The Ideas Report For Serious Investors

By Greenbackd

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By Greenbackd

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The Value Investing Congress took place in Pasadena, California last week.  The Congress is a major event in the value investing community and featured many well known speakers including Paul Sonkin, Bruce Berkowitz, Mohnish Pabrai, Tom Russo, Whitney Tilson, and many others.  Fund managers discuss macro viewpoints as well as specific actionable investment ideas.

The Inoculated Investor has provided a terrific set of notes from the Congress covering two days of sessions.  In addition, detailed notes on Wesco Financial Corporation’s annual meeting are provided.  Charlie Munger’s comments are always worthy of careful attention and this year was no exception.  The entire value investing community owes Ben of The Inoculated Investor a debt of gratitude for providing this level of detail free of charge.

Click on this link for Value Investing Congress Meeting Notes

Click on this link for Wesco Annual Meeting Notes

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  Long Berkshire Hathaway.  Wesco is a 80 percent owned subsidiary of Berkshire Hathaway.

Posted by manualofideas at 03:39 PM | Permalink | Comments (0)

By Greenbackd

Portfolio construction and position sizing are key elements in investing. For every investor, there exists a tension between the desire to maximize the rate of growth of the portfolio while simultaneously minimizing the chance of blowing up. The Kelly Criterion is the method to determine the optimal portion of the portfolio to be invested in any given opportunity. Buffett, Munger, Whitman and Pabrai are all proponents of the theory.

John L. Kelly, Jr, the developer of the Kelly Criterion, seems to have been a remarkable character. According to his entry in Wikipedia, he was a physicist, “recreational gunslinger”, daredevil pilot, developed the vocoder, the first demonstration of which was the inspiration for the HAL 9000 computer in the film 2001: A Space Odyssey, and was a keen blackjack and roulette player, which is a little odd, because his criterion recommends against a bet on the roulette wheel. He died of a brain hemorrhage on a Manhattan sidewalk at age 41, never having used his formula to make money.

The Kelly Criterion output varies depending on two things: the investor’s certainty about the outcome of the investment (the “edge”) and the expected return (the “odds”). I have found it difficult to apply in practice. Hunter at Distressed Debt Investing has a great post on Peter Lupoff’s application of Kelly Theory to event-driven investing in Tiburon Capital Management’s portfolio. Lupoff’s post deals with some of the issues I have had, and is well worth reading.

Posted by manualofideas at 03:34 PM | Permalink | Comments (0)

By Greenbackd

Jeremy Grantham’s 2010 first quarter investor letter (.pdf) appends the first part of a speech he gave at the Annual Benjamin Graham and David Dodd Breakfast at Columbia University in October last year. The speech was titled Friends and Romans, I come to tease Graham and Dodd, not to praise them. In it Grantham discussed the “potential disadvantages of Graham and Dodd-type investing.” It seems to have struck a chord, as I’ve received it from several quarters. As one of the folks who forwarded it to me noted, we learn more from those who disagree with us.

Hat tip Toby, Raj and everyone else.

Posted by manualofideas at 01:13 PM | Permalink | Comments (0)

By Greenbackd

Oh dear (Daily Reckoning via Guru Focus):

04/21/10 Gaithersburg, Maryland – Ken Heebner’s CGM Focus Fund was the best US stock fund of the past decade. It rose 18% a year, beating its nearest rival by more than three percentage points. Yet according to research by Morningstar, the typical investor in the fund lost 11% annually! How can that happen?

It happened because investors tended to take money out after a bad stretch and put it back in after a strong run. They sold low and bought high. Stories like this blow me away. Incredibly, these investors owned the best fund you could own over the last 10 years – and still managed to lose money.

…

Psychologically, it’s hard to do the right thing in investing, which often requires you to buy what has not done well of late so that you will do well in the future. We’re hard-wired to do the opposite.
I recently read James Montier’s Value Investing: Tools and Techniques for Intelligent Investment. It’s a meaty book that compiles a lot of research. Much of it shows how we are our own worst enemy.

One of my favorite chapters is called “Confused Contrarians and Dark Days for Deep Value.” Put simply, the main idea is that you can’t expect to outperform as an investor allthe time. In fact, the best investors often underperform over short periods of time. Montier cites research by the Brandes Institute that shows how, in any three-year period, the best investors find themselves among the worst performers about 40% of the time!

See the rest of the article here.

Posted by manualofideas at 07:02 PM | Permalink | Comments (0)

In a more perfect world, no high school student would be permitted to graduate without understanding the basics of personal finance.  Required material would include elementary topics such as balancing a checkbook, creating and monitoring a budget, and above all else, the power (and peril) of compound interest.  Part of achieving basic financial literacy should also include a working understanding of accounting and financial statements.

Since the primary goal of such a program would be to provide Americans with basic knowledge, a comprehensive accounting text book may be overkill.  Instead, a basic introductory guide to reading financial statements is needed.  Such a guide would cover the three main financial reports:  Balance Sheet, Income Statement, and Cash Flow Statement.  Mariusz Skonieczny, President of Classic Value Investors has written a concise primer on financial statements that allows the reader to gain a basic understanding of these key financial reports.  The e-book is being offered free of charge to readers who subscribe to the Classic Value Investors Blog.

Mr. Skonieczny is also the author of Why Are We So Clueless about the Stock Market? which we reviewed in December.  The author has a talent for simplifying potentially confusing topics for readers who are new to investing and are looking for basic information that will help to build the foundation for further study of accounting topics.

In some ways, Mr. Skonieczny’s e-book may remind the reader of Benjamin Graham’s classic book The Interpretation of Financial Statements which was discussed in one of the earliest book reviews presented on The Rational Walk. In a concise 120 page book, Ben Graham provided the reader with all of the basics required to navigate a financial statement and the book is still very relevant today, more than 70 years after its initial publication.

Neither of these brief surveys of financial statements are sufficient for an individual who is interested in allocating his own capital, but they are solid starts and highly recommended for new investors.

To receive a copy of The Basics of Understanding Financial Statements, visit the Classic Value Investors blog and enter your name and email to subscribe to the blog.  You will then receive an email with a download link.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 07:01 PM | Permalink | Comments (0)

By Greenbackd

Yesterday I discussed Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) about Mauboussin’s research on the tendency of return on invested capital (ROIC) to revert to the mean.

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.

Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.

Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry representation, and business models. Business model difference appears to be a promising explanatory factor.

How to identify ROIC persistence ex ante

The goal of the investor is to identify businesses with future, sustainable, high ROIC. Mauboussin explores three variables that might be predictive of such persistent high ROIC: corporate growth, the industry in which a company competes, and the company’s business model.

Corporate growth

The bad news about growth, especially for modelers, is it is extremely difficult to forecast. While there is some evidence for sales persistence, the evidence for earnings growth persistence is scant. As some researchers recently summarized, “All in all, the evidence suggests that the odds of an investor successfully uncovering the next stellar growth stock are about the same as correctly calling coin tosses.” 16

Industry

Mauboussin finds that industries that are overrepresented in the highest return quintile throughout the measured period are also overrepresented in the lowest quintile. Those industries include pharmaceuticals/biotechnology and software. He concludes that positive, sustainable ROICs emerge from a good strategic position within a generally favorable industry.

Business model

This is perhaps the most useful and interesting variable considered by Mauboussin. He relates Michael Porter’s two sources of competitive advantage – differentiation and low-cost production - to ROIC by breaking ROIC into its two prime components, net operating profit after tax (NOPAT) margin and invested capital turnover (NOPAT margin equals NOPAT/sales, and invested capital turnover equals sales/invested capital. ROIC is the product of NOPAT margin and invested capital turnover.):

Generally speaking, differentiated companies with a consumer advantage generate attractive returns mostly via high margins and modest invested capital turnover. Consider the successful jewelry store that generates large profits per unit sold (high margins) but doesn’t sell in large volume (low turnover). In contrast, a low-cost company with a production advantage will generate relatively low margins and relatively high invested capital turnover. Think of a classic discount retailer, which doesn’t make much money per unit sold (low margins) but enjoys great inventory velocity (high turnover). Exhibit 8 consolidates these ideas in a simple matrix.

Mauboussin examined the 42 companies that stayed in the first quintile throughout the measured period to see whether they leaned more toward a consumer or production advantage:

Not surprisingly, this group outperformed the broader sample on both NOPAT margin and invested capital turnover, but the impact of margin differential (2.4 times the median) was greater on ROIC than the capital turnover differential (1.9 times). While equivocal, these results suggest the best companies may have a tilt toward consumer advantage.

An analysis of the poor performers reveals that they posted NOPAT margins and invested capital turnover “symmetrical” with the high-performing companies i.e. below the full sample’s median.

Mauboussin concludes:

Our search for factors that may help us anticipate persistently superior performance leaves us little to work with. We do know persistence exists, and that companies that sustain high returns over time start with high returns. Operating in a good industry with above-average growth prospects and some consumer advantage also appears correlated with persistence. Strategy experts Anita McGahan and Michael Porter sum it up: 22

It is impossible to infer the cause of persistence in performance from the fact that persistence occurs. Persistence may be due to fixed resources, consistent industry structure, financial anomalies, price controls, or many other factors that endure . . . In sum, reliable inferences about the cause of persistence cannot be generated from an analysis that only documents whether or not persistence occurred.

More to come.

Posted by manualofideas at 12:28 PM | Permalink | Comments (0)

By Greenbackd

In Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) Mauboussin provides a tour de force of data on the tendency of return on invested capital (ROIC) to revert to the mean. Much of my investing to date has been based on the naive assumption that the tendency is so powerful that companies with a high ROIC should be avoided because the high ROIC is not sustainable, but rather indicates a cyclical top in margins and earnings. This view is broadly supported by other research on mean reversion in earnings that I have discussed in the past, which has suggested, somewhat counter-intuitively, that in aggregate the earnings of low price-to-book value stocks grow faster than the earnings of high price-to-book value stocks. I usually cite this table from the Tweedy Browne What works in investing document:

In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”

Mauboussin’s research seems to suggest that, while there exists a strong tendency towards mean reversion, some companies do “post persistently high or low returns beyond what chance dictates.” He has two caveats for those seeking the stocks with persistent high returns:

1. The “ROIC data incorporate much more randomness than most analysts realize.”

That said, Mauboussin presents some striking data about “persistence” in high ROIC companies that suggests investing in high ROIC companies is not necessarily a short ride to the poor house, and might actually work as an investment strategy. (That was very difficult to write. It goes against every fiber of my being.) Here’s Mauboussin’s research:

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.

Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.

Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry

ROIC mean reversion

Here Mauboussin charts the reversion-to-the-mean phenomenon using data from “1000 non-financial companies from 1997 to 2006.” The chart shows a clear trend towards nil economic profit, as you would expect:

We start by ranking companies into quintiles based on their 1997 ROIC. We then follow the median ROIC for the five cohorts through 2006. While all of the returns do not settle at the cost of capital (roughly eight percent) in 2006, they clearly migrate toward that level.

And another chart showing the change:

Mauboussin has this elegant interpretation of the results:

Any system that combines skill and luck will exhibit mean reversion over time. 7 Francis Galton demonstrated this point in his 1889 book, Natural Inheritance, using the heights of adults. 8 Galton showed, for example, that children of tall parents have a tendency to be tall, but are often not as tall as their parents. Likewise, children of short parents tend to be short, but not as short as their parents. Heredity plays a role, but over time adult heights revert to the mean.

The basic idea is outstanding performance combines strong skill and good luck. Abysmal performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods, luck evens out across the participants, pushing results closer to average. So it’s not that the standard deviation of the whole sample is shrinking; rather, luck’s role diminishes over time.

Separating the relative contributions of skill and luck is no easy task. Naturally, sample size is crucial because skill only surfaces with a large number of observations. For example, statistician Jim Albert estimates that a baseball player’s batting average over a full season is a fifty-fifty combination between skill and luck. Batting averages for 100 at-bats, in contrast, are 80 percent luck. 9

Persistence in ROIC Data

“Persistence” is the likelihood a company will sustain its ROIC. If the stocks are ranked on the basis of ROIC and then placed into quintiles, persistence is likliehood that a stock will remain in the same quintile throughout the measured time frame. Mauboussin then measures persistence by analysing “quintile migration:”

This exhibit shows where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41 percent of the companies that started in the top quintile were there nine years later, while 39 percent of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence reveal a similar pattern. So it appears there is persistence with some subset of the best and worst companies. Academic research confirms that some companies do show persistent results. Studies also show that companies rarely go from very high to very low performance or vice versa. 13

These are striking findings. In Mauboussin’s data, there was a 64% chance that a company in the highest quintile at the start of the period was still in the first or second quintile at the end of the 10 year period. Further, it seems that there is a three-in-four chance that the high quintile stocks don’t fall into the lowest or second lowest quintiles after 10 years. It’s not all good news however.

