heard the same thing back in 2000-2003. It is propaganda from the perma bulls and you never hear what is on the other side of the ledger. They were also talking at the time about a job less recovery following the very short recession. The market only started to go higher once the housing boom resumed. Construction activity is a huge employer.

 

The other thing to keep in mind is that most technology companies had very little debt in 2000 and some had a pile of cash. When earnings declined, the stocks went down 50 to 90% anyway. Some stock prices never recovered. How the economy recovers here is much more important than some seem to think especially when you are paying multiples north of 10 times.

 

There are also sectors of the economy where leaders and investors have not learned anything from the crisis. U.S. REIT's is a prime example. Current yield is 4.4% or a very small premium to 10 year treasuries considering that there is very little growth in funds from operations and that payouts remain very close to FFO. After some maintenance capex, there is no money left to invest or to repay debt. Cap rates remain very low. The only thing keeping this bubble alive is the debt market feeding them with low cost debt and Goldman/others issuing shares for them to investors chasing yield. Almost a ponzi scheme.

 

Cardboard

[tiddman]

I think one important difference between the Japanese and US economies that is often overlooked is population growth.  Japan's population has been flat for nearly as long as their economy.  This is certainly not the sole cause, but I think it is related.

 

In the US, the population has growth at about 2-3% per year for a long time and will probably continue to do so.  Unless all of these new people entering the work force immediately join the ranks of the unemployed, the US economy should grow at close to this rate each year.

 

The US has its own issues with deficits, military spending, leveraged consumers, etc. but for the economy to move sideways for 10+ years, I am not sure what the work force would look like at that point -- unemployment of 10-20%?

[Guest Bronco]

Tiddman - we certainly have population growth - but how much of that is from uneducated illegals scrambling across the border (and I don't mean our friends up north).

 

We will certainly inflate our way out of this, it is the America way.  The inflation and stagnation etc.. will be initially part of the deleveraging process...then you will see it in prices of commodities, real estate, commercial goods, etc.

 

Just my opinion though.  But I don't see how else you get out of the U.S. trillions of debt.

 

[Hawk4value]

"There are also sectors of the economy where leaders and investors have not learned anything from the crisis. U.S. REIT's is a prime example. Current yield is 4.4% or a very small premium to 10 year treasuries... After...capex, there is no money left to invest or to repay debt. Cap rates remain very low....  Almost a ponzi scheme."

 

I totally agree. Real Estate investing is a joke. Why would anyone want to buy an illiquid investment like RE, deal with all the management headaches, risk loss of rent in a downturn, being completely subject to macro forces, and assume large contingent liabilities (debt), all for the priviledge of earning a lousey 4% to 6% Cap Rate. This is insane and yet people have have been buying this 'bill of goods' for a long time. I personally would not touch a RE investment unless it offered a 10% to 12% Cash on Cash (Unlevered)return----Period.  

[Guest Bronco]

Hawk4value - obviously, you haven't been watching any infomercials lately.

 

You can buy tons of property, with no money down.  All you need to do is spend $200 on a course and learn all the techniques tought by industry experts.

 

Aside from real estate, you can make a fortune by placing 1000's of tiny llittle ads. 

 

 

 

[Parsad]

Parsad, Have companies really deleveraged or is it pretend and extend?

 

 

From Zero hedge:

 

It is not surprising that nearly 50% of cash was generated from operating cash flow ($1 trillion) while $600 billion came from new debt issuance (the rest from asset disposition). Yet despite consistent claims that companies have massive deleveraged, just $635 billion of debt was repaid, meaning only $35 billion of debt was actually retired!

 

Hi Sea Island,

 

Most of the debt that businesses operate with currently can be serviced in this environment with little difficulty from their cash flows, and many businesses have huge cash piles that would allow them to meet their covenants if things become worse.  The main form of deleveraging I'm referring to is off-balance sheet stuff...credit derivatives, etc.  While you have other derivatives risk in the system, most of the subprime stuff is gone relative to the amount of equity at risk.  Also, extending debt maturities out is a form of deleveraging, since the company can continue to operate without incumberances...Fairfax did this for seven years and it worked like a charm!  Cheers!

