Water: Not the Next Oil?

A couple of years ago, articles with titles such as this one by Rohini Nilekani in Yale Global were fairly common: "Is Water the Next Oil?". Today, the pseudonymous author of the blog The Learning Diary of an Israeli Water Engineer suggests otherwise ("Worldwide water sector devalued"):

I continue thinking that the expansion of the water sector is an illusion, it is not happening and will never [...]. The water crisis is more a media event, or an eternal United Nations issue for travelling to exotic places, than a real investment opportunity. People who "bought" the concept of water as the golden investment opportunity - lost [their] money.

In previous correspondence with this water engineer/blogger, I had asked him what investment opportunities he saw in the sector. His response, in a nutshell, was that most countries that could afford water infrastructure already had it, and most of those that didn't, didn't have the money to pay for it.

The photo above accompanied the Yale Global article.

George Soros Recaps His Investment Decisions in 2008

From a sidebar to an article by George Soros in yesterday's Financial Times about the financial crisis ("The Game Changer"), a self-assessment by the billionaire investor:

THE SOROS INVESTMENT YEAR:

Positions I took were too big for ever more volatile markets

Although I positioned myself reasonably well for what was coming last year, one thing I got wrong cost me dearly: there was no decoupling between markets of the developed and developing worlds.

Indian and Chinese stocks were hit even harder than those in the US and Europe. Since we did not reduce our exposure, we lost more money in India than we had made the year before. Our Chinese manager did better by his stock selection; we were also helped by the appreciation of the renminbi.

I had to push very hard in my macro-account to offset both these losses and those incurred by our external managers. This had its own drawback: I overtraded. The positions I took were too large for the increasingly volatile markets and, in order to manage my risk, I could not go against the market in a big way. I had to try to catch minor moves.

That made it difficult to maintain short positions. Although I am an experienced short-seller, I got caught several times and largely missed the biggest down-draught, in October and November.

On the long side, where I stuck to my guns, I lost an enormous amount of money. I was impressed by the potential in the new deep-water oilfield in Brazil and bought a large strategic position in Petrobras, only to see it decline by 75 per cent at one point in time. We also got caught in the developing petrochemical industry in the Gulf.

We did get out of our strategic long position in CVRD, the Brazilian iron ore producer, in time for the end of the commodity bubble and shorted the other big iron ore groups. But we missed an opportunity in the commodities themselves – partly because I knew from experience how difficult it is to trade them.

I was also slow to recognise the reversal of fortune for the dollar and gave back a large portion of our profits. Under the direction of my new chief investment officer, we did make money in the UK, where we bet that short-term interest rates would decline and shorted sterling against the euro. We also made good money by going long on the credit markets after their collapse.

Eventually I understood that the strength of the dollar was due not to people choosing to hold dollars but to their inability to maintain or roll over their dollar obligations. In a very real sense the strength of the dollar, like the fever associated with sickness, was a measure of the disruption of the financial system. This insight helped me to anticipate the downturn of the dollar at the end of 2008. As a result, we ended the year almost meeting my target of 10 per cent minimum return, after spending most of the year in the red.

A Tall, Cool Drink of... Sewage?

Tomorrow's NY Times Magazine has a general interest article by Elizabeth Royte on the processing of sewage into drinking water, "A Tall, Cool Drink of... Sewage?". The article notes that the reprocessed water is purer (as measured by "T.D.S.", "total dissolved solids") than reservoir water (or even bottled spring water), and yet then Orange County, California treatment plant she profiles pumps the treated water into a reservoir where it filters through sand and gravel for a few months before being pumped into taps by utilities:

In other words, nature messes up the expensively reclaimed water. So why stick it back into the ground? “We do it for psychological reasons,” says Adam Hutchinson, director of recharge operations for the water district. “In the future, people will laugh at us for putting it back in, instead of just drinking it.”

Some have said that the scarcity of potable water in many parts of the world represents a macro trend from which investors can profit, perhaps by investing in the companies that build wastewater treatment plants, or some of the equipment those plants use. I haven't done much homework in this, but I plan to look into it at some point.

Update: Today's NY Times Business Section includes a related article, The Feed: "Can Israel Find the Water it Needs?". The article mentions an Israeli multinational, Netafim, that's active in drip irrigation as well as wastewater treatment and other water resources areas, but it isn't publicly traded.