Before going too far with this result, we need to consider two issues. First, this persistence analysis solely looks at where companies start and finish, without asking what happens in between. As it turns out, there is a lot of action in the intervening years. For example, less than half of the 41 percent of the companies that start and end in the first quintile stay in the quintile the whole time. This means that less than four percent of the total-company sample remains in the highest quintile of ROIC for the full nine years.

The second issue is serial correlation, the probability a company stays in the same ROIC quintile from year to year. As Exhibit 5 suggests, the highest serial correlations (over 80 percent) are in Q1 and Q5. The middle quintile, Q3, has the lowest correlation of roughly 60 percent, while Q2 and Q4 are similar at about 70 percent.

This result may seem counterintuitive at first, as it suggests results for really good and really bad companies (Q1 and Q5) are more likely to persist than for average companies (Q2, Q3, and Q4). But this outcome is a product of the methodology: since each year’s sample is broken into quintiles, and the sample is roughly normally distributed, the ROIC ranges are much narrower for the middle three quintiles than for the extreme quintiles. So, for instance, a small change in ROIC level can move a Q3 company into a neighboring quintile, whereas a larger absolute change is necessary to shift a Q1 and Q5 company. Having some sense of serial correlations by quintile, however, provides useful perspective for investors building company models.

So, in summary, better performed companies remain in the higher ROIC quintiles over time, although the better-performed quintiles will still suffer substantial ROIC attrition over time.

More to come.

Hat tip Fallible Investor.

Posted by manualofideas at 11:32 AM | Permalink | Comments (0)

Warren Buffett started his investment partnership in 1956 with $105,100 of capital made up of his own funds and investments from family and close friends.  According to the BLS inflation calculator, initial capital was $840,920 measured in 2010 dollars which would be a very small sum to start a modern day hedge fund.  What is even more remarkable was the fee structure of the Buffett Partnerships.  Mr. Buffett, as the general partner, took 25 percent of all profits in excess of 6 percent.  There was no “2 and 20″ structure in which the general partner received any guaranteed payment.  With nearly all of his net worth invested in the fund and a young family to support, it obviously took a very self confident 25 year old to start this venture.

Mr. Buffett’s early letters to partners have become investment classics and required reading for value investors.   By reading the letters in chronological sequence, one can see how Mr. Buffett’s investment philosophy evolved over the years.  It is particularly interesting to note that many of the same themes that continue to appear in recent Berkshire Hathaway annual letters were regularly appearing in partnership letters during the 1960s.

On an annual compounded basis, the Buffett Partnership returned 23.8 percent/year to limited partners over its history compared to 7.4 percent/year for the Dow Jones Industrial Average.  The limited partners only had one year (1958) in which their results failed to match the Dow Industrials.  (See The Superinvestors of Graham-and-Doddsville for more details)

In his letter to partners in 1969 announcing his “retirement”, Mr. Buffett had the following to say:

“As long as I am “on stage”, publishing a regular record and assuming responsibility for management of what amounts to virtually 100% of the net worth of many partners, I will never be able to put sustained effort into any non-BPL [partnership] activity.  If I am going to participate publicly, I can’t help being competitive.  I know I don’t want to be totally occupied with out-pacing an investment rabbit all my life.  The only way to slow down is to stop.”

Partners who elected to take part of their final partnership distribution in Berkshire Hathaway stock probably did not notice much of a “slow down” in subsequent years.

I was recently contacted by Frank Gifford, a Berkshire Hathaway shareholder who has studied the partnership letters and agreed to share his notes with readers of The Rational Walk.  Mr. Gifford provides a great 20 page introduction to the letters which is very useful for someone looking for a concise summary.

Click on this link to download the partnership letter notes

Disclosure:  The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:46 PM | Permalink | Comments (0)

Joel Greenblatt outlined his “magic formula” for stock market investing in The Little Book That Beats the Market. The formula ranks stocks based on two simple and easily calculated figures:  earnings yield and return on capital.  Rather than merely looking for the cheapest companies, the goal is to also find good businesses that achieve high returns on capital.  In the interview shown below, Mr. Greenblatt discusses a new fund that he is introducing which will apply the magic formula to global markets.

Forbes has also published a new interview with Joel Greenblatt with some good background information on the magic formula.

Mr. Greenblatt is also the author of You Can Be a Stock Market Genius which we reviewed last year.  Both books are well worth reading.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 02:17 PM | Permalink | Comments (0)

By Greenbackd

Posted by manualofideas at 05:37 PM | Permalink | Comments (0)

The Rational Walk is pleased to have this opportunity to present an exclusive interview with Prem C. Jain, the author of the recently released book Buffett Beyond Value which we reviewed last week.  Prem Jain is the McDonough Professor of Accounting and Finance at Georgetown University.  He has previously taught at the Wharton School of the University of Pennsylvania and the Freeman School of Business at Tulane University.  His research has been published in many prestigious finance and accounting journals including the Journal of Finance and the Journal of Accounting Research.

Professor Jain generously took the time to provide extensive answers to several questions regarding Warren Buffett, the evolution of behavioral finance in academia, defining an investing circle of competence, approaches for investors who wish to expand their competence over time, and much more.

Please click on this link to read the interview in a formatted pdf file.

Q:  There are many books covering Warren Buffett’s career, particularly over the past few years. What made you decide to write a book about Warren Buffett and how is your book differentiated from Buffett biographies such as Snowball?

Most authors of books on Warren Buffett spend a significant part of their books on narratives about Warren Buffett as a person. They do not analyze his investing philosophy in enough detail to develop a good sense of Buffett-style investing. I have tried to fill that gap. Having taught Buffett’s principles for over twenty years and having personally benefitted from his principles, I have written a book that is primarily about Buffett’s investing principles. My book is even more valuable to those who already have some background on Buffett from reading biographical books such as Snowball.

Q:  Much of your book focuses on how investors can learn from Warren Buffett’s techniques and generate market beating returns. Yet, the usual caveat is that investors must not stray from their circle of competence. Many investors have trouble precisely identifying the boundaries of this circle. How would you suggest that investors go about defining their circle of competence?

An investor should start with analyzing one industry that the investor knows the most about. The investor is in his circle of competence if he is not often surprised by the developments in that industry. Else, he needs to study it more. As a professor, I have benefited from investing in education stocks as I understood the business models of several of those companies. Furthermore, to precisely identify the boundaries of one’s circle of competence, one must also test one’s knowledge in several additional stocks in the same industry.

It is often the case that an investor would invest in one company in an industry (say, Wal-Mart) and would not know much about other companies in the same industry (say, Costco and others). To understand Wal-Mart well, they should study and monitor other similar companies as well. This is how I came across Wal-Mart de Mexico (a Wal-Mart subsidiary in Mexico that trades independently). Only after developing a good understanding of one industry, the investor should start investigating in other industries.

Q:  You identify Warren Buffett as a “renaissance investor” because he was one of the first to blend the “growth” and “value” styles into a model that has produced consistently superior results over many decades. Part of Mr. Buffett’s shift toward “growth + value” was due to the influence of Charlie Munger and others such as Philip Fisher, but part of this was due to size. As Berkshire grew, the small “cigar butt” opportunities were not able to “move the needle” for Berkshire. Portfolio size is not an issue for most small investors. In early 2009, there were many small stocks selling under “net-net current assets” as defined by Graham. Does it make sense for small investors to pursue the “cigar butt” style advocated by Graham or does it make more sense to emulate Buffett’s “growth + value” approach?

Buffett’s investing philosophy has evolved over time. An investor can similarly become a better investor over time. In 1963, Warren Buffett invested in American Express because American Express’s stock price had declined in the wake of the infamous Salad Oil Scandal in which American Express lost money. However, the American Express charge card business was not affected. After a year or two, Buffett sold those shares as the price recovered. In this investing approach which is usually classified as “cigar butt” investing, the focus is on finding stocks when declining stock prices can be attributed more to market psychology than to fundamentals.

The “cigar butt” investing is based on examining numbers such as P/E ratios or other quantitative metrics. However, even as far back as 1967, Buffett wrote in his letter to his partners that really big money tends to be made by investors who are right on qualitative (as opposed to quantitative) decisions. Clearly, Buffett’s investing style was evolving.

An evaluation of Buffett’s writings and decisions over decades suggests that he has maintained the principle of not paying excessively as a value investor (or as a “cigar butt” investor), he is now willing to pay a fair price as a growth investor. If we were to think of him as a pure value investor, it would be difficult to explain him paying about market P/E for several of his stock acquisitions such as BYD and Burlington Northern Santa Fe or even Wal-Mart. He has clearly evolved into a value + growth investor over time and has specifically mentioned that value and growth are two sides of the same coin. An investor should not ignore “cigar butts” but in this day and age when information is ubiquitous, cigar butts are not easily found. However, an investor incorporating the principles of both value investing and growth investing together is more likely to earn large returns.

Q:  Professional familiarity in a field does not necessarily extend to investment competence. For example, many doctors have a reputation as terrible investors because they mistakenly believe that knowledge of technical details of drugs or medical devices makes them qualified to pick investments. The same can be true for many in technology and software fields. But at the same time, it seems natural to invest in areas that professionals know the best. How can a doctor, for example, develop an investment circle of competence that would allow for intelligent investment in companies related to his profession?

This is a good example of an investor not making good returns even when he may have a good understanding of a particular product. The reason is that investment circle of competence requires not only the knowledge of the products but also the ability to understand the financial statements and to project future earnings. Many investors can not translate success of a product into financial success of the company.

I recommend the following to doctors and others who are interested in investing. Investor should think whether the company and not just a product will be successful for a long time. They should forecast sales and earnings in dollar terms and not only evaluate a product’s technical ability. If they are financial-statements-challenged, they should join hands with others who know some accounting and finance. This may prove to be a fruitful partnership.

Q:  Over the past decade, behavioral finance has attracted much more attention than in the past, perhaps due to several events over the past 25 years that could not be easily explained by the Efficient Market Hypothesis. I recall as an undergraduate student majoring in Finance in the early 1990s that there were few mentions of Warren Buffett or other investors who have routinely achieved market beating returns. Most references to Mr. Buffett tended to dismiss his record as an aberration unlikely to be replicated. Do you see this attitude changing in Finance departments today?

Warren Buffett has had tremendous influence on the academia. In 2003, I invited him to Georgetown University to conduct a question-answer session and the response from the students and the faculty was overwhelming. The finance discipline now acknowledges that professors during the 1970s to 1990s overemphasized the market efficiency paradigm. Fortunately, we have people like Buffett who constantly reminded the academia that the professors had much to learn. And professors have learned. For example, in one of the courses at Georgetown, the first class of the course centers on what we may learn from Warren Buffett. Thanks to Buffett that we do not claim that markets are efficient all the time. It is not easy but if investors work hard, they can beat the indexes and possibly earn very high returns.

Q:  How can investors prepare themselves to mentally deal with temporary declines in the market value of their investments? Even if an investor finds undervalued companies, it is obviously possible for market prices to suffer material declines. We have seen this in Berkshire Hathaway, for example, over the past two years. Is the ability to deal with temporary declines a matter of inherent temperament or personality that cannot be changed, or can investors find ways to improve their investment temperament over time?

Knowledge is the best antidote to making bad decisions. For example, if you know about jewelry and diamonds, all that glitters is not gold for you. Your knowledge will allow you to pick diamonds in the rough and hold on to them. In investing, if you know a lot about certain companies and their managers, you will not become nervous and sell the stock at the wrong time or when the market declines. No wonder, Buffett suggests that you should invest only in companies you understand. Both in 2000 and 2009 when Berkshire stock prices went down by about 50%, I added to my Berkshire holdings.

Q:  Most individual investors attempt to pick stocks on a part time basis. How much time per week do you think is required for part time investors to dedicate to this pursuit? It seems like spending a couple of hours each weekend reading Barron’s or The Wall Street Journal simply wouldn’t be sufficient, yet most people do not have 15 to 20 or more hours per week to delve in more deeply. How should investors think about the time investment required to actively pursue undervalued opportunities?

This is related to an earlier question. If a person has a full time day job, he should study only one industry at a time. Only after he understands one industry, he should move to studying other industries. If he does that, he would not need more than a few hours a week. After several years, he should end up with 20 stocks to invest about 5% in each. In the meantime, he can invest partly in an index fund and party in individual stocks. An average investor need not hold more than 20 stocks in a portfolio. Buffett does not invest in a large number of stocks and most of his holdings are for the long term. In Berkshire, five of the top stocks have often constituted 50% of its total stock holdings. Finally, if a person is very busy and does not have any time to find good stocks, he should simply invest in an index fund such as the Vanguard S&P 500 index fund.

