IIC 2020: The Long and Short of Bad Credit..and Bad Credit Analysis by Joel Litman (President and CEO, Valens Research)

Moderated by: Satish Betadpur, CFA (Managing Director, Head of Investments, State Street Global Advisors)

Contributed by: Vivek Rathi, CFA

Joel Litman started his session with a gracious photo of outstanding investors of last century. May be one of the few photos where we can see Warren Buffet, Benjamin Graham, Charlie Munger, Tom Knapp, ED Andersen, Walter Schloss  (WJS parner)  William Raune (Raune Cuniff, Sequoia fund),etc. together. The underlying philosophy was to show the amazing investment record of these market masters.  Most of these legends have consistently generated high Alpha over long period of time. Warren Buffet have generated over 12% Alpha for over 40 years, Charlie Munger had generated consistent alpha ranging around 15% before joining Warren Buffet. He continues with highlighting the contribution of Prof. Benjamin Graham in the field of Valuation and Analysis. In fact, the origins of CFA certification are also traced to Prof. Graham’s efforts to formalise certification for security analysis way back in 1940’s (though CFA program finally took off in 1963). Finally, he stresses on the importance debit/credit in Analysis and valuation, these terms appears more than 400 times in Prof. Benjamin Graham’s Books (Security Analysis and Intelligent Investor).

As popularly said, history does not repeats its rhymes and it is amply clear in financial markets. He describes how global crisis of 2008 were similar to crisis of 1908. He goes on to explain the effect of interest rates on credit cycle. He further explains that the rising interest rates are not same as high interest rates. High interest rates are a problem but rising rates may not be bad. Finally, he completes by showing how high interest rates may lead to credit crisis which in turn would drive collapse in equity market. The pattern was same for most of the crisis over last decade. Almost all of them were preceded by squeeze in availability of credit (Panic of 1907, The great depression of 1929, The Roosevelt recession of 1937-38, Dot com bubble of 2000, The global crisis of 2008, etc.)

He further talks on evolution of accounting, for example, the cash flow statement went through 7000 amendments before getting accepted in late 1880’s. At that point he highlights the loop holes in GAAP and IFRS accounting. According to him, the GAAP reported earnings do not give the correct picture, the earnings are distorted. He cites the opening remark of Warren Buffet in 2018 and 2019 Berkshire Hathaway Annual Shareholders meeting to substantiate his point on GAAP reported earnings. In 2019, Warren Buffet said “GAAP Rules..I’ve warned you about the distortions. The bottom line figures..totally capricious. It’s really a shame”. For example, on valuations using EBITDA, he quotes Warren Buffet, who believes it may not be a good measure to value a company (as depreciation is real expense, omitting it in valuation will not give correct picture). Similar observations were made by Charlie Munger and Seth A. Klarman. He cites distortion in Amazon.com GAAP reported earnings to support the above points on GAAP.

 The analysis of the aforementioned distortion by UAFRS (Uniform Accounting, Uniform Financials and Uniform Analytics) council has helped identify over 130 potentially material inconsistencies in GAAP/IFRS accounting. This ambiguity would be resolved with adoption UAFRS. Finally, he confirms, one can’t be great investor by relying on GAAP/IFRS reported earning’s nor by relying on Credit rating agencies.

On markets, according to him, S&P has potential upside of 30% from current level. Though, these projections may change if there is change of government in United States.


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