 

[Myth465]

"There are also sectors of the economy where leaders and investors have not learned anything from the crisis. U.S. REIT's is a prime example. Current yield is 4.4% or a very small premium to 10 year treasuries... After...capex, there is no money left to invest or to repay debt. Cap rates remain very low....  Almost a ponzi scheme."

 

I totally agree. Real Estate investing is a joke. Why would anyone want to buy an illiquid investment like RE, deal with all the management headaches, risk loss of rent in a downturn, being completely subject to macro forces, and assume large contingent liabilities (debt), all for the priviledge of earning a lousey 4% to 6% Cap Rate. This is insane and yet people have have been buying this 'bill of goods' for a long time. I personally would not touch a RE investment unless it offered a 10% to 12% Cash on Cash (Unlevered)return----Period.  

 

My brother and I have discussed moving into Real Estate here in Houston. My folks did it in the 80s and it turned out ok. You could start with $20k and keep buying properties and renting them out. Eventually you could end up with 20 properties and a nice set of tax losses to offset other income.

 

I have thought about it for a while, but believe Buffett was right. Someone asked him why he didn’t do real estate and he said he makes money in stocks, and it’s much easier. It would take 2-3 months (a lot of headaches) to buy a house and the risks are huge. Then if I were to move it would be even more annoying. The leverage is nice, but I prefer to just buy FUR with 10% of my money. I would rather let Ashner do the work, and focus on deep value with the other bit of my money. Klarman says REITS are overpriced, but is hoping to find deals in commercial real estate. I would like to buy a property as an inflation hedge but don’t think it’s worth it. I prefer the freedom. The only way I would buy one is if I walked into a bunch of equity and could pull capital out of the purchase vs. putting it in.

 

[tiddman]

Tiddman - we certainly have population growth - but how much of that is from uneducated illegals scrambling across the border (and I don't mean our friends up north).

 

Not sure if you are kidding or serious... but new illegal immigrants have been estimated in the 500,000 per year range for the past few years, while the overall population is growing at about 5-7x that.  And many of those illegals later become legal, and most of them are employed (which is usually the reason that they came to the US to begin with).  I don't think the country is at risk to be overrun with unemployed illegal aliens.

 

But I don't see how else you get out of the U.S. trillions of debt.

 

I tend to agree, and with the military spending, the US is basically taking a mortgage on its future in order to finance the wars of today.  I am not sure if they will ever reap any kind of economic benefit that would offset this spending.

 

However, it was less than 10 years ago that the US ran a budget surplus... for 4 years running in fact, and it didn't take wild inflation to get there.  I think looking at the deficit in a deep down cycle in the economy and assuming that it will remain there forever is a mistake.

 

Why would anyone want to buy an illiquid investment like RE, deal with all the management headaches, risk loss of rent in a downturn, being completely subject to macro forces, and assume large contingent liabilities (debt), all for the priviledge of earning a lousey 4% to 6% Cap Rate.

 

Look at it this way.  Generally, over long periods (10+ years), real estate that is in economically successful areas appreciates at somewhere around 3-8% per year long term.  You can safely buy such an asset with leverage up to 4:1, probably 3:1 with more safety.  With 5% appreciation and 3:1 leverage that is a 15% long term return, and real estate has a natural inflation hedge.  I can see how that can be attractive.  This applies to a single unit residential property or an office tower.

 

Many REITs invest for yield instead of appreciation, and I agree that a cap rate of 4.4% is too low -- that is lower even than the cap rates at the market peak in 2006.  A cap rate of 6-8% is probably more safe/reasonable.

 

[tiddman]

I have thought about it for a while, but believe Buffett was right. Someone asked him why he didn’t do real estate and he said he makes money in stocks, and it’s much easier.