Q:  If an investor decides that he has no particular circle of competence or lacks the time to dedicate to the pursuit, does it make more sense to invest in index funds or in mutual funds such as Fairholme that are run by proven value oriented managers? In your book, you recommend against investing in hedge funds due to the asymmetry that is common in the “2 and 20” compensation models. Does the same caveat apply to value oriented mutual funds? Although they are more cost efficient, certainly index funds remain far cheaper.

For a person who has no particular circle of competence but has decided to invest in the stock market, I recommend investing an index fund and not in mutual funds. An investor is less likely to sell an investment in an index fund when the market goes down than if he were to invest in a mutual fund. I am afraid that the investor would blame the manager for not performing well in a down market and sell all his holdings at the wrong time. It may not be the manager’s fault at all but the investor may not be able to see through the effect of the market on an otherwise well run mutual fund. Even the best of managers do not outperform the market in all the years. The only time a busy investor should invest in a mutual fund is when the investor is extremely comfortable with the manager’s style of investing and has examined it in great detail. It is not enough to simply examine a manager’s past performance and invest with the manager.

Q:  One of the most difficult decisions involves when one must sell an investment at a loss. You cover this topic in the book and suggest that investors should be willing to sell at a loss if subsequent events lead the original investment thesis to be invalid. This is perhaps the most difficult aspect of investing for most people because selling at a loss involves admitting a mistake and making it “permanent”. Is this just a matter of inherent “stubbornness” or can investors take any steps to mentally allow them to sell at a loss with more philosophical detachment?

I think we are hard-wired not to admit mistakes. Selling at a loss is indeed difficult. Or, we are optimistic and hope for an improvement in the stock price. I recommend two specific steps. First, one should write detailed notes whenever a purchase decision is made. Periodically, as the company makes earnings announcements or other important announcements, the notes should be updated. I have benefited from this practice a lot. When individuals are forced to write their thoughts on the paper, they can more easily see the right thing to do. For example, if one has a good knowledge of the company’s products, managers and financial statements, a decline in the stock market may be a good time to invest more in the stock market. Second, they should compute a stock’s intrinsic value periodically. I discuss the concept of intrinsic value in detail in my book.  When the intrinsic value is below the current stock price, they may find it easier to sell.

Q:  Berkshire Hathaway is often misunderstood by the media and characterized as Warren Buffett’s “hedge fund”. This leads many investors to worry about succession at Berkshire. Do you have any views regarding who Mr. Buffett’s successor will be and how confident are you that the success will (a) be able to retain Berkshire’s unique culture and (b) continue Mr. Buffett’s capital allocation track record? It seems like the next CEO will have impossible shoes to fill. Could this result in a “shooting for the moon” attitude that could introduce greater risk at Berkshire?

If the Berkshire board decides to have only one person at the top, I think Ajit Jain is the right person. After all, Buffett talks to him every day, insurance is the most important part of Berkshire, and he has been at Berkshire for about 25 years. (This has nothing to do with the fact that I have the same last name. I don’t know him at all.) The two other names often mentioned are those of Tony Nicely of GEICO and David Sokol of MidAmerican and NetJets. It will however not matter much if any one of the three is the CEO. After all, the Berkshire CEO does not interfere with the subsidiary CEOs.

Yes, the culture! What is the culture at Berkshire, I have often asked myself. Once we reflect on some of the unique features of the Berkshire culture, we are less likely to be concerned about the future of Berkshire even if the next CEO is not as good as Warren Buffett. There are at least two important features of the Berkshire culture. First, the subsidiary CEOs (and employees) are compensated according to what is most meaningful. Buffett has often talked about compensation based on return on assets or other appropriate metrics. This creates a sense of fair play resulting in high productivity. Second, subsidiary CEOs are given independence to make all decisions at the subsidiary level. Hence, Berkshire will continue to do well after Buffett because of its decentralized management structure. The capital allocation process may not be as good as it is today under Buffett but there are many people who have been close to Buffett and my guess is that the new CEO will continue to do a good job for a long time to come.

Professor Jain, this has been very insightful.  Thank you very much.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 06:47 PM | Permalink | Comments (0)

By Greenbackd

Alfred Winslow Jones is generally regarded as the progenitor of the modern “hedge fund.” Jones’s strategy, to construct a portfolio 130% long and 30% short (known as “130/30″), seems pretty prosaic by today’s standards, but it was state-of-the-art when he established the partnership A. W. Jones & Co. in 1949. In the April 1966 Fortune article, The Jones Nobody Keeps Up With (.pdf), by Carol Loomis (the same Carol Loomis who edits Buffett’s Berkshire Hathaway shareholder letters), Loomis described Jones’s strategy thus:

[The] fund’s capital is both leveraged and “hedged.” The leverage arises from the fact that the fund margins itself to the hilt; the hedge is provided by short position – there are always some in the fund’s portfolio.

How did Jones’s “hedge” work?

In effect, the hedge concept puts Jones in a position to make money on both rising and falling stocks, and also partially shelters him if he misjudges the general trend of the market. He assumes that a prudent investor wants to protect part of his capital from such misjudgements. Most investors would build there defenses around cash reserves or bonds, but Jones protects himself by selling short.

And his strategy seemed to perform. Loomis reports that he was up 670 percent for the ten-year period to May 1965. Here’s Jones’s performance chart from the article (performance of a $100,000 investment net of fees):

Particularly interesting was Loomis’s assessment of Jones’s ability to predict the direction of the market:

Jones’s record in forecasting the direction of the market seems to have been only fair. In the early part of 1962 he had his investors in a high risk position of 140 [indicating Jones was unhedged 140% long]. As the market declined, he gradually increased his short position, but not as quickly as he should have. his losses that spring were heavy, and his investors ended up with a small loss for the fiscal year (this is the only losing year in Jones’s history). After the break, furthermore, he turned bearish and so did not at first benefit from the market’s recovery. Last year, as it happens, Jones remain quite bullish through the May-June decline, and then got bearish just about the time the big rally began. As prices rose in August, Jones actually moved to a minus 18 risk – i.e., his short positions exceeded his longs, with the unhedged short position amounting to 18 percent of partnership capital.

A perfect contrary indicator. Regardless, he seems to have generally been right when purchasing individual stocks:

Despite these miscalculations about the direction of the market, Jones’s selections of individual stocks have generally been brilliant.

Loomis credits someone else with the idea for the limited partnership structure and fee calculation adopted by Jones:

The idea is common to all the hedge funds, and the idea was not original with Jones. Benjamin Graham, for one, had once run a limited partnership along the same lines.

It’s hard to find a place in investment where Ben Graham hasn’t gone first.

Posted by manualofideas at 10:30 AM | Permalink | Comments (0)

By Greenbackd

In A Crisis In Quant Confidence*, Abnormal Returns has a superb post on Scott Patterson’s recounting in his book The Quants of the reactions of several quantitative fund managers to the massive reversal in 2007:

In 2007 everything seemed to go wrong for these quants, who up until this point in time, had been coining profits.

This inevitably led to some introspection on the part of these investors as they saw their funds take massive performance hits.  Nearly all were forced to reduce their positions and risks in light of this massive drawdown.  In short, these investors were looking at their models seeing where they went wrong.  Patterson writes:

Throttled quants everywhere were suddenly engaged in a prolonged bout of soul-searching, questioning whether all their brilliant strategies were an illusion, pure luck that happened to work during a period of dramatic growth, economic prosperity, and excessive leverage that lifted everyone’s boat.

Here Patterson puts his finger on the question that vexes anyone who has ever invested, made money for a time and then given some back: Does my strategy actually work or have I been lucky? It’s what I like to call The Fear, and there’s really no simple salve for it.

The complicating factor in the application of any investing strategy, and the basis for The Fear, is that even exceptionally well-performed strategies will both underperform the market and have negative periods that can extend for three, five or, on rare occasions, more years. Take, for example, the following back-test of a simple value strategy over the period 2002 to the present. The portfolio consisted of thirty stocks drawn from the Russell 3000 rebalanced daily and allowing 0.5% for slippage:

(Click to enlarge)

The simple value strategy returns a comically huge 2,450% over the 8 1/4 years, leaving the Russell 3000 Index in its wake (the Russell 3000 is up 9% for the entire period). 2,450% over the 8 1/4 years is an average annual compound return of 47%. That annual compound return figure is, however, misleading. It’s not a smooth upward ride at a 47% rate from 100 to 2,550. There are periods of huge returns, and, as the next chart shows, periods of substantial losses:

(Click to enlarge)

From January 2007 to December 2008, the simple value strategy lost 20% of its value, and was down 40% at its nadir. Taken from 2006, the strategy is square. That’s three years with no returns to show for it. It’s hard to believe that the two charts show the same strategy. If your investment experience starts in a down period like this, I’d suggest that you’re unlikely to use that strategy ever again. If you’re a professional investor and your fund launches into one of these periods, you’re driving trucks. Conversely, if you started in 2002 or 2009, your returns were excellent, and you’re genius. Neither conclusion is a fair one.

Abnormal Returns says of the correct conclusion to draw from performance:

An unexpectedly large drawdown may mark the failure of the model or may simply be the result of bad luck. The fact is that the decision will only be validated in hindsight. In either case it represents a chink in the armor of the human-free investment process. Ultimately every portfolio is run by a (fallible) human, whether they choose to admit it or not.

In this respect quantitative investing is not unlike discretionary investing. At some point every investor will face the choice of continuing to use their method despite losses or choosing to modify or replace the current methodology. So while quantitative investing may automate much of the investment process it still requires human input. In the end every quant model has a human with their hand on the power plug ready to pull it if things go badly wrong.

At an abstract, intellectual level, an adherence to a philosophy like value – with its focus on logic, discipline and character - alleviates some of the pain. Value answers the first part of the question above, “Does my strategy actually work?” Yes, I believe value works. The various academic studies that I’m so fond of quoting (for example, Value vs Glamour: A Global Phenomenon and Contrarian Investment, Extrapolation and Risk) confirm for me that value is a real phenomenon. I acknowledge, however, that that view is grounded in faith. We can call it logic and back-test it to an atomic level over an eon, but, ultimately, we have to accept that we’re value investors for reasons peculiar to our personalities, and not because we’re men and women of reason and rationality. It’s some comfort to know that greater minds have used the philosophy and profited. In my experience, however, abstract intellectualism doesn’t keep The Fear at bay at 3.00am. Neither does it answer the second part of the question, “Am I a value investor, or have I just been lucky?”

As an aside, whenever I see back-test results like the ones above (or like those in the Net current asset value and net net working capital back-test refined posts) I am reminded of Marcus Brutus’s oft-quoted line to Cassius in Shakespeare’s Julius Caesar:

There is a tide in the affairs of men,

Which, taken at the flood, leads on to fortune;

Omitted, all the voyage of their life

Is bound in shallows and in miseries.

As the first chart above shows, in 2002 or 2009, the simple value strategy was in flood, and lead on to fortune. Without those two periods, however, the strategy seems “bound in shallows and in miseries.” Brutus’s line seems apt, and it is, but not for the obvious reason. In the scene in Julius Caesar from which Brutus’s line is drawn, Brutus tries to persuade Cassius that they must act because the tide is at the flood (“On such a full sea are we now afloat; And we must take the current when it serves, Or lose our ventures.”). What goes unsaid, and what Brutus and Cassius discover soon enough, is that a sin of commission is deadlier than a sin of omission. The failure to take the tide at the flood leads to a life “bound in shallows and in miseries,” but taking the tide at the flood sometimes leads to death on a battlefield. It’s a stirring call to arms, and that’s why it’s quoted so often, but it’s worth remembering that Brutus and Cassius don’t see the play out.

* Yes, the link is to classic.abnormalreturns. I like my Abnormal Returns like I like my Coke.

Posted by manualofideas at 10:45 PM | Permalink | Comments (0)

By Greenbackd

Yesterday I highlighted an investment strategy I first read about in a Spring 1999 research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise, simply stated, is to identify undervalued small capitalization stocks where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’m going to explore it in some depth over the next few weeks.

The idea is reminiscent of “Super” Mario J. Gabelli’s Private Market Value with a Catalyst methodology, the premise of which is the value of a company “if it is acquired by an informed wealthy family, or by another private or public corporation, as opposed to the price it is trading at in the stock markets. Simply put, it is the intrinsic value of a company plus the control premium:”

To calculate PMV, Gabelli first takes into account the free cash flow (after allowing for depreciation), deducts debt and net options (stock options) and adds back the cash. To this, he then applies an ‘appropriate’ multiple to arrive at the PMV. It sounds simple enough, but where you can go completely wrong is the multiple. Gabelli says he either looks at recent valuations of similar acquisitions or applies an appropriate historical industry acquisition multiple to arrive at the PMV.

