Speculating on McGraw Hill

Standard-and-poors-300x168McGraw Hill (MHP) is the parent company of Standard and Poors (S&P), the credit rating agency.  On February 4th McGraw Hill announced that it expected a Government lawsuit regarding S&P’s alleged fraud.  The alleged fraud relates to mis-rating mortgage-backed securities.  News of this lawsuit sent the stock tumbling from $58.34 on 1st February to $42.67 on 8th February (down 27% in a week).

Screen Shot 2013-03-01 at 12.40.14 PM

The stock has recovered some 11% to $47.24, but it is still 16% down on recent highs.  I expect the stock to recover to recent highs within a couple of months.

  • Buy MHP @$47.24

This is a “special situations” trade and will be part of my speculative portfolio.  I must set careful stops to limit losses or protect profit.  I will sell on 5% drop (@ $44.88) and will sell the whole position if it gets back to $58.

POSTMORTEM

Writing today, 30th March, this looks like a great call.  MHP is up over 10% in a month.

Screen Shot 2013-03-31 at 9.54.14 AM

UPDATE

Writing today, 24th April, I have decided to get out of McGraw-Hill.  The stock has stalled at $52, which gives me a nice 10% profit (with TD Waterhouse taking 3% in foreign exchange fees! – 1.5% on buying and 1/5% on selling).

  • Sell MHP @ $52.00

Quants

Fascinating documentary about ‘quants’ and their role in the 2008 crash.  Quants built models to predict the likelihood of default of mortgages that had been bundled into Collateralized Debt Obligations (CDOs).  Those models did not adequately address the correlation between defaults: they did not account for the situation where many mortgages default simultaneously.  This is what happens when you test a model with an inadequate range of historical data, or when you do but you discard the inconvenient truths that they reveal.

Getting out of Goldman Sachs

I bought Goldman Sachs (GS) at $155.17 on 15th April 2011. The stock trended downward through April and May and on 22nd May I predicted that the legal risk (real or perceived!) relating to Goldman’s actions during the 2007 mortgage bubble and 2008 stock market crash would drive the stock down to $100.

Today the stock traded as low as $110.04 with no bottom in sight. Goldman is indeed being sued by National Credit Union Administration over risky mortgage securities, but legal risk is the least of Goldman’s troubles. It seems that we are looking at a new recession in the US and significant debt-related risk in European banks. Both of these issues are significant risk factors for banks such as Goldman.

I have struggled with this decision more than any other. It’s tough to take a loss on a stock that looked so promising on paper, but I have to set aside my emotional need to hold until the stock comes back and make a fact-based decision. It’s time to sell.

What to do with the proceeds? We look for non-cyclical, non-financial stocks with minimal European exposure and a significant yeild. There are few better than Kinder Morgan Energy Partners (KMP), which operates pipeline systems and offers a 6.6% yeild at current prices.

  • SELL Goldman Sachs (GS) @ US$114.00
  • BUY Kinder Morgan Energy Partners (KMP) @ US$70.05

POSTMORTEM

One month after these trades, on 10th September 2011, this looks like a good call. Goldman Sachs is down 13% since I sold while Kinder Morgan is down only 2%.

Image

Goldman Sachs is now down to US$102 on global debt worries and mortgage bubble lawsuits. This is very close to the prediction I made back on 22nd May 2011 that Goldman would be beaten down to US$100 before recovering.

UPDATE

Goldman broke US$100 today, 12th September 2011.

Aside

Is the Price Right?

The fundamental method for valuing a stock, and the entire market, is the Price to Earnings Ratio (or PE Ratio). So what constitutes good value: what is a low PE Ratio? Historically, the PE Ratio of the S&P 500 has averaged around 16 over the past hundred years.

Image

But there has been a definite increase in PE Ratios recently (the entire bull market of the 1990s began and was sustained with PE Ratios above 16) so we need to look at recent examples of the market’s highs a lows to judge its limits.

What was the PE Ratio before major, recent crashes?

  • When the mortgage bubble hit its height in October 2007 the PE Ratio was 27.31. The market crashed shortly after.
  • When the dot com bubble hit its height in March 2000 the PE Ratio was 43.22. Again, the market crashed thereafter.

And what was the PE Ratio before major, recent bull markets?