 

... for Buffett, but not for most people.  You also need a lot more money to invest in order to become wealthy with stocks than with other assets.  Buffett started with $100, and if he were only investing his own money, even at 21% per year for 50 years he'dl have "only" around a million dollars.  The way that Buffett got wealthy was by the leverage effect of investing other people's money.

 

Real estate investing provides another form of leverage, which in some ways is riskier but also easier for the typical person to obtain.  I know a lot more people that have become wealthy via real estate than by the stock market.

[Myth465]

I have thought about it for a while, but believe Buffett was right. Someone asked him why he didn’t do real estate and he said he makes money in stocks, and it’s much easier.

 

... for Buffett, but not for most people.  You also need a lot more money to invest in order to become wealthy with stocks than with other assets.  Buffett started with $100, and if he were only investing his own money, even at 21% per year for 50 years he'dl have "only" around a million dollars.  The way that Buffett got wealthy was by the leverage effect of investing other people's money.

 

Real estate investing provides another form of leverage, which in some ways is riskier but also easier for the typical person to obtain.  I know a lot more people that have become wealthy via real estate than by the stock market.

 

Very true but for me at the moment its not worth the time. If you have money coming in via a Job then you have a choice to make concerning capital allocation. For most RE is the best deal, for me at least this year its going to have to be stocks.

 

Also RE is like any other investment. It makes sense at the right price. Where I am its close but doesnt make sense from a time perspective.

[SharperDingaan]

 

Nothing like a contoversial comment or two!

 

Keep in mind that the optimal hedge is 50% cash. Go above or below this & you're taking a directional position. You get zero P&L impact, and a change in both cash and cost base.

 

The cost of cash is the T-Bill rate + the liquidity discount on whatever you want to buy (not in the textbook). Yes a central bank can reduce the T-Bill rate to near zero, but removing the liquidity discount is a lot harder; as the very high TED & euro spreads of last year proved. Liquidity is also very like the decay on a call option where the X axis is leverage and the Y axis is economic responsiveness. Reduce from 40x to 20x and leverage goes down, but economic responsiveness doesn't improve by much.

 

In the real world we mostly are not liquid. Lots of bids but you cant sell the asset (will your spouse really let you sell the house?). It is because we can't sell that the option markets exist.

 

Understand liquidity, & much of the 'angst' instantly dissapears.

 

SD

[twacowfca]

 

Nothing like a contoversial comment or two!

 

Keep in mind that the optimal hedge is 50% cash. Go above or below this & you're taking a directional position. You get zero P&L impact, and a change in both cash and cost base.

 

The cost of cash is the T-Bill rate + the liquidity discount on whatever you want to buy (not in the textbook). Yes a central bank can reduce the T-Bill rate to near zero, but removing the liquidity discount is a lot harder; as the very high TED & euro spreads of last year proved. Liquidity is also very like the decay on a call option where the X axis is leverage and the Y axis is economic responsiveness. Reduce from 40x to 20x and leverage goes down, but economic responsiveness doesn't improve by much.

 

In the real world we mostly are not liquid. Lots of bids but you cant sell the asset (will your spouse really let you sell the house?). It is because we can't sell that the option markets exist.

 

Understand liquidity, & much of the 'angst' instantly dissapears.

 

SD

 

 

 

Sharper, I perceive that you've touched on two or three profound ideas, but I can't quite wrap my arms around them.  Can you give two or three examples or illustrations of these concepts and walk me through them?

[Guest ValueCarl]

SD, that's an interesting post on liquidity.

 

Would you be so kind to illustrate this "liquidity discount" on any given purchasing decision for identifying cost? Thx.

 

<The cost of cash is the T-Bill rate + the liquidity discount on whatever you want to buy (not in the textbook). Yes a central bank can reduce the T-Bill rate to near zero, but removing the liquidity discount is a lot harder; as the very high TED & euro spreads of last year proved. Liquidity is also very like the decay on a call option where the X axis is leverage and the Y axis is economic responsiveness. Reduce from 40x to 20x and leverage goes down, but economic responsiveness doesn't improve by much.>

 

 

 

[Rabbitisrich]

Wouldn't the liquidity discount be a negative number with regard to T-bills? I thought the LIBOR-OIS and TED spreads demonstrated the cash like quality of perceived "risk-free" securities by showing how valuable they became relative to risky securities.