“Some of the factors that we look at while deciding multiples to apply are: what the business is going to be worth in five years from now, what kind of return on equity can we get over time, how much further debt can be put on the company, the tax rate and what the company would be worth if there was no growth or at some particular rate (4 or 8 per cent for instance),” he explains. Of course, the multiple – and the PMV – changes over time, as it is a function of interest rates, the capitalisation structure and taxes, all of which have an indirect impact on the value of the franchise.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recall were each called “Endangered Species Update” and discussed the returns from the strategy. It seems that those follow-up reports are now lost to the sands of time. All that seems to remain is the press release of the final report:

For the last few years, Piper Jaffray has been reporting on the difficulties that small public companies face in today’s equity markets. Since the late 1990s many well run, profitable companies with a market capitalization of less than $250 million have watched their share prices underperform the rest of the stock market. With limited analyst coverage and low trading liquidity, many high-quality small companies are “lost in the shuffle” and trade at significantly lower valuation multiples than larger firms. Since our 1999 report “Wall Street’s Endangered Species,” we have held the position that:

This is a secular, not cyclical, trend and the undervaluation will continue. The best strategic move to increase shareholder value is to pursue a change-of-control transaction. Company management and the Board should either sell their company to a large strategic acquirer with the hope of gaining the buyer’s higher trading multiple, or take the company private.

In the last few of years, many small public companies identified this trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.

Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:

Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.

In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.

Piper Jaffray did follow up the reports in a 2006 article called Is There a Renewed Prospect of Going-Private Transactions? Their conclusion:

Small-Cap Stocks Outperform

Small-cap stocks have experienced a dramatic resurgence over the past five years. With weak performances from large-cap stocks, small-caps have become more favorable investments with better returns and stronger trading multiples. Here is what we have seen:

• Over the last one-, three- and five-year periods, companies in the Russell 2000 have offered average returns of 21%, 227% and 240%, respectively, compared to S&P 500 companies with average returns of 16%, 89% and 57%, respectively.
• The valuation gap that we saw five years ago between the bottom two deciles of companies in the Russell 2000 and the S&P 500 no longer exists, with the last two deciles in the Russell trading at only a 3% discount to the median EBIT multiple of S&P 500 companies and a 9% premium over the median P/E multiple.

(Click to embiggen)

Despite the rebound in valuations, small-cap stocks continue to face the same capital market challenges:

• For companies with market caps between the $50 million and $250 million range, there are approximately 1.3 analysts covering each stock versus 7.7 analysts for companies with market caps of more than $250 million.
• Trading volumes are slightly higher, with the last three deciles trading an average 202,276, 176,092 and 223,599 shares, respectively, per day, but still significantly below the volume of S&P 500 companies, which trade an average of 4.0 million shares per day.

More to come.

Posted by manualofideas at 01:37 PM | Permalink | Comments (0)

By Greenbackd

Back in the spring of 1999, when the world was enamored of dot coms and not much else, three guys at Piper Jaffray, Daniel J. Donoghue, Michael R. Murphy and Mark Buckley*, produced a superb research report called Wall Street’s Endangered Species. The thesis of the paper was that there were a large number of undervalued companies with strong fundamentals and solid growth prospects in the small cap sector (defined as stocks with a market capitalization between $50M and $250M) lacking a competitive auction for their shares. Donoghue, Murphy and Buckley argued that the phenomenon was secular, and only mergers or buy-outs would ”close their value gap:”

Management buy-outs can provide shareholders with the attractive control premiums currently experienced in the private M&A market. Alternatively, strategic mergers can immediately deliver large cap multiples to the small cap shareholder.

I believe that this phenomenon led to the emergence of activist investors in the small cap sector over the last decade. More on this in a moment.

Endangered species report

The document is drafted from the perspective of a M&A team selling corporate advisory services. Here’s the pitch:

Many well-run and profitable public companies in the $50-250 million market capitalization range are now trading at a significant discount to the rest of the stock market. Is this a temporary, cyclical weakness in small stocks that is likely to reverse soon? No, these stocks have been permanently impaired by a shift in the economics of small cap investing. This persistent under-valuation is sure to be followed by a rise in M&A activity in the sector. We have already seen an uptick in the number of “going private” transactions and strategic mergers involving these companies. Management teams that identify this trend, and respond to it, will thrive. The inactive face extinction.

Donoghue, Murphy and Buckley’s thesis was based on the then relative underperformance of the Russell 2000 to the S&P 500:

The accompanying graph, labeled Exhibit I, illustrates just how miserably the Russell 2000 lagged the S&P 500 not only last year but in 1996 and 1997 as well. Granted, small cap returns have tended to run in cycles. Since the Depression, there have been five periods during which small cap stocks have outperformed the S&P 500 (1932-37, 1940-45, 1963-68, 1975-83, and 1991-94). It is reasonable to believe that small caps, in general, will once again have their day in the sun.

They argued that the foregoing graph was a little misleading because the entirety of the Russell 2000 universe wasn’t underperforming, just the smallest members of the index:

However, a closer look at the smallest companies within the Russell 2000 reveals a secular decline in valuations that is not likely to be reversed. The table in Exhibit II divides the Russell 2000 into deciles according to market capitalization. Immediately noticeable is the disparity between the top decile, with a median market capitalization of $1.5 billion, and the tenth decile at less than $125 million. Even more striking is the comparison of compounded annual returns for the past ten years. The data clearly demonstrates that it is not the commonly tracked small cap universe as a whole that is plagued by poor stock performance but rather the smallest of the small: companies less than about $250 million in value.

Stocks trading at a discount to private company valuations

The underperformance led to these sub-$250M market cap companies trading at a discount to private company valuations:

Obscurity in the stock market translates into sub-par valuations. As shown in Exhibit IV, the smaller of the Russell 2000 companies significantly lag the S&P 500 in earnings and EBIT multiples. It is startling to find that with an average EBIT multiple of 9.0 times, many of these firms are valued below the acquisition prices of private companies.

And the punchline:

Reviving shareholder value requires a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring public, and into those of either: 1) management backed by private capital, or 2) larger companies that can capture strategic benefits. Either remedy breathes new life into these companies by providing cheaper sources of capital, and by shifting the focus away from quarterly EPS to long-term growth.

Increasing M&A activity

The market had not entirely missed the value proposition. M&A in the small cap sector was increasing in terms of price and number of transactions:

Darwin’s Darlings

Donoghue, Murphy and Buckley argued that the value proposition presented by these good-but-orphaned companies, which they called “Darwin’s darlings,” presented an attractive opportunity, described as follows:

Despite the acceleration of orphaned public company acquisitions in 1997 and 1998, there remains a very large universe of attractive public small cap firms. We sifted through the public markets, focusing on the $50-250 million market capitalization range, to construct a list of the most appealing companies. We narrowed our search by eliminating certain non-industrial sectors and ended up with over 1500 companies.

We analyzed their valuations relative to the S&P 500. The disparity is so wide that the typical S&P 500 company could pay a 50% premium to acquire the average small cap in this group without incurring earnings dilution. Those dynamics appear to be exactly what is driving small cap takeover values. The median EBIT multiple paid for small caps in 1998 was roughly equal to where the typical S&P 500 trades.

We honed in on those companies with multiples that are positive, but even more deeply discounted at less than 50% of the S&P 500. Finally, we selected only those with compounded annual EBIT growth of over 10% for the past five years. As shown in Exhibit VII, these 110 companies,“Darwin’s Darlings,” have a median valuation of only 5.8 times EBIT despite a compounded annual growth rate in EBIT of over 30% for the past five years.

The emergence of activists

Donoghue, Murphy and Buckley identified the holders of many of these so-called “Darwin’s darlings” as “small cap investment funds focused on likely take-over targets:”

As detailed in the description of our “Darwin’s Darlings” in Exhibit VIII, management ownership varies widely among these companies. For recent IPOs of family-held businesses, management stakes are generally high. For those that were corporate spin-offs, management ownership tends to be low. We frequently find large blocks of these stocks held by small cap investment funds focused on likely take-over targets, leading to a surprisingly high percentage of total insider ownership (management plus holders of more than 5%).

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected by the fact that they are so thinly traded. In most cases it takes more than six months to accumulate a 5% position in the stock without moving the market. Hence, we expect virtually all acquisitions in this sector to be friendly. There is no question that some very attractive targets cannot be acquired on a friendly basis. However, coercing these companies into a change of control means being prepared to launch a full proxy fight and tender offer.

In When Wall Street Scorns Good Companies, a Fortune magazine article from October 2000, writer Geoffrey Colvin asked of Darwin’s darlings, “So why are all these firms still independent?”

The answer may lie in another fact about them: On average, insiders own half their shares. When the proportion is that high, the insiders are most likely founders; they have enough stock to fend off any hostile approach, and they haven’t sold because they aren’t ready to give up control. Not many outside investors want to go along for that ride. Thus, low prices.

But there’s still a logical problem. Since the companies are so cheap, why don’t managers buy the shares they don’t already own– take the company private at today’s crummy multiple, then sell the whole shebang at an almost guaranteed higher price? Going private has in fact become more popular than ever, but what seems most striking is how rare it remains. Of Piper Jaffray’s 1999 Darwin’s Darlings– 110 companies–only three went private in the following 12 months. That makes perfect sense if you figure that many of the outfits are run by owner-managers whose top priority is keeping control. Announce a going-private transaction and you put the company in play, and even a chummy board may feel obliged to honor its fiduciary duty if a higher bid comes along.

Thus we reach the somewhat ugly truth about Wall Street’s orphaned stars: Many of them (not all) like things the way they are–that is, they like staying in control. The outsider owners are typically a diffuse bunch in no position to put heat on the controlling insiders. The stock price may be lousy, but when the owner-managers decide to sell–that is, to get out of the way–it will almost certainly rise handsomely, as it did for the 19 of last year’s Darwin’s Darlings that have since sold.

So shed no tears for these scorned companies, and don’t buy their shares without a deep understanding of what the majority owners have in mind. In theory the spreading corporate governance movement ought to protect you; in practice the shareholder activists have bigger fish to fry. Such circumstances may keep share prices down, but that’s the owner-managers’ problem. At least, in this case, the market isn’t so mysterious after all.

I believe that the third paragraph above best describes the reason for the emergence of the activists in the small cap sector. Observing that stock prices rose dramatically when owner-managers of “Wall Street’s orphaned stars” decided to sell, and outside investors were “typically a diffuse bunch in no position to put heat on the controlling insiders,” activist investors saw the obvious value proposition and path to a catalyst and entered the fray. This led to a golden decade for activist investing in the small cap sector, one that I think is unlikely to be repeated in the next decade. Regardless, it’s an interesting strategy, and an obvious extension for an investor focussed on small capitalization stocks and activist targets.

*Donoghue, Murphy and Buckley in 2002 founded Discovery Group, a fund manager and M&A advisory that takes significant ownership stakes (up to 20%) in companies trading at a discount to “fundamental economic value.”

Posted by manualofideas at 02:39 PM | Permalink | Comments (0)

By Ravi Nagarajan

Despite a snowstorm that caused the absence of several speakers, the Columbia Investment Management Conference in New York today included many interesting presentations and panel discussions.  The highlight of the day was the conversation between Columbia Professor Bruce Greenwald and Martin Whitman, Founder and Portfolio Manager of Third Avenue Management.

Mr. Whitman has a sixty year history in the investment management field and represents a distinguished voice of experience we can all learn from.  This article includes several topics that were included in the discussion between Prof. Greenwald and Mr. Whitman but it is not a complete transcript and, unless otherwise noted, is based on the authors notes and recollection of the conversation rather than a presentation of direct quotes.

The Evolution of a Value Investor

Most investors who have arrived at a “value oriented” strategy moved toward the approach over a period of time.  Many of us know the story of Warren Buffett reading every book on investing in the Omaha library but not reaching the conclusion that value investing represents the best strategy until reading Ben Graham’s The Intelligent Investor in 1950.  A similar “evolution” was the case for Mr. Whitman who entered the business as a security analyst at Shearson, Hammil in 1950.  For the first four years, Mr. Whitman focused on many of the traditional benchmarks that security analysts today still concentrate on such as earnings per share growth and predicting near term price movements.

In 1955, Mr. Whitman read Between the Sheets by William J. Hudson which is a book (currently out of print) regarding the importance of paying particular attention to the balance sheet.  This book combined with several real life examples at the time convinced Mr. Whitman that emphasizing balance sheet quality should be more heavily considered in the field of security analysis.  Mr. Whitman also gained a great deal of experience working as a portfolio analyst for William Rosenwald starting in 1956. Experience in stockholder litigation and bankruptcy, fields that were shunned at the time, also provided important lessons regarding analyzing the capital structure of distressed firms.

