Editor’s note: I’ve known Dan Ferris, as both a friend and as a colleague at Stansberry Research, for many years. I’ve learned a lot from him about how to value stocks. Recently, he talked about how we’re in the midst of a speculative mania, and discussed five traits of speculative manias. In today’s essay, Dan shares the remaining two traits… explains why you must prepare for poor returns… and offers three actions he believes every investor should take immediately…
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Q2 hedge fund letters, conference, scoops etc
You need to understand what a mania looks and feels like to survive it.
That’s why recently, I detailed five traits of speculative manias.
I continue to believe several years’ worth of stock-price gains will evaporate quickly when the current mania finally ends. But human nature is perverse. Following the herd into expensive stocks gets more attractive as it gets more risky.
Don’t let the mania tempt you to overpay for stocks to make a quick buck.
But also, don’t let it deter you from investing in attractive securities and assets whenever and wherever you find them.
I’ll explain more on that subject in a moment. But first, let’s go over the final two traits common to speculative manias…
6. “This time is different”
The most famous example of Trait No. 6 was days before the 1929 crash, when economist Irving Fisher said stock prices had reached “a permanently high plateau.”
Today, anybody who does not acknowledge that U.S. equities are trading near their highest valuations of all time (second only to January 2018) is as blinded as Fisher. U.S. equities have always performed poorly from current valuations.
Even famous investors try to convince themselves and others that “this time is different.” Jeremy Grantham published a report saying exactly that, titled “This Time Seems Very, Very Different.”
Warren Buffett appears to have abandoned his primary metric for gauging the value of the overall market (U.S. total market cap divided by gross domestic product) to a nebulous statement that stocks are cheap as long as interest rates stay low.
Markets love to reward hubris, right up until the minute they destroy it. Only overconfidence and lack of experience could lead anyone to believe banishing fear and doubt is possible. It’s not. Living with it and managing it is possible and necessary for investment success.
7. Financial shenanigans
This trait describes the nuts-and-bolts reasons why investors lose money in individual stocks during a financial mania.
As equity markets rise higher, the incentive to keep reporting good results grows stronger, compelling management teams to report better numbers than business reality might dictate.
The worst financial shenanigans are the ones that affect entire swaths of the stock and bond markets. They tend to go on – detected or not – for a long, long time. Then one day, the chickens start coming home to roost, and investors suddenly find themselves deep underwater.
Today, there’s an enormous underlying problem affecting the overwhelming majority of U.S. public companies: the increasing use of non-GAAP accounting in quarterly and annual financial reports.
GAAP stands for generally accepted accounting principles. It’s the standard for reporting financial results. Sometimes, a business might feel the standard doesn’t accurately portray the true financial performance of the business. So instead, it will publish figures not supported by the GAAP standard to portray the business in a more accurate light.
Non-GAAP figures aren’t inherently bad. Free cash flow (FCF) – my favored earnings metric – is a non-GAAP number. The problem comes when differences between GAAP and non-GAAP numbers grow larger. That’s what’s happening today, as noted in an October 26 blog post by State Street analyst Michael Arone…
“Today, the difference between GAAP and non-GAAP earnings is very wide. In the second quarter, the average difference for companies in the Dow Jones Industrial Average reporting both GAAP and non-GAAP earnings was a whopping 20 percent…
Eventually, when the spread gets too wide, earnings and [stock] prices are likely to come crashing down, resulting in smaller differences between the two accounting measures.”
Financial data and software company FactSet also recently noted that…
“The fourth quarter marked the 18th time in the past 20 quarters in which the bottom-up [earnings per share] estimate decreased during the first two months of the quarter while the value of the [S&P 500 Index] increased over this same period.”
The per-share intrinsic value of a business can only increase if its earnings per share (EPS) also increases. This statistic suggests that the market is either OK with all the unpublished abuses of non-GAAP accounting, or that a reckoning may be at hand.
Lastly, a June 2017 article in the CPA Journal studied non-GAAP adjustments for six large social media companies – Facebook, Groupon, Pandora, LinkedIn, Twitter and Yelp – from 2011 to 2015. The authors concluded: “The magnitude of non-GAAP adjustments increased over time for all the companies in this study.”
So… what can increased non-GAAP reporting do to your returns?
Just look at General Electric. It was once the bluest of blue-chip stocks, but its share price was down almost 45 percent last year. GE’s comeuppance was years in the making…
Especially during the tenure of former CEO Jack Welch from 1981 to 2001, GE became a notorious earnings manipulator. Welch fostered a highly competitive make-your-quarterly-numbers-or-else corporate culture. The culture might not be as competitive now, but the financial reporting hasn’t improved and investors are fed up.