Also, reader SL directed my attention to this article in the current Barron's, about American Water Works (NYSE: AWK), "The Spigot Reopens at American Water Works".

From Joel Greenblatt to Jim Rogers, Part III: The Importance of Macro Trends

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long.

The Importance of Paying Attention to the Relevant Macro Trends

Another lesson I picked up over the last year and a half was the importance of paying attention to the relevant macro trends when evaluating potential investments. It's important to remember here that the Magic Formula is a backward-looking screening system: it uses trailing 12-month data to calculate earnings yield and return on invested capital, on the theory that, more often than not, trailing data are predictive of future performance. The impact of relevant macro trends can determine to what extent this will be true. For example, a wallboard company might have had impressive trailing twelve month earnings at the beginning of 2006, due to the residential construction boom that peaked during the previous year, but those trailing earnings wouldn't have been a good guide to its earnings during the construction bust to come. Below is an example of a mistake I made last year by not paying attention to the relevant macro trend.


Anatomy of a Mistake

I originally wrote the following postmortem on the GuruFocus website on April 24th. Since then, the stock is down a little bit more (it closed at $11.78 today), but otherwise nothing has changed materially.

Recently, I've written about the importance of acknowledging and addressing relevant macro-trends when evaluating investment opportunities. This doesn't mean that I think one should only invest in a company when the relevant macro-trends or macro-environment are in its favor; I would consider investing in a company facing negative macro-trends or a negative macro-environment if I thought those negative macro-trends were fully priced-in, or if I thought those negative macro-trends were nearing an end.


One example of an investing mistake I made by not paying attention to the relevant macro-trend was my investment in Barrett Business Services Inc. (BBSI) at $24.28 per share last year in my Magic Formula portfolio. Today BBSI closed at $12.50 per share.


Barrett is a staffing/PEO firm serving small and mid-sized businesses primarily. When I bought the stock last year, Barrett Business Services was fundamentally a solid company: no debt, lots of cash, a no-nonsense CEO who had steadily built the company up over 27 years and owned 25% of the company's stock, etc. That's all still true today, but nevertheless, it was a mistake to buy the company when I did, because I didn't consider the relevant macro-trend.


The relevant macro-trend in Barrett's case was the real estate bust in California. Although Barrett has operations in several regions of the country, and clients in different industries, most of its business comes from California. Because California experienced one of the biggest real estate booms in the country, it also is experiencing one of the biggest real estate busts, and the effects on California's economy have been worse than on the national economy so far (on today's conference call, Barrett's CEO estimated that California's unemployment rate is now about 7.5%). Also, during economic downturns, outsourced/temporary workers are often the first to get laid off, so Barrett was quick to feel the consequences of this (conversely, as Barrett's CEO pointed out on today's call, outsourced/temporary workers are also the first to get hired during an economic upturn).


Ideally, the best time to invest in a company like BBSI would be just as the negative macro-trend was ending, but of course there is no way to time that exactly. That doesn't mean, however, that I can let myself off the hook for buying BBSI when I did. The magnitude of the real estate bust in California was obvious at the time, and I should have connected the dots and realized how this would lead to a deterioration in California's labor market.


On today's conference call, Barrett's CEO discussed how he would be using this economic downturn (as he had used previous downturns) to increase market share and position Barrett to do well during the next economic upturn. I have no reason to doubt that. I would consider investing more in BBSI within the next few months, assuming it's still on the Magic Formula list. It was still a mistake for me to buy BBSI when I did though, at the beginning of the current downturn.

A counter example of a stock I bought last June that was facing a positive macro trend is the oil royalty trust BPT that I posted about here earlier today and last Friday. Not surprisingly, I am up 50%+ on BPT over the same time frame that I am down 50%+ on BBSI.

The Economist: "The Cracks are Showing"

Here's the latest in a series of editorials and op/eds that have appeared in various papers this year on the sorry state of American infrastructure, this time from The Economist: Infrastructure: The Cracks are Showing. The Economist piece repeats the startling estimate from the American Society of Civil Engineers, that $1.6 trillion will need to be spent over five years just to maintain the adequacy of our current infrastructure in the U.S. It also quotes a union president estimating that "47,500 jobs will be created for every $1 billion the government spends on infrastructure."

There you have two reasons to bet on a significant increase in federal spending on infrastructure in the U.S. over the next few years:

• We need it.
• It will create jobs (which can help replace the ones lost in residential construction and other industries hit by the real estate and credit busts).
  