“Cheap is Not Sufficient”

At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme:  It is not sufficient for a security to be “cheap”.  It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness.   In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”.  This might include current year earnings compared to the stock price, current year cash flow, and many others.  However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company.  A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.

A New Take on Graham’s “Net-Nets”

Mr. Whitman believes that it is a “myth” that there are no “net-net” opportunities available in the market today.  We discussed Graham’s concept of net-nets in a prior article and came up with some examples of such opportunities over the past year (for example, see the articles on Hurco and George Risk Industries).  However, such opportunities are very rare and often exist only in the most thinly traded stocks and therefore are rarely actionable.

Rather than adhering to Ben Graham’s original concept of “net-nets”, Mr. Whitman has made a few modifications.  Instead of using current assets as the store of value, he looks at “readily ascertainable asset value” and tries to buy at a large discount to that value.  Assets that can be readily convertible to cash may include high quality real estate, for example.  In certain situations, assets such as real estate may be more valuable in a liquidation than inventories which are part of current assets but often highly impaired in distressed situations.

One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations.  The true value of a company may never come out if there is no threat of a change in control.  This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business.

When asked if the management of a typical public company is overpaid, Mr. Whitman said “you’d better believe it” due partly to the fact that most Boards of Directors are “a bunch of wimps, including me.”  This serves as a reminder that there is one other characteristic that many value investors share:  Humility and a willingness to admit errors.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.  

Posted by manualofideas at 08:41 AM | Permalink | Comments (0)

By Greenbackd

Jae Jun at Old School Value has updated his great post back-testing the performance of net current asset value (NCAV) against “net net working capital” (NNWC) by refining the back-test (see NCAV NNWC Backtest Refined). His new back-test increases the rebalancing period to 6 months from 4 weeks, excludes companies with daily volume below 30,000 shares, and introduces the 66% margin of safety to the NCAV stocks (I wasn’t aware that this was missing from yesterday’s back-test, and would explain why the performance of the NCAV stocks was so poor).

Jae Jun’s original back-test compared the performance of NCAV and NNWC stocks over the last three years. He calculated NNWC by discounting the current asset value of stocks in line with Graham’s liquidation value discounts, but excludes the “Fixed and miscellaneous assets” included by Graham. Here’s Jae Jun’s NNWC formula:

NNWC = Cash + (0.75 x Accounts receivables) + (0.5 x  Inventory)

Here’s Graham’s suggested discounts (extracted from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

As I noted yesterday, excluding the “Fixed and miscellaneous assets” from the liquidating value calculation makes for an exceptionally austere valuation.

Jae Jun has refined his screening criteria as follows:

Volume is greater than 30k

NCAV margin of safety included

Slippage increased to 1%

Rebalance frequency changed to 6 months

Test period remains at 3 years

Here are Jae Jun’s back-test results with the new criteria:

For the period 2001 to 2004

For the period 2004 to 2007

For the period 2007 to 2010

It’s an impressive analysis by Jae Jun. Dividing the return into three periods is very helpful. While the returns overall are excellent, there were some serious smash-ups along the way, particularly the February 2007 to March 2009 period. As Klarman and Taleb have both discussed, it demonstrates that your starting date as an investor makes a big difference to your impression of the markets or whatever theory you use to invest. Compare, for example, the experiences of two different NCAV investors, one starting in February 2003 and the second starting in February 2007. The 2003 investor was up 500% in the first year, and had a good claim to possessing some investment genius. The 2007 investor was feeling very ill in March 2009, down around 75% and considering a career in truck driving. Both were following the same strategy, and so really had no basis for either conclusion. I doubt that thought consoles the trucker.

Jae Jun’s Old School Value NNWC NCAV Screen is available here (it’s free).

Posted by manualofideas at 11:50 AM | Permalink | Comments (0)

By Ravi Nagarajan

Note to Readers:  The following essay is part of an introductory section of an upcoming analysis of Berkshire Hathaway to be published by The Rational Walk shortly after the 2009 Berkshire Hathaway Annual Report is released at the end of February.  The full analysis will be available for purchase as premium content with certain excerpts to be provided on The Rational Walk blog free of charge.

For a formatted PDF File of the following essay, please click on this link.

From Cigar Butts to Business Supermodels

There are numerous books and publications that provide detailed accounts of the history of Berkshire Hathaway as well as Warren Buffett’s life and career.  It is also impossible to fully understand Berkshire without studying the life and career of Vice Chairman Charles T. Munger.  A list of resources for those interested in a comprehensive history of the company and its leaders is provided as an appendix to this document (available in the forthcoming full analysis).  This section merely attempts to provide some context regarding the remarkable history of Berkshire Hathaway and Warren Buffett’s investment approach.

Warren Buffett’s Early Investment Philosophy

Warren Buffett’s early investment philosophy was largely based on the principles developed by Benjamin Graham.  Mr. Buffett has stated on many occasions[1] that his view of investing changed dramatically when he first read Mr. Graham’s book, The Intelligent Investor, in early 1950.  Up to that point, Mr. Buffett had read every book on investing available at the Omaha public library but none were as compelling as Mr. Graham’s straight forward approach summarized in the phrase: “Margin of Safety”.

Benjamin Graham’s approach is more fully documented in Security Analysis which, in contrast to The Intelligent Investor, is more targeted toward professional investors.  Mr. Graham’s approach involved examining securities from a quantitative perspective and making purchases only when downside risks are minimized.  This approach rarely involved speaking to management since doing so could adversely influence the analyst’s impartial view of the data.  In particular, Mr. Graham was a proponent of purchasing stocks selling well under “net-net current asset value” arrived at by taking a company’s current assets and subtracting all liabilities.  In such cases, the buyer was paying nothing for the business as a going concern and had some downside protection due to liquid assets far in excess of all liabilities.

Mr. Buffett was able to leverage the “deep value” approach advocated by Benjamin Graham throughout the 1950s.  In the five year period ending in 1961, the Buffett Partnerships trounced the Dow Jones Industrial average with a cumulative return of 251 percent compared to 74.3 percent for the Dow[2].  While Mr. Buffett employed multiple strategies, one approach involved finding companies that fit the “cigar butt” mold, meaning that they had “one puff left” and could be purchased at a deep bargain price.  This approach led Mr. Buffett to begin acquiring shares of Berkshire Hathaway, a struggling New England textile manufacturer, in late 1962. While Berkshire Hathaway was trading well under book value at the time, Mr. Buffett would later say that book value “considerably overstated” intrinsic value[3].

From Cigar Butts to Insurance

Berkshire Hathaway, as it existed in 1963 when the Buffett Partnership became the company’s largest shareholder, was a cheap company from a quantitative perspective but it was not a good company in terms of offering a business that had durable competitive advantages.  In fact, over the next two decades, Berkshire Hathaway continued to invest in the textile mills but would never gain sufficient traction to complete with overseas competitors with lower cost structures.  Textiles are a commodity business and the low price producer has the advantage.  In retrospect, Mr. Buffett’s purchase of Berkshire Hathaway was a mistake[4].

While Berkshire’s textile mills were doomed to eventual failure, a period of profitability[5] appeared in the mid to late 1960s that presented Mr. Buffett with a choice:  He could either reinvest the profits in the textile business or redeploy the funds elsewhere.  Above all else, Mr. Buffett is a master capital allocator.  He could see the troubles brewing in textiles and, despite attempts by Berkshire’s textile managers to obtain capital for new investments, Mr. Buffett chose to deploy the funds elsewhere.

Berkshire’s entry into the insurance business with the purchase of National Indemnity in 1967[6] was a transformational event for the company.  The textile business, despite a temporary period of profitability, required significant capital investments to continue to remain competitive.  In contrast, insurance operations that are well run generate significant cash in the form of “float”.  Float represents funds that are held by an insurance business between the time when policyholders submit payment and when funds are eventually paid out to settle claims.  As long as underwriting practices are sound, float represents a low cost means of funding investments.  By purchasing National Indemnity, Berkshire was on its way to transforming from a textile manufacturer consuming large amounts of capital at low to negative rates of return into an insurance powerhouse generating large amounts of float for investment in other businesses offering better prospects of high returns.

See’s Candies:  The Turning Point

Few Californians can recall a holiday season where See’s Candies were not a prominent part of the festivities.  The brand is so powerful in California and other western states that many consumers would never think of buying a competing product.  See’s Candies is a textbook example of a company with a formidable “moat”.  Such companies have built up brand identity that cannot be replicated by new entrants even with significant capital investments[7].

Berkshire Hathaway Vice Chairman Charles Munger has been widely credited with convincing Warren Buffett that there are certain situations where deviating from Benjamin Graham’s “deep value” approach can be justified.  Mr. Munger has rebutted[8] the notion that his influence was a deciding factor in Mr. Buffett’s overall record, but many accounts[9] of the events surrounding the See’s Candies purchase supports the conclusion that Charlie Munger deserves much credit for shifting Berkshire’s bias from cigar butts selling at a “bargain price” to excellent businesses selling at a “fair price”.

See’s Candies is the perfect example of a business that produces an excellent return on equity year after year but requires very little capital investment in order to sustain the “moat” that makes such returns possible.  When Berkshire purchased See’s Candies for $25 million in 1972, the company only had $8 million of net tangible assets.  However, See’s was earning approximately $2 million after tax at the time[10].   $17 million of the $25 million purchase price could not be accounted for by assets on See’s balance sheet but represented the value represented by intangible “brand equity”.

Over the first twenty years of Berkshire’s ownership of See’s Candies, sales increased from $29 million to $196 million while pre-tax profits grew from $4.2 million to $42.4 million.  However, that is not even the most amazing part of the story.  What is more remarkable is that Berkshire Hathaway only had to reinvest $18 million of retained earnings over that twenty year period while $410 million of cumulative pre-tax earnings were sent back to Berkshire for redeployment in other investments[11].

There have been many other key turning points in the history of Berkshire Hathaway but the decision to pay a “premium price” for See Candies in 1972 may best symbolize the transformation of Mr. Buffett’s approach toward investing.  This is perfectly summarized in Mr. Buffett’s 1992 Letter to Shareholders:

In my early days as a manager I, too, dated a few toads.  They were cheap dates – I’ve never been much of a sport – but my results matched those of acquirers who courted higher-priced toads.  I kissed and they croaked.

After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous).  Said the pro:  “Practice doesn’t make perfect; practice makes permanent.”  And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.

Berkshire Hathaway is the company it is today because Mr. Buffett stopped kissing toads like the original Berkshire textile business and started aggressively pursuing supermodels like See’s Candies instead even if they were more “expensive dates”.  As we shall see, Berkshire has no shortage of supermodels today.

[1] For example, see Mr. Buffett’s preface to any recent edition of The Intelligent Investor.
[2] The Buffett Partnership track record is available in many publications.  See, for example, Roger Lowenstein’s Buffett: The Making of an American Capitalist, 1995 Hardcover Edition, Page 69.
[3] See comment in Berkshire Hathaway Owner’s Manual, Page 5.
[4] Mr. Buffett directly stated that buying Berkshire was a mistake in his 1989 letter to shareholders.
[5] See Lowenstein, Page 133.
[6] For a good history of the National Indemnity purchase, see Lowenstein, pages 133 to 135.
[7] For an excellent brief history of See’s Candies, see Max Olson’s paper entitled Quality without Compromise.
[8] See Mr. Munger’s statement in Poor Charlie’s Almanack, Third Edition, “Rebuttal:  Munger on Buffett”
[9] For example, see Alice Schroeder’s account of the See’s Candies purchase in Snowball:  Warren Buffett and the Business of Life, Chapter 34.
[10] See the appendix to Warren Buffett’s 1983 Letter to Shareholders.
[11] See Warren Buffett’s 1991 Letter to Shareholders.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure: The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 11:18 AM | Permalink | Comments (0)

The Manual of Ideas: Are there any books on value investing, particularly globally oriented investing, that you have found valuable but investors may not be broadly familiar with?

Ori Eyal: Reading voraciously is a characteristic that all great investors share in common. There is simply no better way to gain wisdom and learn about the world than to read great books.

For international investing, Jim Rogers’s earlier books, Investment Biker, Adventure Capitalist, and Hot Commodities are good. The Economist is a great weekly magazine to read and learn about the world. I also think Mohnish Pabrai’s The Dhandho Investor and Joel Greenblatt’s You Can Be a Stock Market Genius are great investing books.

Economics is a key investing skill so I think everyone should read Milton Friedman, especially his books Capitalism and Freedom and Free to Choose.

Trying to forecast what the future will look like is an important investing skill. To this end I recommend books by Ray Kurzweil, Fantastic Voyage and The Singularity Is Near. Bill Gates has called Ray Kurzweil “the best person I know at predicting the future of artificial intelligence.”

