The Caribou Factor
In the 1970s, it was feared that construction on the Trans- Alaskan pipeline would disrupt the migratory patterns and feeding habits of the Porcupine Caribou Herd. Speaking on behalf of their cloven-hoofed brothers, environmentalists held up construction of the pipeline for about eight years. This caused Atlantic Richfield, the pipeline’s owner, to re-price the bonds it had issued to finance the project. In other words, they lost a lot of money.
Since then, costly complications that turn up halfway through a big project have been referred to in the investment community as “the caribou factor”.
When you think about, though, it’s not just the big financial projects where such factors figure. Recognizing the caribou factor is a simple acknowledgment that you don’t own a crystal ball, and you can’t predict the future. All of life is a kind of caribou avoidance and recovery game. From inflation, war and corporate downsizing, to icy streets, drunk drivers and empty parking lots late at night. There are caribou everywhere.
Investing, as ARCO learned in the 1970s, is no different than anything else in this life. Consider all the variables most common stock investors watch. Revenues, profits, returns on equity, debt and dividends. Not to mention share volume, intra-day highs and lows and closing prices. The list goes on and on…
Caribou Factor: Potential Caribou Herds
You control none of those things.
To you, they’re all potential caribou herds, waiting to migrate to your portfolio. In other words, your money leaves your control when you buy stocks and bonds.
Marty Whitman, chief of Third Avenue Funds, refers to you and I (and often himself) as OPMIs. That’s Outside Passive Minority Investors. If that doesn’t sound like a very powerful position, you’re right, it’s not.
In a bankruptcy, OPMIs, in their normal role as common shareholders, are last in line. They usually leave empty- handed.
So-called investment professionals can’t help you much, either. It’s common knowledge that over 90% of all mutual funds fail to beat the market. They fail to avoid the caribou. They should call themselves financial safari guides. They seem to find caribou for a living.
There is, however, a powerful ray of hope for investors.
Caribou Factor: The Price You Pay
You can call it your timing, or when you buy or even what you buy. No matter how you arrive at it, no matter what incantations you intone or what stars you plot, or how much accounting you know, or how many numbers you run, or if you’re Warren Buffett or John Q. Public…Investing boils down to one, simple assessment that you, the investor, and you alone must determine: the price you pay.
Given that the caribou factor takes over after you buy, it behooves you to spend more time on assessing the price you pay than on anything else. That goes for any passive investment you make: stocks, bonds, futures, options, MITTs, TIPs, you name it. Your number-one concern, I believe, is what it’s worth to you, and how much you’ll pay. All other factors move across your financial landscape, on bad days alternately devouring and befouling it, on good days…ignoring you and not providing you with one iota of benefit.
If you want to obsess about something as an investor, obsess about the price you pay. Low price to book is, obviously, one way to buy on the cheap. High earnings yield, more commonly known as low P/E, is another way.
Buy a $10 stock trading at half of book value, and you could profit, even if the company shuts down. Buy the same stock at $40, and you’re placing a long shot bet that caribou won’t like the flavor of your money.
The Caribou Factor: Every Caribou in the Countryside
If you buy the S&P 500 at 20 times earnings, and it reverts to its historical mean of 16 times earnings…and then falls in half from there, well, don’t be surprised. That kind of price (i.e. high) is a signed, sealed invitation to every caribou in the countryside. When stocks fall well below 16 times earnings, the food supply dries up, and caribou herds thin out.
Invest in a company that trades at a market cap of $177 million, and owns a few billion dollars worth of land, and you could still get hit with a caribou infestation. But the odds are against it. Buy the same company for a premium to the fair market land values, and you’re playing craps at the Caribou Casino.
In the stock market, tilting the odds in your favor – by controlling the price you pay – is the best you can do. In fact, buying low price to book value stocks and selling them every two years produced a 22% average annual return between 1930 and 1980. Those aren’t entirely caribou-free returns, but they’re as good as it gets.
Buying value at extreme lows in price is one of the most reliable caribou repellents around. Maybe cheap stocks smell like Eskimos. High prices, on the other hand, smell like female caribou in heat.
Fortunately, you get to choose which scent you’ll wear – what price you’ll pay.
for The Daily Reckoning
March 11, 2003
Yesterday, the stock market seemed to be on the edge of panic. McDonald’s dropped back to levels it hasn’t seen in 10 years – $12.42. SBC hit 9-year lows.
Fannie Mae and Freddie Mac fell 7% and 6%, respectively, after St. Louis Fed president William Poole wondered aloud if they had enough capital to withstand a shock in the mortgage market.