An October Bloomberg article said as much, noting that GE reports four separate EPS numbers, each excluding various expenses. Bloomberg said GE is one of 21 S&P 500 companies to report more than one EPS figure – though nearly all S&P 500 companies report some form of non-GAAP metrics, up from 58 percent of S&P 500 companies using non-GAAP reporting 20 years ago.
I suspect that when the current mania ends, many companies will suddenly get religious about GAAP accounting again as the deficiencies they’re hiding finally become unavoidable. This will send many share prices sharply lower… likely reflecting enough investor revulsion to push prices well below reasonable intrinsic values.
Non-GAAP issues could lead to thousands of stock prices falling 50 percent or more from their ultimate tops, whenever those tops finally arrive.
It may take more than a few years for such a top to arrive, or it may not. Remember, we don’t bet on predictions. We simply prepare our portfolio for the widest possible range of outcomes.
That includes the likelihood that good businesses purchased at cheap prices will generate acceptable long-term returns. Speaking of which…
I’ve only done it three times in my career.
But all three times, it worked out well…
In the April 2008 issue of Extreme Value, I told readers the housing crisis wasn’t half over and to stay away from leveraged companies in banking and homebuilding. I recommended selling short Lehman Brothers, the only big firm not bailed out by the government.
Readers made 82 percent in five months on that advice. In 2008-2009, about 165 banks failed, including behemoths like mega savings and loan company Washington Mutual. Housing prices plummeted and didn’t bottom out until 2012.
It was a good time to get cautious.
I got cautious again in May 2011, when I told readers about the importance and value of holding cash. It turned out that was right at the top of the market, before we saw a major 20 percent plunge in stock prices that lasted until October.
And in November 2015, I told readers why it was so great to hold cash again. That was two months before the 10 percent plunge that kicked off 2016.
I wasn’t predicting market crashes any of these times. And I’m not predicting one today. The point is, you don’t need to predict what’ll happen in the stock market.
You only need to prepare…
Today, you need to prepare for poor returns and lower prices of financial assets.
Returns are low right now across all of the major asset classes. Cash yields top out at around 1.5 percent if you’re lucky. Triple A-rated corporate bonds yield about 3.6 percent. Stock dividends (as measured by the S&P 500) yield 1.84 percent. Those are lousy long-term returns, and taxes and inflation will only make them worse.
It has been this way for the past couple of years. That’s why we’ve focused on not buying too many stocks in my newsletter Extreme Value since early 2015, when the vast majority were prohibitively expensive.
Thanks to this strategy, we’ve been able to avoid too many bad bets – even ones that could have seemed like good deals – right before sudden, unforeseen downturns…
For example, in July 2015, we published four lists of some of the cheapest stocks in the U.S. We looked at the cheapest stocks based on price-to-book ratio… the ones with the cheapest cash flows… and the worst-performing stocks of the prior one- and three-year periods.
Nearly all of these companies were value traps. We didn’t recommend buying a single one. On average, the best-performing stocks of the four lists fell nearly 12 percent over the next year or so. The worst-performing stocks fell nearly 50 percent on average.
Instead, we recommended buying just one stock and selling 16 before the market took a 10 percent dive from May to August. And all in all, we told investors to avoid more than 100 stocks and to sell 20 of them… in what turned out to be the worst year for the market since 2008.
The market treated readers who took our advice a lot better than it treated most investors.
Of course, we aren’t perfect. I have no doubt we’ll tell investors to sell and/or avoid stocks sometimes only to watch the market rise. But we don’t waste time predicting how stock prices will move in the short term. Neither should you. It’s a fool’s errand.
We didn’t predict that the market would drop. We didn’t need to, because the data in front of us indicated that stocks weren’t a great bet. That’s true today, too. Stocks are expensive… And if the market goes up more from here, they will become an even worse, more expensive bet.
Believe me, telling investors to hold plenty of cash and avoid most stocks isn’t winning me any friends. But it’s nearly impossible to call yourself a value investor these days without doing exactly that.
We continue to recommend three actions for investors right now…
- Hold plenty of cash
Cash is a call option on future steals. It will become most valuable to you when others find it in shortest supply.
- Sell short the shares of deteriorating businesses
This is difficult. You’ll need to manage your short book, aggressively exiting any time you think the wind is blowing too hard against you.
- Buy value-priced assets wherever and whenever you find them
Don’t let the mania prevent you from investing in a truly attractive situation.
That’s all. It’s easy to figure out what to do, but hard for most investors to do it: Avoid most stocks. Hold cash and gold. Don’t predict. Prepare.
Good investing,
Dan Ferris
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