To broaden your latticework of mental models, I highly recommend books by Richard Dawkins, Jared Diamond, Richard Feynman, Michael Pollan and John Brockman. I also think Buzzmarketing by Mark Hughes and Influence by Robert Cialdini are must read books.

Finally, I highly recommend the fantastic publications by The Manual of Ideas: Downside Protection Report, Portfolio Manager’s Review, etc. I also think that Value Investor Insight is great.

Read a sample issue of Downside Protection Report.

Read a sample issue of Portfolio Manager's Review.

Posted by manualofideas at 03:45 PM | Permalink | Comments (0)

By Greenbackd

Regular readers of Greenbackd know that I’m no fan of “the narrative,” which is the story an investor concocts to explain the various pieces of data the investor gathers about a potential investment. It’s something I’ve been thinking about a great deal recently as I grapple with the merits of an investment in Japanese net current asset value stocks. The two arguments for and against investing in such opportunities are as follows:

Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive.

Agin it: Japan is a special case because it has weak shareholder rights and a culture that regards corporations as “social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.” In support of this argument I cite the recent experiences of activist investors in Japan, and Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values (yes, it supports both sides of the argument). Further, the prospects for Japan’s economy are poor due to its large government debt and ageing population.

How to break the deadlock? Montier provides a roadmap in his excellent Behavioural Investing:

We appear to use stories to help us reach decisions. In the ‘rational’ view of the world we observe the evidence, we then weigh the evidence, and finally we come to our decision. Of course, in the rational view we all collect the evidence in a well-behaved unbiased fashion. … Usually we are prone to only look for the information that happens to agree with us (confirmatory bias), etc.

However, the real world of behaviour is a long way from the rational viewpoint, and not just in the realm of information gathering. The second stage of the rational decision is weighing the evidence. However, as the diagram below shows, a more commonly encountered approach is to construct a narrative to explain the evidence that has been gathered (the story model of thinking).

Hastie and Pennington (2000) are the leading advocates of the story view (also known as explanation-based decision-making). The central hypothesis of the explanation-based view is that the decision maker constructs a summary story of the evidence and then uses this story, rather than the original raw evidence, to make their final decision.

…

All too often investors are sucked into plausible sounding story. Indeed, underlying some of the most noted bubbles in history are kernels of truth.

As to the last point, arguably, the converse is also true. Investors have missed some great returns because the ugly stories about companies or markets were so compelling.

There are several points that are not contentious about an investment in Japan. The data suggests to me and to everyone else that there are a large number of net current asset value bargains available there. The contention is whether these net current asset value stocks will perform as they have in other countries, or whether they are destined to remain net current asset value bargains, the classic “value traps.” My own penchant for value investing, and quantitative value investing in particular, makes this a reasonably simple matter to resolve. I am going to invest in Japanese net current asset value stocks. Here are the bases for my reasoning:

• I believe that value investing works. I believe that this is the case because it appeals to me as a matter of logic. I also believe that the data supports this position (see Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk). Where a stock trades at a significant discount to its value, I am going to take a position.
• I believe that Graham’s net current asset value works. In support of this proposition I cite the papers listed in the “Fer it” argument above.
• I believe that simple quantitative models consistently outperform expert judgements. In support of this proposition generally I cite James Montier’s Painting By Numbers: An Ode To Quant. Where the data looks favorable to me, I am going to take a position, and I’m going to ignore the qualitative factors.
• I believe that value is a good predictor of returns at a market level. In support I cite the Dimson, Marsh and Staunton research. I am not dissuaded from investing in a country simply because its growth prospects are low. Value is the signal predictor of returns.

The arguments militating against investing in Japan sound to me like the arguments militating against any investment in a NCAV stock, which is to say that they are arguments rooted in the narrative. I’ve never taken a position in a NCAV stock that had a good story attached to it. They have always looked ugly from an earnings or narrative perspective (otherwise, they’d be trading at a higher price). As far as I can tell, this situation is no different, other than the fact that it is in a different country and the country has economic problems (which I would ignore in the usual case anyway). While the research specific to NCAV stocks in Japan is not as compelling as I would like it to be, I always bear in mind the lessons of Taleb’s “naive empiricist,” which is to say that the data are useful only up to a point.

This is not to say that I have any great conviction about Japan or Japanese net current asset value stocks. Far from it. I fully expect, as I always do when taking a position in any stock, to be wrong and have the situation follow the narrative. Fortunately, the decision is out of my hands. I’m going to follow my simple quantitative model – the Graham net current asset value strategy – and take some positions in Japanese net nets. The rest is for the goddess Fortuna.

Posted by manualofideas at 12:26 PM | Permalink | Comments (2)

Respected value investor Aaron Edelheit of Sabre Value recently discussed his investment approach and current investment opportunities in an exclusive interview with Portfolio Manager's Review. The full interview will be published in the forthcoming monthly issue of the Review. Here is a quick excerpt for those looking to pick up a good book:

The Manual of Ideas: Are there any “off-the-beaten path” books that have made you a better investor?

Aaron Edelheit: I just read a fantastic book called “The First Tycoon,” by T.J. Stiles, about Cornelius Vanderbilt. There were many lessons and ideas I drew from the book about what made him so successful, and I think there is a lot to learn about history as well.

Read the full interview with Edelheit as soon as it is published -- subscribe to Portfolio Manager's Review today.

Posted by manualofideas at 04:26 PM | Permalink | Comments (0)

Posted by manualofideas at 01:23 PM | Permalink | Comments (0)

In recent weeks, Kraft’s proposed acquisition of Cadbury has generated a great deal of interest.  When an investor with Warren Buffett’s reputation characterizes the deal as making him “feel poorer”, observers might wonder what could possibly motivate a CEO such as Kraft’s Irene Rosenfeld to pursue such a transaction.

While we cannot pretend to know Ms. Rosenfeld’s motives, there are some general observations investors can make regarding the incentive systems and motivations that make value destroying mergers and acquisitions very common.  Understanding these motives can help investors avoid situations where managements seem prone to destroying value.

Compensation Systems

In most public companies, CEO compensation is set by the Board’s compensation committee.  Usually, the base pay recommendation is made by compensation consultants who evaluate the CEO pay of companies in a “peer group”.  The peer group is inevitably made up of companies with similar revenues since this is considered to be a good proxy for the complexity of the business.

The trouble with setting base compensation by looking only at revenues is that CEOs are then given the incentive to retain earnings and pursue growth for the sake of revenue growth alone.  This can be done either through unwise internal growth or through acquisitions.

The situation gets even worse when stock options are issued to the CEO without adjusting the strike price over time for retention of earnings.  Since most options have a fixed strike price that is usually set at the market value of the stock on the date of the grant along with a ten year term, a CEO can simply retain earnings in order to boost the value of the option.  In contrast, paying dividends would reduce the value of the option.  Such option plans provide every incentive for CEOs to retain earnings even if there are no profitable opportunities for expansion of the business.

Thrill of the Deal

The day to day routine in any job can become boring eventually even in dynamic industries.  It is natural for people to seek some level of “excitement” in their jobs.  When the individual in question is the CEO, it may be more exciting to get on the corporate jet and meet other executives who may wish to “do a deal” than to attend to the routine matters of running the business.

Once a deal is underway, investment bankers and other advisors with strong incentives to see the transaction occur are brought in and create a sense of “deal momentum” that can be hard to break.  Most CEOs have risen to power by being aggressive and not taking “no” for an answer.  This is usually a healthy attribute but can lead to economically harmful deals when other psychological factors are at work and legions of advisors are pushing for the deal to occur.

Ego and Legacy

Most executives who reach the top have a healthy ego and would like to be remembered as great business leaders long after they retire.  This can be a healthy attribute and can lead to excellent performance if the energy is directed in a productive way.  However, the desire to be famous and well respected can lead to value destroying deals.  The temptation offered by doing deals that result in photos on the front page of the Wall Street Journal can be hard to resist.

Start Modifying Incentives with Compensation Reform

Of the factors discussed in this article, compensation systems are likely the easiest to modify in a way that discourages value destroying mergers and acquisitions.  By tying base compensation and bonus to per-share intrinsic value creation rather than simply looking at revenue growth, management incentives can be aligned with shareholder interests.  Stock option plans with a strike price that adjusts for retention of earnings would also be a vast improvement.  Unfortunately, there are few signs that such reforms will gain traction anytime soon.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 12:34 AM | Permalink | Comments (0)

By Greenbackd

In “Black box” blues I argued that automated trading was a potentially dangerous element to include in a quantitative investment strategy, citing the “program trading / portfolio insurance” crash of 1987. When the market started falling in 1987 the computer programs caused the writers of derivatives to sell on every down-tick, which some suggest exacerbated the crash. Here’s New York University’s Richard Sylla discussing the causes (care of Wikipedia).

The internal reasons included innovations with index futures and portfolio insurance. I’ve seen accounts that maybe roughly half the trading on that day was a small number of institutions with portfolio insurance. Big guys were dumping their stock. Also, the futures market in Chicago was even lower than the stock market, and people tried to arbitrage that. The proper strategy was to buy futures in Chicago and sell in the New York cash market. It made it hard — the portfolio insurance people were also trying to sell their stock at the same time.

The Economist’s Buttonwood column has an article, Model behaviour: The drawbacks of automated trading, which argues along the same lines that automated trading is potentially problematic where too many managers follow the same approach:

[If] you feed the same data into computers in search of anomalies, they are likely to come up with similar answers. This can lead to some violent market lurches.

Buttonwood divides the quantitative approaches to investing into at three different types and their potential for providing a stabilizing influence on the market or throwing fuel on the fire in a crash:

1. Trend-following, the basis of which is that markets have “momentum”:

The model can range across markets and go short (bet on falling prices) as well as long, so the theory is that there will always be some kind of trend to exploit. A paper by AQR, a hedge-fund group, found that a simple trend-following system produced a 17.8% annual return over the period from 1985 to 2009. But such systems are vulnerable to turning-points in the markets, in which prices suddenly stop rising and start to fall (or vice versa). In late 2009 the problem for AHL seemed to be that bond markets and currencies, notably the dollar, seemed to change direction.

2. Value, which seeks securities that are  cheap according to “a specific set of criteria such as dividend yields, asset values and so on:”

The value effect works on a much longer time horizon than momentum, so that investors using those models may be buying what the momentum models are selling. The effect should be to stabilise markets.

3.  Arbitrage, which exploits price differentials between securities where no such price differential should exist:

This ceaseless activity, however, has led to a kind of arms race in which trades are conducted faster and faster. Computers now try to take advantage of arbitrage opportunities that last milliseconds, rather than hours. Servers are sited as close as possible to stock exchanges to minimise the time taken for orders to travel down the wires.

In arguing that automated trading can be problematic where too many managers pursue the same strategy, Buttonwood gives the example of the August 2007 crash, which sounds eerily similar to Sylla’s explanation for the 1987 crash above:

A previous example occurred in August 2007 when a lot of them got into trouble at the same time. Back then the problem was that too many managers were following a similar approach. As the credit crunch forced them to cut their positions, they tried to sell the same shares at once. Prices fell sharply and portfolios that were assumed to be well-diversified turned out to be highly correlated.

It is interesting that over-crowding is the same problem identified by GSAM in Goldman Claims Momentum And Value Quant Strategies Now Overcrowded, Future Returns Negligible. In that presentation, Robert Litterman, Goldman Sachs’ Head of Quantitative Resources, said:

Computer-driven hedge funds must hunt for new areas to exploit as some areas of making money have become so overcrowded they may no longer be profitable, according to Goldman Sachs Asset Management. Robert Litterman, managing director and head of quantitative resources, said strategies such as those which focus on price rises in cheaply-valued stocks, which latch onto market momentum or which trade currencies, had become very crowded.

Litterman argued that only special situations and event-driven strategies that focus on mergers or restructuring provide opportunities for profit (perhaps because these strategies require human judgement and interaction):

What we’re going to have to do to be successful is to be more dynamic and more opportunistic and focus especially on more proprietary forecasting signals … and exploit shorter-term opportunistic and event-driven types of phenomenon.

As we’ve seen before, human judgement is often flawed. Buttonwood says:

Computers may not have the human frailties (like an aversion to taking losses) that traditional fund managers display. But turning the markets over to the machines will not necessarily make them any less volatile.

And we’ve come full circle: Human’s are flawed, computers are the answer. Computers are flawed, humans are the answer. How to break the deadlock? I think it’s time for Taleb’s skeptical empiricist to emerge. More to come.