The two government-sponsored lenders may or may not be able to survive a major tremor in housing…but surely many of their customers will not. Fannie and Freddie, it might be recalled, were set up to finance houses for people who couldn’t afford them. Gradually taking business from competitors, and given a huge boost from lower interest rates, they became the major players in the biggest boom ever in the mortgage industry.
When houses are bought and sold in America – even old houses – a curious thing happens: the net level of debt goes up. You might think that the fact that Mr. Jones moves out of 110 Willow Ave. and Mr. Smith moves in would be, economically, neutral. The house is just as it was; no new wealth has been created.
But Mr. Smith, typically, finances the purchase through Fannie Mae at a higher price, and with less equity remaining, than Mr. Jones had. In this manner, across the entire U.S. of A., debt increased by $350 billion last year, says a Fed report, much of which was spent.
Often, Mr. Jones doesn’t even leave his house. He merely refinances it. Rarely does he use the occasion to reduce his debt; instead, he almost always increases it.
Altogether, again according to Fed figures, the debt load on America’s houses went up $700 billion – an amount equal to 10% of the nation’s total housing equity at the beginning of the year.
This is the money that is keeping the economy growing (barely). But the cost is high. For if Americans take out 10% of their equity every year, soon they will have none left. They will all be renting – from Fannie Mae!
Recent signs point to a turnaround. People are getting weary of digging deeper and deeper holes for themselves. More of them are going bankrupt each year. Health care and energy costs are rising steeply. (“Soaring Gas Prices Changing Lifestyles,” says a Washington Post headline.) It has become more and more difficult to find good jobs. They’re still refinancing; they need the money. But they are less willing to part with money when they get it. Walmart reports slowing consumer sales. Even savings rates are headed back up – recently clocked at about 4%, up sharply from their level below 2% in the late ’90s.
As long as they have jobs and housing prices are rising, people will probably keep making their mortgage payments. But come the day when housing prices fall…(the year-on- year median price of new houses fell by 2.6% in January)…or people lose jobs…then, Fannie & Freddie will be in serious trouble. They may survive the shock – but not with today’s share price.
But here’s Eric with yesterday’s Wall Street report:
Eric Fry, from New York City…
– The stock market can’t seem to shake its predilection for heading south. Try as it might, it cannot seem to find its true north. Yesterday, the Dow took another 172 paces in the wrong direction to close at 7,568. The Nasdaq, following the Dow’s misguided lead, headed 27 steps to the south, ending up at 1,278.
– Gold, looking very much like the eagle scout of this metaphor, advanced $3.90 to $354.80 an ounce. Surprisingly, and much to the bewilderment of gold bulls, the shares of most precious metals companies tumbled right along with the general market yesterday. The XAU Index dropped 3.7%, despite the rallying gold price.
– It’s tough enough to make a dollar in this market, without losing money when you’re “right”. But, sadly, that’s been the situation in the gold shares market for the last several weeks. Gold has been holding solidly above $350 an ounce, while most gold stocks have been sinking. The XAU Index, for example, has dropped more than 15% so far this year, even while gold has gained about 2%.
– No one can say exactly why the gold stocks are behaving so poorly. But one plausible explanation is that, for brief periods of time, gold stocks will behave as mere stocks, rather than surrogates for gold itself. That’s because, when an investor looks to raise money he will often sell his winners first. (The losers will come back, right?) Gold stocks, being among the very few winners in most investors’ portfolios, are logical candidates for money-raising…and so they are sold.
– But once this liquidation runs its course, and assuming that gold remains strong, the gold sector should rebound nicely. That’s the rosy scenario, at least…
– General Electric’s pension plan “gains” contributed $806 million to pretax profits in 2002, even though the company’s pension actually LOST $5.25 billion last year – a staggering sum equivalent to 29% of GE’s pretax income.
– If only such financial alchemy were possible forever, we could enjoy a swell new bull market in no time. But, alas, GE’s pension plan “profit” last year was little more than an accounting fiction. The company simply relied upon a legal – albeit deceptive – accounting practice that permitted the industrial giant to book a profit based upon its ESTIMATED pension gain of 8.5%, rather than its ACTUAL loss of 11.6%.
– Deceptive pension accounting is but one of the many fictions that helped perpetuate the late-1990s bull market. Unfortunately, dear reader, fiction must yield to reality…eventually. And in the case of pension plan fundamentals, “Reality bites!”
– If, for example, the S&P 500 companies had included their actual pension plan losses in their 2001 earnings – instead of their fictional gains – earnings for the S&P 500 would have been about 69% lower than what the companies reported for 2001, according to Credit Suisse First Boston Corp. In other words, without fictional pension plan profits the S&P 500 would have reported earnings of $68.7 billion in 2001, rather than $219 billion.
