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The Arithmetic of Equities

riting a periodic managers letter is risky. You can be really, really smart and write excellent, insightful letters month after month and nobody notices. Then you write one really, really dumb letter and everybodys talking about it. Oh, you thought I was talking about me? Hah! Well I can understand the confusion. Actually I was thinking of Bill Gross, of PIMCO fame.

Grosss recent letter proclaiming (yet again) the death of equities is getting lots of attention mostly because compared to his usually insightful pronouncements it is extremely silly. Gross employs several shaky arguments. First, he irts with the notion that nearly a centurys worth of 6.6% real returns on U.S. stocks must be a hundred-year uke because real GDP growth is closer to 3.5%. This argument seems to crop up a lot lately; I wont bother with it here because it has been refuted very well by Ben Inker of GMO and because even Gross seems to suspect its weakness. The argument he really believes in focuses more on the past 30 years. Grosss notion is that although Jeremy Siegels 6.6% estimate of the long-term return on stocks appears to have remained valid since 1912 it is actually contradicted by the record of the past 30 years. As everyone knows, stocks had one really rotten decade in the 2000s. But that was hardly a surprise. Entering the 2000s PEs were exceptionally high and had been elevated above historic levels for much of the previous two decades. The lost decade all by itself doesnt look like a refutation of the long-term advantages of equities. It just looks like a longish anomaly well explained by the excesses of the last few years of the boom.

Gross knows this. His argument gains force by switching the subject from the 10-year performance of equities to the relative performance of bonds and equities not over 10 years, but 30. Here is the critical passage: Jeremy Siegels rather ill-timed book a rming the equity cult, published in the late 1990s, allowed for brief cyclical bear markets, but showered scorn on any heretic willing to question the inevitability of a decade-long period of upside stock market performance compared to the alternatives. Now in 2012, however, an investor can periodically compare the return of stocks for the past 10, 20, and 30 years and nd that long-term Treasury bonds have been the higher returning and obviously safer investment than a diversi ed portfolio of equities. (Emphasis added.) My rst response to this is who cares? I suppose that lacking any other data one might decide to value stocks or bonds based entirely on statistics about their historical performance. But to do this in the rst instance, ignoring abundant and relevant current data is absurd. Suppose I wanted to know whether you have high blood pressure. I could ask you about your diet. I could ask whether you exercise regularly. I could ask whether your parents or grandparents had high blood pressure. I could do any or all of those things and get a decent result. Or I could, you know, actually take your blood pressure. Of course Gross is right that historically weve been in a great era for bonds and more recently a bad one for stocks. This is not only a true statement it is a decent one-sentence summary of how Whitebox made its money over our rst decade. We did any number of clever (and some not so clever) things over that time, but if I absolutely had to sum up in a single sentence our core strategy for the 2000s it would be: Buy the bond and sell the stock. It is a rst principle at Whitebox to be security agnostic: to penetrate the labels like bond and stock and hybrid and assess the real status of a security by the risks and rewards that ow from the combination of economic circumstances and the details of capital structure. For most of the last decade it was quite clear to us that equities bore all their traditional risk but o ered only bond-like rewards (at best), while high yield bonds often o ered equity-like returns that could be shielded from default risk by shorting the all too risky stock of the same or a similar rm. Buying the bond and selling the stock has been the core day-to-day business of both our convert arb and credit funds for most of their history. For the mortgage trade we shorted the bonds (via credit default swaps). But the mortgage bonds we shorted were really an equity play. The whole structured nance game was based on the speculation that the slender equity stake held in homes nanced with minimal down payments would grow as prices continued to rise. The failure of that bet wiped out the all-too-thin equity layer of the homeowners capital structure and exposed the mortgage bond below to equity-like risk. The mortgage trade can be reduced to the notion that things named mortgage bonds were being exposed to equity risk, while o ering only bond-like rewards, and thus made excellent shorts.
THE WHITEBOX ADVISOR