[Rabbitisrich]

Or actually, shouldn't the liquidity discount (premium) be implied by the current rate of T-Bills?

[SharperDingaan]

 

Assume that you & everyone other western PM is convinced that Europe is done for, & the emerging market is where its at. The western $ inflow is 5x the local demand for the EM stock, the price goes up, & rapidly. Why? the market is flooded with idiots willing to give up increasing amounts of cash for a diminishing float of stock. It is liquid, it is overliquid.

 

One year on, & our western PMs are convinced that Europe is where its at & EM is done for. But the market is populated with only a few local people, that are willing to give up progressively less cash for the increasing float of stock. The price drops like a brick because it is illiquid. In very simple terms, the liquidity discount is the (price paid - price received)/price paid.

 

The discount occurrs because a seller has to get out, you're the only bid, & you're willing to give up cash. If you were to simply exchange one turd for another (to establish a 'market' price for valuation purposes) there would be either no discount, or something very nominal.

 

SD 

[SharperDingaan]

 

Imagine you have $41 of asset supported by $40 of debt & $1 of equity. In grossly basic terms you have 40:1 leverage ($40 debt/$1 equity). Now imagine that you manage to 'de-lever' by selling $18 of asset for a net gain of $.10 - you now have $23.0 of asset, $21.90 in debt, & $1.10 in equity, or 19.91:1 leverage. You`ve reduced debt by 50% but not really improved your equity - which is what actually increases your economic responsiveness.

 

Redo the calculation iteratively, but assume that on every $2 of deleverage you make a progressively larger gain (as you can progressively afford to wait for a higher bid). Plot equity (highest on the bottom) on the Y axis against leverage on the X axis. The shape should look familiar.

 

The unusual Y axis is simply to make the plot more obvious.

 

SD 

 

[SharperDingaan]

 

Modern finance asserts that you can sell any asset at a low enough price, there is liquidity. VaR is so sure of it that it can assert with 95% probability that you cant lose more than $X, 19 times out of 20. And because JPM & pretty much every CFA has had this drilled into them - it can only be so!

 

Long Term Capital blew up because they forgot about credit risk. Credit default swaps got invented to hedge the risk ... but everybody missed that you`re reliant on the liquidity of the counter party. That mistake blew up all 5 US I Banks. GS proved that if you could stack all the gold on the floor, & get yourself blessed (WEB), you could survive a run. 

 

But ... regulators don`t let you count 100% of the MV of a CCC asset for regulatory purposes. Basel II & III now have much higher VaR capital multiples than they used to. ..... because even they recognize that liquidity is a problem.

 

Heat water from 99C to 100C and it takes a lot of additional energy to overcome the latent heat of evaporation & get the liquid to turn to steam. In the financial market that `latent heat`is central bank provided liquidity. When you don`t have it you get a collapse (UK in 2009)

 

SD

 

[Guest ValueCarl]

SD, if there is at least one thing I learned from you for sure, it's the reason why mechanical and/or chemical engineers might make outstanding financial engineers in the case of business.

 

You didn't happen to graduate from the Indian Institute of Technology, did you?  :D

[Myth465]

Thanks for the reminder Parsad. They always seem to come when I am about to do something crazy or over think something. I will stick to my strategy and will look to keep my cash position at a decent level, unless a huge deal comes along.

You are right that we don’t have statutory requirements and what not, and can afford a haircut. It may even be beneficial if we have a bit of cash available.

 

In times like this I review my investment quotes and came across these 2 gems. One is old, and one is new but both give great advice for these times.

 

Warren Buffett - "An argument is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: “Maintain buying reserves until current uncertainties are resolved,” etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear and you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values."

 

Levy Harkins - "Certainty - You pay a very high price for it in the investment world and then you hardly ever get what you paid for."