  • When the market began its recovery in March 2009 (after the 2007 mortgage bubble and 2008 stock market crash) the PE Ratio was 13.32
  • When the market began its bull run on March 2003 (after the 2000 dot com bubble and 9/11, and their respective stock market crashes) the PE Ratio was 21.31

So we can conclude that PE Ratios above 27 are possibly high and the PE Ratios below 22 are possibly low. Of course, there are many other factors to consider before predicting future bull or bear markets, but the PE Ratio is a good place to begin. Today’s PE Ratio of 22.73 is quite low, but not indicative of the beginning of a major advance.

It is important to note that these limits are a means to judge the overall market (i.e., the entire S&P500) rather than individual stocks. Just because a stock has a PE Ratio of less than 22 does not mean I will buy it. In fact, as a value investor, my policy is never to buy a stock with a PE Ratio above 20 and I generally look for stocks with a PE Ratio of 17 or less.

Fear and Loathing … of Goldman Sachs

Goldman Sachs (GS) closed at $135 on Friday on rumours of a Federal Investigation into mortgage securities sold prior to the 2007 mortgage bubble and 2008 stock market crash.

Goldman is certainly guilty of shorting mortgages while selling them to customers, and for selling them for more than they thought they were worth, but that’s not illegal. (Hey, here’s a tip: don’t get investment advice solely from the people selling the investment!). Much was made of internal emails indicating that some Goldman staff thought that one of their deals was “shitty”. I’m pretty sure I could find a guy at Microsoft that thought Vista was shitty: does that mean that anyone who sold Vista was a crook? Of course not. Some products are good, and some are not.

Goldman is down 13% from where I purchased it last month, making the return even better from this inherently good company, but I think this Federal Investigation will beat the stock up for months to come. I predict that the Government needs to make Goldman suffer. They will keep after them until the stock hits a low at around $100 and then say, “Look how low the stock is…they have been punished enough.”. Meanwhile the earnings will have been as strong as ever and, once people’s gaze moves on to the next shiny object, the stock price will come roaring back.

UPDATE

Goldman Sachs has indeed gone below $100 but this has had little to do with the fuss surrounding the firm and more to do with the debt crisis in Europe. Writing today, on 30th December 2011, Goldman is at $90.43 (67% of book value!) and in the doldrums along with all other major financial stocks.

Image

UPDATE

Today, 15th March 2012, Goldman is at $123. A decent recovery, but not as good as its peers. Negative press continues and Goldman has not shaken it’s reputation as the selfish banker. They need to work on their PR!

Image

UPDATE

Writing today, August 10th 2012, it seems that the second part of my prediction has come true: the US Department of Justice has indicated that it will not be prosecuting Goldman for any alleged wrongdoings in the 2008 stock market crash or the preceding mortgage bubble.

The price has yet to recover.  GS is still at $122.

UPDATE

Writing today, 15th February 2013, GS is at $155.  Prediction has come true, but it took a long time.

Vampire Squid or Tall Poppy?

I just read Too Big To Fail by Andrew Ross Sorkin, so I am aware what happened to the US investment banks (and the global economy) in the 2007 mortgage bubble and 2008 stock market crash. My conclusion? Just another bubble!

In Australia they have a phrase, “Tall Poppy Syndrome”. This is the self-defeating practice that some societies have of bringing down those who have achieved success, especially those who display their success. Australia and the UK are enthusiastic practitioners of Tall Poppy-ism: possibly a reaction to monarchy and the class system. The US tended to celebrate success and “The American Dream” so it seemed to me that it was less inclined to participate in Tall Poppy-ism. I think the crash of 2008 changed this. Perhaps the US considers Wall Street to be their monarchy? In any event, some want to tear down the tallest poppy of Wall Street: Goldman Sachs (GS).

Chief poppy cutter is Matt Taibbi, whose recent piece in Rolling Stone entitled The People vs. Goldman Sachs is causing a stir this week. I read the piece. It’s overly dumbed-down (his analogies are silly, even for a non-financial audience) and populist, but he does have a point: dealing with a bank should not be a “buyer beware” situation. As a new shareholder, I like Goldman’s earnings growth prospects and their strong position in the industry. I think the spectre of litigation and new regulation (neither of which will amount to much) is depressing the share price, making it good value. I bought it on 15th April for $155. Taibbi and his adherents have driven it down to $142. My opinion? I just wish I had known to wait a couple of weeks until Taibbi’s article came out to buy! Or would that be insider trading?