During the nancial crisis our big trade was to buy sludge, performing bonds priced at 30 cents or less. Sludge was one of the most dramatic instances Ive ever seen of the equity potential in a capital structure being shifted over to bonds. At 30 cents and less on a dollar our principal was fully secured by the bonds prospects in recovery; meanwhile most of the equity upside also resided in the bonds. Sludge was pretty much the last gasp of the great buy-the-bond-sell-the-stock trade of the last decade. What Gross is missing is that the trade of the present and perhaps the trade of the new decade is to sell the bond and buy the stock. Too many bonds today bear frightful equity riskwhich Ill de ne for the moment as the risk of permanent loss of capitaland virtually no equity upside, and miniscule yields to boot. The other day I was chatting with Jamie Lyngstad, who serves on our equity team, about an equity screen weve been running. Weve been looking for stocks with PE less than 15, free cash ow greater than earnings, and paying at least 5% of market cap to a combination of dividends and buybackswith buybacks getting a healthy share of that. At one point Jamie looked at me and said, You know this is really a bond screen. And of course he was right. The three things one wants from a bond are security of principal, reliable coupons/strong interest rate coverage, and high yield. Taking these in reverse order in our screen the yield speaks for itself. For reliable coupons essentially one wants a healthy business; cash ow exceeding earnings is a reasonable proxy for that. But what about security of principal, the greatest attraction of a true bond, the very reason its called a bond? Heres a simple principle about principal: principal is secured by price. Assuming healthy business, the lower the PE the more secure the principal and the more bond-like the stock. Think of it like this: the best measure of security of principal is how much one needs to know about the future to be con dent the principal will be returned. A bond secured by collateral of enduring value amounting to several times the price of the bond is all but perfectly secure. In most plausible futures the asset will cover the loan. In any scenario in which that is not trueinvasion, the acts of an especially angry godno other asset including Treasuries will be worth much either. We know the future of this bond because the value of the assets vastly exceeds the price. Similarly, if a stock is selling at a PE of 50, you have to be right about too many things to consider the principal secure: at a minimum you have to be right about both future earnings and future PE. With a PE of 12, several points below the historic average, you can get away with being right about either future earnings or future PE. With a stock selling well below book, all you have to be right about is book value and the e ciency of your claim. Basically I am a bond guy. I like fat coupons. And I like return of principal. But I take my bonds where I can nd them. And these days the place to nd fat coupons and return of principal is among blue chip equities. The typical stock in our selected blue chip group looks something like this: It earns a dollar a share and has a PE of 12. But it produces $1.10 in free cash ow (FCF), de ned as earnings + depreciation maintenance cap-ex. Of that $1.10, 30 cents is being returned to shareholders via
THE WHITEBOX ADVISOR

dividends and 36 cents is being returned to shareholders via stock buybacks. To stress test the notion of these stocks as bonds, lets look at what happens to our blue chips over the next 10 years under a negative but not catastrophic scenario.Start by assuming 20% of these companies go broke early on so we never get a dime out of them. Given the strength of most of these rms that would be an extraordinary event, but lets assume it. For the rest lets assume that revenues grow 4% a year, which is just in ation plus population growth, a signi cantly lower gure than most of these rms have seen over time. But remember all these rms are buying back enough stock so that even with just 4% revenue growth earnings grow 7% annually. Further assume that cash ow back to stockholders is not reinvested in their portfolios to compound in the future but goes straight into the nearest mattress and produces a zero return. Similarly assume that all the new projects in which these companies invest are ill conceived so that the retained portion of earnings also produces a zero return. Where are we in 10 years? On our $12 investment weve gotten back about $3.32 in dividends. Thats allowing for both the 20% bankruptcies and the 7% earnings growth. Our annual earnings will have grown to $1.55. What about PE? Assume the world just keeps on hating stocks and PEs contract to 10. Our original investment of $12 has a market value of $15.50 plus the $3.32 cash in our mattress for a total of $18.82 on extremely conservative assumptions. The arithmetic of equities is about as straightforward as can be. So why, oh why, oh why cant people bring themselves to buy equities? Why do U.S. institutions hold less of their money in equities today than they have for decades? In my last letter I mocked the current fanatical devotion to the idea of mean reversion in all things. But as I said then, really the opposite fault, the belief that trends must go on forever is far more common and dangerous. And thats what we are seeing. The combination of the tech wreck, the nancial crisis, the lost decade, the Dow collapsing from 14,000 in late 2007 to 6,500 17 months later and the current traumas of Europe are just too much to deal with.Yet the current prospects of equity investors di er in three crucial ways from the prospects faced by such investors during the previous two decades. First, there is quality. Today we are seeing $1.10 in free cash flow for every $1 in earnings. During the evil years it was far more common for free cash ow to be signi cantly below earnings. Second, we are seeing much more disciplined capital allocation. Two-thirds of earnings are being returned to shareholders. All too often during the days of the New Economy that gure approached zero. Finally, there is price. All too often during the lost years PEs would have been not 12 but 35. Today, however, the supreme consideration is not price as such but the pathway of prices. Proportionally, a contraction in PE from 35 to 29 looks just like a contraction from 12 to 10, in both cases around 17%. But here is the great di erence. A contraction from 35 to 29 is very likely one step on a path that leads to 15. A contraction from 12 to 10 is also only one step on a path.
THE WHITEBOX ADVISOR

And that path also very likely leads to 15. And yet the world cannot buy enough bonds. Well here is the ugly truth: the best-case scenario for bonds today is the worst-case scenario for stocks. In the worst case for stocks, earnings grow even more slowly than in our example PEs contract, and shareholder capital grows even more slowly with some unpleasant volatility along the way caused by the occasional global crisis. In the best case for bonds, rates rise only modestly and bondholders su er modest capital losses. The more likely case for bonds is that rates rise signi cantly; bond markets su er just that volatility bondholders sought to avoid; nominal capital losses are material; and losses after in ation are devastating. Meanwhile in the high in ation/high rate scenario, nominal earnings rise with nominal GDP; the dominant and best- nanced rms in a sector gain competitive advantage over their weaker, more-leveraged brethren; and our blue chips look relatively better than ever. Andrew J. Redleaf September 25, 2012

THE WHITEBOX ADVISOR