Posted by manualofideas at 10:48 AM | Permalink | Comments (0)

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By Nadav Manham

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By Greenbackd

Continuing the quantitative value investment theme I’ve been trying to develop over the last week or so, I present my definition of a simple quantitative value strategy: net nets. James Montier, author of the essay Painting By Numbers: An Ode To Quant, which I use as the justification for simple quantitative investing, authored an article in September 2008 specifically dealing with net nets as a global investment strategy: Graham’s net-nets: outdated or outstanding? (.pdf). Quelle surprise, Montier found that buying net-nets is a viable and profitable strategy:

Testing such a deep value approach reveals that it would have been a highly profitable strategy. Over the period 1985-2007, buying a global basket of net-nets would have generated a return of over 35% p.a. versus an equally weighted universe return of 17% p.a.

An annual return of 35% over 23 years would put you in elite company indeed, so Montier’s methodology is worthy of closer inspection. Unfortunately he doesn’t discuss his methodology in any detail, other than to say as follows:

I decided to test the performance of buying net-nets on a global basis. I used a sample of developed markets over the period 1985 onwards, all returns were in dollar terms.

It may have been a strategy similar to the annual rebalancing methodology discussed in Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update. That paper demonstrates a purely mechanical annual rebalancing of stocks meeting Graham’s net current asset value criterion generated a mean return between 1970 and 1983  of “29.4% per year versus 11.5% per year for the NYSE-AMEX Index.” It doesn’t really matter exactly how Montier generated his return. Whether he bought each net net as it became a net net or simply purchased a basket on a regular basis (monthly, quarterly, annually, whatever), it’s sufficient to know that he was testing the holding of a basket of net nets throughout the period 1985 to 2007.

Montier’s findings are as follows:

• The net-nets portfolio contains a median universe of 65 stocks per year.
• There is a small cap bias to the portfolio. The median market cap of a net-net is US$21m.
• At the time of writing (September 2008), Montier found around 175 net-nets globally. Over half were in Japan.
• If we define total business failure as stocks that drop more than 90% in a year, then the net-nets portfolio sees about 5% of its constituents witnessing such an event. In the broad market only around 2% of stocks suffer such an outcome.
• The overall portfolio suffered only three down years in our sample, compared to six for the overall market.

Several of Montier’s findings are particularly interesting to me. At an individual company level, a net net is more likely to suffer a permanent loss of capital than the average stock:

If we define a permanent loss of capital as a decline of 90% or more in a single year, then we see 5% of the net-nets selections suffering such a fate, compared with 2% in the broader market.

Here’s the chart:

This is interesting given that NCAV is often used as a proxy for liquidation value.

Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.

Montier believes this may provide a clue as to why the net net strategy continues to work:

This relatively poor performance may hint at an explanation as to why investors shy away from net-nets. If investors look at the performance of the individual stocks in their portfolio rather than the portfolio itself (known as ‘narrow-framing’), then they will see big losses more often than if they follow a broad market strategy. We know that people are generally loss averse, so they tend to feel losses far more than gains. This asymmetric response coupled with narrow framing means that investors in the net-nets strategy need to overcome several behavioural biases.

Paradoxically, it seems that what is true at the individual company level is not true at an aggregate level. The net net strategy has fewer down years than the market:

If one were to frame more broadly and look at the portfolio performance overall, the picture is much brighter. The net-net strategy only generated losses in three years in the entire sample we backtested. In contrast, the overall market witnessed some six years of negative returns.

Here’s the chart:

And it seems that the net net strategy is a reasonable contrary indicator. When the market is up, fewer can be found, and when the market is down, they seem to be available in abundance:

The main drawback to the net net strategy is its limited application. Stocks tend to be small and illiquid, which puts a limit on the amount of capital that can be safely run using it. That aside, it seems like a good way to get started in a small fund or with a individual account. Montier concludes:

…In various ways practically all these bargain issues turned out to be profitable and the average annual return proved much more remunerative than most other investments.

Good old Benjamin Graham. What a guy.

Posted by manualofideas at 05:26 PM | Permalink | Comments (0)

Watch an excellent presentation by James Montier of Societe Generale.

(Thanks to David Lau for the link.)

Posted by manualofideas at 12:01 PM | Permalink | Comments (0)

We are pleased to announce a partnership with Greenbackd, whereby we will occasionally republish Greenbackd content for the benefit of our members. Greenbackd is a widely respected online source of information for value-oriented investors, and we are pleased to make their analysis available right here. The following is a recent article by Greenbackd:

One of the most fascinating examples of the phenomenon of mean reversion was identified by Werner F.M. DeBondt and Richard H. Thaler in Further Evidence on Investor Overreaction and Stock Market Seasonality. DeBondt and Thaler examined the relative performance of quintiles of stocks on the NYSE and AMEX ranked according to book value. As an adjunct to the main study, one of the variables they analyzed was the relative earnings performance of stocks in the lowest and highest price-to-book quintiles.

DeBondt and Thaler’s findings are as interesting as they are counter-intuitive. Stocks in the lowest price-to-book quintile (the cheapest stocks) grew their earnings faster than the stocks in the highest price-to-book quintile (the most expensive stocks). Tweedy Browne set out DeBondt and Thaler’s findings in Table 3 below, which describes the average earnings per share for companies in the lowest and highest quintile of price-to-book value in the three years prior to selection and the four years subsequent to selection:

In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”

The implication here is that not only does the price of stocks that are cheap relative to other stocks regress to the mean, but the underlying performance does too. That’s an amazing finding. There’s really no good reason why low price-to-book should be such a good predictor for short and mid-term earnings growth. I’ve spent some time thinking about why this might be so, and the only possible explanation I can come up with is magic. Nothing else fits.

Posted by manualofideas at 07:37 PM | Permalink | Comments (0)

The author of this opinion piece is hedge fund manager Nick Gogerty.

Business values are tied to 2 things, a competitive dynamic and perceived value by the purchaser.

Put these 2 pieces together and you end up with price.  Please note this is a little more subtle than supply and demand and the framework varies with each market.

The competitive dynamic means substitute offerings.  If a business model or offering is truly unique or has a defensible market position via geography like railroads or mental perceived value like impulse purchases of fast moving consumer product brands a firm may be able to extract higher margins. 

Many competitive environments are relatively stable with the top 3-5 players holding 50-60% of market share and dictating price via competition between them. 

It is like a horse race with most of the horses being about equal and extracting a median profit margin in the respective industry with some slight  point of differentiation.  If a horse nudges ahead with an innovation or advantage they may extract higher profits for awhile.  The duration and scope of that advantage is their competitive moat.  The moats success is measured by sustainable extra market profit margin.

Gum by gum

People paying an Extra $0.05 for a pack of $0.50 gum might just double the profits for a company in a 10% net margin business.  If you don't believe you are brand conscious ask yourself, when was the last time you bought a generic piece of gum at the counter.

This competitive dynamic of limited shelf space at the check-out counter and a relatively non-innovative space means high margins for those 4-5 firms who can dominate the 3 foot battle field by the check out counter. 

The latest innovative blister pack packaging was probably treated with serious anger when the first innovator put it in place. It meant everyone else would have to offer something competitive, spending capital and a dipping into margins until the costs were spread to the consumer at a new but accepted average price point for gum.  The first mover had an edge for awhile with the new perceived value via the packaging borrowed from the pharma industry.  Old wine into new bottles doesn't revolutionize the wine industry for long but means competitors have to keep up.

The real innovators dilemma: staying ahead

Innovators in a space have 2 challenges, they must create something new of value and be able to extract higher margins for the risks of failure.  At the same time, depending on the innovation, innovators know that in many instances they are tipping their hand to their competitors who will replicate the innovation.

These horse races produce many winners over time, mostly consumers who see each unique horse, try out innovations of product, supply chain, brand, pricing etc.  Each successful innovation leading to higher initial margins via happy paying customers gets extracted away by competitive replicators. This usually means most of the benefits end up with the consumer.  That is how capitalism typically works assuming no collusion is in place.  Positive externalities in the form of valued innovations are company led, but consumer driven.

The goal for a firm is to either have an innovation process for continuous advantage or an innovation that is so unique or protected it can't easily be replicated.  Southwest airlines has a unique corporate culture that puts out a different vibe than one would anticipate from a price led competitor.  Otherwise airlines are a horrible business with few sustained +10-15 year profitable margin firms.  No moat equals business margin misery.  Network hubs, airmiles etc.  all proved to be false profits as they were replicable.

Some businesses have geographic moats, such as the short haul rail roads. They mostly compete with trucking instead of each other.  This is an example of an asymmetric moat.  Find the key component such as fuel, unions etc. that drive the relationship and you can understand the business and potential moat better.  Most of it boils down to 2-3 key metrics. 

As an investor, I am not interested in figuring out what is "hot" for earnings next quarter, but rather what might the next 3-9 years look like. This does limit the industries one can assess and it often means skipping the sexy sectors.  High sustained margins may not always correlate with lots of media coverage.

 The fun part of investing is figuring out what the moat is for each industry and competitor.  The best businesses have multiple moats that all contribute to margin and are harder for others to replicate.  Moats come in different shapes and forms. 

A good value investor is really a good collector of mental moat models and the competitive positioning for each participant in a market.  There are really only probably 20-25 key datapoints needed to understand a marketplace and all of its participants.  Of course one needs the framework to put around the needle in the haystack. 

Most Wall Street and popular analysis is about selling more haystack.  Great ideas aren't sold by the pound.  This fact means many miss the the effective and elegant thesis for the sake of the data heap.  The nice thing about value is that often it moves slowly or the investor can choose an industry where it moves slowly.

Find the moat.  Measure the Moat for its length (time) and depth (extra margin) and then you are one step closer to understanding value in the horse race of capitalism.  Anybody can tell you price, few spend the time to understand value.

Posted by manualofideas at 07:32 PM | Permalink | Comments (0)

By Nadav Manham

One of the themes of this blog [The Investor's Consigliere] is that the value investing mindset, the ability to buy at the largest discount between present price and future intrinsic value, can be found and studied inside of businesses too, not just in people who buy stocks for a living.  

Lots of professional investors lay out money to buy a stock they hope to sell within about two years at a big profit.  This article from the NYT style section demonstrates that professional diamond dealers do the same thing, and at the highest end they do it Buffett/Munger-style, by making big concentrated bets. 

In December 2008 Laurence Graff paid $24.3 million for the legendary (to him, not to me) Wittelsbach diamond.  That $24.3 million became inventory, part of working capital.  It's called working "capital" for a reason, and like any other kind of capital it's supposed to earn a return, in cash.  I used to know this only in the abstract; it was only when I got involved in a small private equity venture that I came to understand it in my bones: working capital sucks. 

Working capital, namely inventory and/or accounts receivable, is a kind of Purgatory for cash, a painful but necessary intermediate state between cash lying around doing nothing and making cash money from a business.  No one wants to enter Purgatory unless there is something better on the other side, and for working capital that "something better" is a acceptable return on the pre-Purgatory cash you started with.  Laurence Graff is a billionaire who owns a private company; there was no shortage of opportunities for him to do something else with that $24.3mm.  That he chose to invest it in one blue rock means 1) he loves the game and 2) he thinks he can earn a better return from investing in diamond working capital than from anything else. 

The article goes into some of the reasons why, which convince me he has a good shot at earning a good return on his investment.  It comes down to know-how and lack of competition.  Thousands of people and institutions can invest $24.3mm in a stock, but I can count on my hands the number of people who know how much to bid for a diamond like the Wittelsbach, and then know how to maximize its value two years out (an eternity in working capital-years!), first by cutting and polishing it properly, then by creating just the right kind of buzz via a Smithsonian exhibition, then by knowing the names and diamond-buying habits of every single potential buyer in the world, then by setting it just right in a necklace, then by selling it at the best price, and finally, last but not least, by collecting the money in cash (that last part is harder than it seems).

Laurence Graff dropped out of school at 14.  If he took an MBA investing class I suspect he would fail.  If he read this blog post I suspect he would have no idea what I'm talking about.  But whether he knows it or not, in his little corner he's the world's greatest value investor.  And furthermore, if you shake the family tree of the world's other greatest value investors, you'll almost always find a grocer, or a dry-goods merchant, or maybe even a diamond dealer--someone who knew all about value investing in working capital.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:14 AM | Permalink | Comments (0)

David Lau shares investing lessons from former Merrill Lynch analysts Richard Bernstein, David Rosenberg, and Jeff Saut. Here are some highlights:

Richard Bernstein’s lessons

1. Income is as important as capital gains. Because most investors ignore income opportunities, income may be more important than capital gains.

2. Most stock market indicators have never actually been tested. Most don’t work.

3. Most investors’ time horizons are much too short. Statistics indicate that day trading is largely based on luck.

4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.

5. Diversification doesn’t depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.

David Rosenberg’s lessons

1. In order for an economic forecast to be relevant, it must be combined with a market call.

2. Never be a slave to the data - they are no substitutes for astute observation of the big picture.

3. The consensus rarely gets it right and almost always errs on the side of optimism - except at the bottom.

4. Fall in love with your partner, not your forecast.

5. No two cycles are ever the same.

Bob Farrell’s lessons

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an excess in the other direction.