There are also the benefits that increased infrastructure spending will stimulate the economy in the short term and potentially increase the productivity of the economy over the longer-term.

What companies might benefit from this macro trend in U.S. infrastructure spending when it comes? One may be Perini Corp., (PCR), a Magic Formula company I invested in earlier this year (perhaps a little too soon). Here's a link to a description of Perini's infrastructure subsidiary, Perini Civil. Massachusetts-based Perini Corp.'s merger with Tutor-Saliba (announced via this press release in April) will result in a combined company with a presence in infrastructure from coast to coast. From the April press release:

"Perini’s civil construction projects include portions of the Boston Central Artery/Tunnel project ($650 million); New Jersey Light Rail Transit ($142 million) and rehabilitations of the Triborough, Williamsburg and Whitestone bridges in the New York City area ($443 million). In addition, Perini has started work on the Harold Structures mass transit project in Queens, NY ($139 million) and express toll lanes along Route 95 in Maryland ($87 million)."

[...]

"Tutor-Saliba’s major ongoing and completed building projects include the Las Vegas Wynn Encore Hotel ($1.3 billion); the San Francisco International Airport reconstruction ($1.1 billion); the UCLA Westwood Hospital ($537 million); Planet Hollywood Towers in Las Vegas ($490 million) and the Los Angeles Police Headquarters building ($234 million)."

From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long.

The Magic Formula

For those unfamiliar with the Magic Formula, it's Joel Greenblatt's Buffett- and Graham-inspired mechanical system of buying a basket of "good" and "cheap" stocks. From Graham, Greenblatt got the emphasis on buying a basket of cheap stocks. In the Magic Formula, Greenblatt uses earnings yield, defined as EBIT/Enterprise Value, to measure "cheapness". Greenblatt uses EBIT instead of earnings to account for differences in interest payments and taxes among different companies, and he uses enterprise value instead of price to account for different levels of net cash or net debt. From Buffett, Greenblatt got the emphasis on finding "good" companies, defined as companies with high returns on tangible capital. Greenblatt calls this return on invested capital (ROIC) and defines it as [EBIT/(Net working capital + Net fixed assets)]. Greenblatt set up a website, Magic Formula Investing.com, to make it easy for individual investors to follow this system. The site ranks its universe of thousands of (mostlyAmerican) stocks by earnings yield and by return on invested capital, and lists those stocks that have the best combined scores (i.e., not necessarily the "cheapest" or the "best", but the stocks that represent the best combination of "cheap" and "good" according to the system).

After reading Joel Greenblatt's The Little Book that Beats the Market in late 2006, I began investing the better part of my money according to the methodology in the book in early 2007. During this time, I read a number of books on value investing (e.g., The Essays of Warren Buffett, Benjamin Graham's The Intelligent Investor, etc.) that reinforced some of the principles of Greenblatt's Magic Formula.

I knew enough about the boom in commodities to be sure to include some of the handful of commodity companies that appeared on the list, but also included companies in other sectors. Aside from the commodity companies, all of which did well, and a couple of small cash-rich drug companies that were bought out for modest premiums, virtually every other stock in the portfolio plummeted. Judging from the lamentations on Yahoo! Finance's Magic Formula Investing Message Group, this has been a common experience.

In fairness to Joel Greenblatt, he did warn in his book that his Magic Formula system (like any mechanical system) wouldn't work all the time, and could under-perform the market for a few years in a row. In the book (pp. 71-73), Greenblatt also alluded to the hot-cold-hot roller coaster performance of O'Shaughnessy's screens in the 1990s, and to a period of under-performance experienced by his friend and fellow money manager Richard Pzena (neither O'Shaughnessy nor Pzena is mentioned by name in the book, but their identities are fairly clear from the descriptions). Nevertheless, the jaw-dropping Magic Formula losses last year (in what was, admittedly, an awful year for most broad-based value strategies) contrasted sharply with the back-tested performance of the Magic Formula system in Greenblatt's book. Over a 17-year testing period, the all-cap portfolio (with a minimum market cap of $1 million) only had one down year (the bear market year of 2002), and that year it merely had a single-digit loss.

After analyzing some of my losers, and see what some successful investors did differently, the lessons I took away were the importance of paying attention to the relevant macro trends, and that in a market when most stocks and most sectors are performing poorly, excessive diversification can be a liability.