– Stock market declines in the past two years have led to more than $200 billion in pension fund losses for S&P 500 companies, according to the CSFB study. Incredibly, almost none of those losses have appeared on corporate income statements. (GE’s monster pension loss, for example, appeared only in a footnote on page 27 of its latest annual report). But these multi-billion dollar losses are no less real for being well concealed.
– Therefore, even if the economy were to improve dramatically tomorrow, the accumulated fictions upon which our beloved stock market rests are so considerable that corporate earnings – the real kind – are unlikely to make any significant headway any time soon. To the contrary, lower profits and therefore, lower share prices are the more likely outcome.
– “This is a secular bear market,” David Tice explains in a recent interview with Newsday. “It has a long way to run. As much as we would like there to be prosperity in the U.S., we see that the excesses and imbalances from this excess boom have got to be wrung out of the system.”
– Tice, as many Daily Reckoning readers know, is the manager of the Prudent Bear Fund and a regular contributor to Strategic Investment. “We partied hard,” says Tice, “but now we will experience the hangover.” Tice advises investors to sell stocks and buy gold. “That’s how we’re playing it,” he says.
– Reasons for macro-economic caution are certainly not in short supply. The nation’s dismal unemployment trend may be one of the very best reasons to worry that corporate profits will remain under pressure.
– “The percentage of Americans who have been out of work for six months or longer reached the highest level in more than a decade last month and could soon exceed the peak of the 1990 recession,” USA Today reports. “The steady rise in the number of long-term jobless, who made up 22.1% of all unemployed workers in February, according to the Labor Department, is a telling sign the economy is in worse shape than the headline 5.8% unemployment rate would suggest. Further, private-sector payrolls, measured on a year-over- year basis, have been falling for 20 months. That’s the longest decline since the mid-1940s, according to the Economic Policy Institute, a think tank…The percentage of people out of work for more than 26 weeks hasn’t been this high since October 1992, when the economy was recovering from recession.”
– Workers who don’t work very quickly become consumers who don’t consume…and we all know where that leads.
Back in Paris….
*** Warren Buffett: “Occasionally, successful investing requires inactivity.” Buffett thinks this is one of those times. Well, yes…if you already got out of stocks. If not, we remind you, dear reader, it is Code Fuschia here at the Daily Reckoning office. Get out of stocks. Buy gold and eurobonds. Then, you can be as inert as congressman.
*** Oh là là…when will the Nikkei ever find its bottom? Yesterday it dropped below 8,000…10 years after investors thought it had bottomed out in 1993.
*** Maria is featured in this week’s Madame Figaro magazine. She is pictured in a variety of exotic get-ups, with the island of Mauritius as the background.
*** War, war, war….it seems as though it is all anyone talks about. Last night, at a small gathering of Americans who have lived in Paris for many years, the talk was war…and almost all were appalled by it.
“Did you see what they are doing to those prisoners….” one began. “You know, those people arrested as suspected terrorists. They’re putting hoods on their heads and forcing them to kneel for long periods. They aren’t allowed to sleep…I don’t know what else….but it sounds barbaric.”
“People in the U.S. seem to be in favor of this kind of thing….they support the war against Iraq,” she continued.
“But I don’t get it….they’ve all gone a little nutty. Did you see that they arrested some guy coming out of a shopping mall for wearing an anti-war tee-shirt…and they’re searching grandmothers at airports? I mean, does anyone really think that my grandmother is a terrorist?
“Yes, it’s a kind of hysteria,” another agreed, “it’s like the McCarthy years…a witch hunt…”
“Now wait a minute,” your editor rose to defend his dead countrymen. “Everybody compares the McCarthy period to the Salem witch hunt. But that was a time when America really did seem to be in danger. The Soviet Union had just beaten the German army, had atomic bombs, and had a man much worse than Saddam Hussein in power – Josef Stalin. McCarthy wasn’t looking for witches; they don’t exist. He was looking for communists…and there were at least a few. As moronic as it was to be looking for bolsheviks in Hollywood in the late ’40s, it was probably less silly than pretending that every grandmother and girl scout is planning to attack the Pentagon today.”
*** Even at the bar where your editor had lunch yesterday, the talk was war. Two elderly gentlemen came in with a chess set. They sat down at a nearby table, spread out the game, and ordered beers. One wore a small hat and never took his eyes off the board. The other chatted, swore, got up a few times, and fidgeted.
“Merde…” said he, after his rook was taken.
“Look at that…my side of the board looks like a battlefield….look at all the fallen soldiers…” he continued to himself…
“It reminds me of the battles of Clovis [King of the Frankish tribes, A.D. 466-511]…I don’t know why….I was just thinking of Clovis…we think he was such a great king. But he was really just a barbarian.
“But Bush…you know, he’s a barbarian too…a modern barbarian.”