Act 1, Scene 1
The curtain opens on Sherlock Holmes, pacing intently around his office. He stops briefly to light his pipe. On the sofa, poring over a Value Line summary, sits Fräulein Maria, slightly flushed. Behind her, the great mathematician Carl Jacobi stares through the window at the street below, deep in thought.
HOLMES: There must be opportunity here somewhere. Cash just will not do. But the banks are a mess. Consumers in hock, agreed. All the sovereigns -- Europe, North America, Japan-- levered to the gills.
HOLMES: I quite agree, Maria. Of course, what we are looking for will not be obvious. The undervalued parts of the market are often so still and quiet. Like a dog I once knew that didn’t bark. <Pauses to re-light pipe> But how to find them?
JACOBI: <Agitated, turning suddenly from the window> For the last time, Holmes. Invert! You must always invert!
Figure 1: Carl Jacobi: Always Invert
And invert we must.
There is no mathematics that relates to investing which even approaches the complexity of Jacobi's elliptic functions. However, the concept of inverting terms to generate additional insight into a tricky problem is appealing in principle. Perhaps this is what Charlie Munger means when he frequently incites the mantra of the great Prussian mathematician.
One observation I have often had of the capital markets in retrospect is that the great trades often come from the quiet sidelines, rather from the blazing headlines. Perhaps, when we look back on this period ten years hence, focus on the various train wrecks and squeaky wheels of the current financial crisis will be viewed as time wasted. But is there an analytic approach that could help us identify attractive places on the quiet sidelines? Are there terms we can invert which shed light on untapped opportunities?
Turning Current Yield on its Head: The Cap Rate Example
Summing up the great bounce of 2003 to 2007 in a simple phrase, it would be the quest for current yield. Investors, we were constantly reminded in those years, wanted income and dividends. Jim Grant even went so far as to coin a name for the less discerning members of this class -- the yield pigs.
The yield pigs drove down a wide variety of rates and spreads to record lows at the peak of the bounce in late 2006 and early 2007. Amongst the low rates was the real estate valuation metric known as the "cap rate." The cap rate is simply the ratio of the net operating income of a rental property divided by the market value of the property. If a building that yields $5 Million in net operating come can be sold for $100 Million, then the cap rate of that transaction is 5%.
Inverting the cap rate (that is dividing the price by the operating income) gives us a multiple of price to net operating income. In our example above, the building would have been sold for a multiple of 20X. The lower the cap rate, the higher the multiple. If our building with $5M net operating income can be sold at a 4% cap rate then the value of the property would rise to $125M.
If we play about with assumptions of cap rates, one can make a couple of interesting obervations. As cap rates approach zero, multiples rise towards infinity. As cap rates rise to high numbers, then multiples approach zero.
So now we play a game of what if? What if the late stages of the real estate bubble were about momentum players projecting the continued decline of cap rates toward zero? What if they had been 180 degrees wrong?
As long as the trend of rates and spreads was towards zero, investing for yield made a lot of sense. You made your coupon and you got a multiple boost. But at the opposite extreme, where rates rise towards infinity, investing for yield is a losing strategy. In a rising inflation environment you want to do something else, but what?
The Inverse of Yield
Investing for yield is a strategy that works only some of the time. In a world with a relatively fixed supply of money, investing capital to earn interest is generally worthwhile. As investors receive interest (or dividends) while at the same time retaining ownership of their capital, they increase their share of the overall money supply and become relatively wealthier. And wealth, when it comes right down to it, is a relative game.
However when money supply starts expanding unnaturally quickly – call it “quantitative easing”, “credit easing” or just good old fashioned money printing – then profiting from “yield” is a more complicated undertaking. Part of the investor’s income stream just keeps him even with the growth in the overall supply of money. The higher the growth in money, the bigger the premium investors require to stay in the yield game. At a certain point, the point where projected growth in money supply becomes very high, investors ought to look beyond mere yields.
In the days when we used to read the newspaper to get stock quotations, I once questioned why the annotation “p” appeared beside the dividend amount for certain shares listed on the Vancouver Stock Exchange. It turned out that the “p” indicated a stock dividend. What, I asked, is the point of issuing a stock dividend? The company stays the same size and everyone just owns slightly more shares? The more I look at “income producing” investments these days, be they t-bills or bonds or high dividend equities, the more I am reminded of these old stock dividends on the VSE.
The inverse of yield investing, in my view, is the ownership of scarce assets. These assets are owned not because of a yield, but because they are valuable and will maintain their “wealth share.” Money, as we all know, can be created for nothing. But you can’t print wealth.
More Practically…
But if we felt like taking our capital and walking away from instruments offering an increasingly dubious “yield”, where would we put it? Real estate, the asset class that throughout history has separated the noble from the commoner, would be an obvious place to go under normal circumstances. But as the central asset of the recent bubble, one suspects that real estate is over-owned, over-built and over-priced. And if that weren’t enough, we know real estate is extremely over-leveraged.
One non-yielding investment of interest is silver. As noted recently in this space, silver is scarce, of growing utility and significantly undervalued. Gold and platinum, although subject to slightly different supply and demand dynamics, ought to work out in a similar way.
Having made a pitch for shiny metal bars, one should not forsake all other assets. In my view there are many businesses which own assets even more scarce and useful than the precious metals. Two areas that look attractive are grain handling infrastructure and software.
Grains, grain handling and processing: Jim Rogers says that one day it will be farmers who will be driving all the fancy cars. That may be a bit excessive, but certainly the demand profile here is one of the least likely to be affected by the broader economy. If we have inflation, grains, whose inflation-adjusted price has declined approximately 50% from 1982 to 2009, ought to hold their own.
Figure 2: Wheat Prices ($US 1982-2009)
More interesting than the grains themselves is grain handling capacity, especially in cases where it is protected from competition. During the grain price spikes of the 1970’s, elevators filled up. On a growing commodity price there is less risk in carrying inventory and more speculators looking for a way to squeeze out shorts from the futures market. With higher grain inventories, handling capacity shrinks and operators should be able to exert significant pricing power. In terms of individual names, Viterra, Andersons and ADM should be worthy of some investigation in North America and Singapore-listed Wilmar International, whose focus is palm oil, also looks attractive.
Software: For different reasons, software companies may also be an attractive area to study. In a market that was willing to pay anything for yield, few cared for assets. Intangible assets, the stock-in-trade of most software companies, were especially shunned. However, the right intangible assests can prove to be very scarce and may allow a software business to exert considerable pricing power.
Screening the lower EV/Assets ratios results in a list of many fairly healthy software businesses with excellent balance sheets. I have posted at length on Novell Inc. and RealNetworks, but Microsoft and Cray Computer (a software business disguised as a hardware business) also look good to me in the longer run.
Software players with strong balance sheets have an important embedded option, in my view. As Venture Capital – the industry – faces headwinds, venture capital the concept may allow existing software players to pick up cheap interests in the next generation of innovative software franchises. A growing software platform has few equals in terms of scarce assets.
Investing based on scarcity, rather than on yield, has an admittedly counter-intuitive feel for anyone who has been involved in the capital markets of the past decade. But, to summon the wisdom of Holmes again, “When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”
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