3. There are no new eras - excesses are never permanent.

4. Exponential rising and falling markets usually go further than you think.

5. The public buys the most at the top and the least at the bottom.

Read more investing lessons here.

Posted by manualofideas at 10:36 AM | Permalink | Comments (0)

No one enjoys dwelling on past errors whether we are talking about investments, career choices, or poor decisions in personal relationships.  It is far more pleasant to think about what has worked well in the past and to relegate unpleasant memories to what George Orwell referred to in 1984 as the “memory hole”.  In Orwell’s story, the “memory hole” is a chute through which all evidence of unfavorable events are sent to an incinerator by order of a totalitarian government. The attempt to erase bad memories by a government is tyranny;  doing the same in business and investments can lead to repeating the same errors again and again.

While it is never productive to endlessly dwell on mistakes, it is healthy to examine key errors to see whether any lessons can be learned.

“Pie on Face Award” for 2009 …

The Rational Walk is not an investment newsletter and does not provide investment advice.  Nevertheless, at times, we discuss specific securities and views regarding the business prospects for companies.  One such example last June involved a decision to favor shares of Wal-Mart Stores over shares of Sears Holdings.

Let’s be clear:  The mere fact that a stock was sold that has since appreciated by nearly fifty percent does not, by itself, justify the “pie on face” award.  During any six month period, virtually anything can happen in the stock market and price movements cannot be used to evaluate the success or failure of an investment decision.  The reason this decision was a mistake was based on faulty reasoning at the time rather than subsequent short term stock price movement.  Let’s take a look at the two main factors behind the decision.

Error #1:  Excessive Fixation on Macroeconomic Factors

As described in the article, the decision to purchase Sears Holding shares was based on a belief that the underlying real estate assets far exceeded the overall market capitalization of the company.  While the book value of the real estate holdings are carried at historical cost, evidence existed to justify much higher valuations.  In fact, Bruce Berkowitz of the Fairholme Fund assigned his team to a methodical examination of property tax assessments and concluded that the real estate alone could be worth $80 to $90/share.

Throughout the spring of 2009, like most investors, I spent significant time following macroeconomic trends and thinking about the implications of the severe recession on my investments.  Since the tax assessments the Fairholme team examined were from 2008, I became concerned that the values of the real estate may have become impaired since the analysis took place, particularly due to the impact of the recession on commercial real estate such as malls.

Error #2:  Changing Investment Rationale After Initial Investment

The second error involved changing my investment rationale after the initial investment was made.  In the case of Sears Holdings, my initial investment rationale was a play on a severe undervaluation of the company’s real estate holdings rather than an investment in the retail operations of the company.  In my view, if Sears Chairman Edward Lampert could engineer a turnaround at the retail operations, that could add even more value but was not essential to the investment thesis.  In other words, the investment came with a free option on the recovery of the retail operations.

In addition to allowing my macroeconomic concerns impact my views on the value of the company’s real estate holdings, I also became worried that customers would abandon the retail stores given the weakness of Sears and Kmart relative to stronger competitors.  But it made no sense to allow this to impact the investment decision since the retail operations were not part of the original investment thesis.

Lessons Learned

Perhaps the most important lesson to learn is that paying excessive attention to the macroeconomy is generally unhelpful when making specific investment decisions.  This is why Warren Buffett always says that his investment decisions are not made with regard to macro conditions.  It was easy to justify making “exceptions” to this rule in a year like 2009 when talk of depression was widespread.  But it was an error.

The second lesson is to always remember why a security was purchased to begin with.  If the investment thesis centered on real estate value, then only a true erosion of the original thesis should justify a decision to liquidate below appraised intrinsic value.

As of today, Sears Holdings has reached my original high estimate of the intrinsic value of the real estate holdings at nearly $90 per share.  A buyer of the shares today might have to justify the purchase based on the retail operations; a buyer at $50 did not need to consider the retail operations to justify a purchase.  Based on the original investment thesis, Sears shares would be sold at current levels.  However, due to the faulty thinking discussed in this article, they were sold prematurely at $61 thereby giving up an additional 50% of upside.

It so happens that even at $61, the shares were sold at a significant profit.  The performance even exceeded the S&P 500 return over the holding period.  But that is hardly the point.

Examining this type of mistake is never pleasant but it is necessary to avoid repeat performances.  All investors should take the time to do the same to avoid the risk that the “memory hole” will extinguish such experiences and lead to future errors.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 09:52 PM | Permalink | Comments (0)

The Financial Times recently featured an interview with investor Jim Rogers. Here are some of the highlights:

What is the secret of your success?

As I was not smarter than most people, I was willing to work harder than most. I was prepared to examine conventional wisdom. If everyone thinks one way, it is likely to be wrong. If you can figure out that it is wrong, you are likely to make a lot of money.

What is your basic investment strategy?

Buy low and sell high. I try to find something that is very cheap, where a positive change is taking place. Then I do enough homework to make sure I am right. It has got to be cheap so that, if I am wrong, I don’t lose much money. Every time I make a mistake, it is usually because I did not do enough homework.

Do not underestimate the value of due diligence. In the 1960s, General Motors was the world’s most successful company. One day, a GM analyst went to the board of directors with the message: “The Japanese are coming.” They ignored him. Investors who did their homework sold their GM stock – and bought Toyota instead.

I’m not buying any stocks at the moment. If anything is undervalued now it is commodities and some currencies.

Where should people put their money in the recession?

Invest only in things you know something about. The mistake most people make is that they listen to hot tips, or act on something they read in magazines.

Most people know a lot about something, so they should just stick to what they know and buy an investment in that area. That is how you get rich.

You don’t get rich investing in things you know nothing about.

Read the full interview.

Posted by manualofideas at 12:09 PM | Permalink | Comments (0)

Bill Stewart and W.P. Stewart have followed a GARP-oriented investment approach ("growth at a reasonable price") for a long time and have put together an above-average track record. While the firm hit upon hard times last year and lost both assets and its NYSE listing, it continues to manage roughly $1.5 billion in assets. On November 6, W.P. Stewart held an annual investment seminar, the proceedings of which may be followed online. You may find some of the presentations worthwhile.

Click here to access the W.P. Stewart annual investment seminar.

(Thanks to David Lau for the link.)

Posted by manualofideas at 09:04 PM | Permalink | Comments (0)

Posted by manualofideas at 10:30 PM | Permalink | Comments (0)

Here is a CNBC video of the complete event with Bill Gates and Warren Buffett at Columbia University on November 12, 2009. Read the transcript.

Posted by manualofideas at 07:10 PM | Permalink | Comments (0)

Warren Buffett and Bill Gates appeared at Columbia Business School yesterday and answered questions from students for over an hour.  The full video is provided below and a transcript has been posted documenting the full session.  I found Mr. Buffett’s response to one question to be particularly important for individuals who are interested in being an active investor:

QUESTION: Hi, I’m Brian Seedabalker. I’m a second-year student. Mr. Buffett, it’s great to see you again. I was on the trip to Omaha last month. Thank you for hosting us. My question is, how would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?

BUFFETT: Well, it depends whether they are going to be an active investor. Graham distinguished between the defensive and the enterprising and that. So if you are going to spend a lot of time on investment, you know I just advise looking at as many things as possible and you will find some bargains. And when you find them, you have to act. It doesn’t — it hasn’t changed at all since I was here in 1950, 1951. And it won’t change the rest of my life. You start turning pages. When I got out of school, I turned every page in Moody’s 10,000-some pages twice, looking for companies. And you have to find them yourself. The world isn’t going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time.

The worst investment mistakes tend be those made by individuals who buy stocks on hot tips or cursory research such as reading a one page Value Line report or a newspaper article.  Intelligent investing takes a great deal of time, and if you think about it, why would this be a surprise?  Mr. Buffett’s advice to buy an index fund if you do not intend to invest the time in research is exactly correct.

The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 06:04 PM | Permalink | Comments (0)

Introduction: "Carl Icahn, a prominent activist investor in corporate America, talks about his career and how he became interested in finance and involved in shareholder activism. He discusses his thoughts about today's economy and American businesses and their inherent threats and opportunities. He believes that the biggest challenge facing corporate America is weak management and that today's CEOs, with exceptions, might not be the most capable of leading global companies. He sees opportunities for current, intelligent college students to succeed in the corporate world if they work hard and can identify valuable business pursuits."

Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

Do you receive Portfolio Manager's Review in the mail each month? Then you are eligible for a FREE copy of Jeff Benedict's book on R. C. Willey. Email us to request it.

Posted by manualofideas at 08:53 AM | Permalink | Comments (0)

An exclusive interview with Professor Max Otte, one of the leading proponents of value investing in Europe's academic finance establishment, was published in a recent issue of Portfolio Manager's Review. The interview with Max Otte, Professor of Corporate Finance at the Fachhochschule Worms in Germany, sheds light on the peculiarities of investing in Europe and provides worthwhile advice for value-oriented investors. Excerpts:

The Manual of Ideas: You teach Bruce Greenwald´s Columbia University seminar on value investing in Europe. Are there examples of value investing theory that have to be “adjusted” in the context of investing in European stock markets? More specifically, are there any accounting or other pitfalls non-European investors should especially look out for?

Professor Max Otte: Europe simply is “more messy and complicated” — if you don’t have a truly global player, you really have to go country by country. That’s ten times the market research you do for a U.S. company. This is a reason why many U.S. investors don’t look here too much, which in my view is a big mistake. The legal system is as reliable as in the U.S. (fewer liability suits), and the business culture is generally one of more trust than in the U.S. The firms are generally more global than U.S. firms, which often tend to be run with a U.S.-centric approach.

As IAS/IFRS are taking hold, accounting is becoming very similar. However, in the German-speaking countries (Germany/Austria/Switzerland), we had the conservative principle of the lower value (cost or market) in financial account. This often understated income and assets and created hidden reserves. Some companies that do not need to fulfill the requirements of the major stock exchanges still cling to the old national standards, which I think were much superior in providing reliable minimum figures and stabilizing the economy. Again, those figures were not always “true and fair,” but much less subject to manipulation than, for example, GAAP.

Warren Buffett doesn’t like the idea that he has to disclose holdings over three percent in a public company in Germany once he starts buying.

MOI: Are there any countries in Europe that you find especially appealing? Perhaps individual sector or company opportunities that have arisen from local macroeconomic dislocation? Are there any European countries you find particularly unappealing?

Professor Otte: First, Europe as a whole is a rather tremendous place and as attractive as many emerging markets. Multiples are down and often lower than in the U.S., and revenue margins in European companies are generally lower than in the U.S. So many European companies have more fat to carry them through the crisis and can work on their margins.

Since I’m an active investor myself and my time is limited, I stick to what I know. I have a rather small universe of stocks. Over 80 percent of my holdings are in Europe right now, just 10 percent in the U.S., and the rest in Asia and gold.

My favorites are still German, Austrian and Swiss family-controlled “hidden champions” — often world market leaders in niche markets, often with very sound balance sheets, excellent growth prospects and long-term oriented management. Currently, you can buy many of these stocks at valuations as if they would never grow again. I presented three [ideas] at the Value Investing Seminar in Molfetta in 2007 – CTS Eventim, United Internet, and AWD – and investors who bought them below my recommended price would have broken even by the summer of 2009 despite the crisis. More of them: Grenke Leasing, Fielmann, Celesio, Takkt. Among large players, Nestlé looks very good, as do the pharmaceuticals.

Read the Portfolio Manager's Review interview with Professor Max Otte.

Subscribe to Portfolio Manager's Review, the acclaimed monthly investment research publication for value-oriented institutional investors.

Start 30-day FREE trial of European Value Report, the research newsletter that features two European investment ideas in each monthly issue.

Posted by manualofideas at 04:03 PM | Permalink | Comments (0)

Elizabeth Ody of Kiplinger.com shares the following advice and insights in a recent article:

Warren Buffett, chairman of Berkshire Hathaway: I have no idea what the stock market's going to do tomorrow, or next week, or next month or next year. But over a 10-year period you will do considerably better owning a group of equities than you will owning Treasuries. In fighting the economic war, we've taken action that sows the seeds of substantial inflation down the road. Not in the next six months or year, but 10 years from now the dollar will buy a lot less than it buys today.

Robert L. Rodriguez, chief executive of First Pacific Advisors: Don't run with the herd. Being surrounded by people who are doing the same thing as you offers a false sense of protection. Today, being a loner means owning short-maturity, high-quality debt on the bond side. And if the U.S. government continues to blow up the nation's balance sheet through massive deficits, you should probably move at least 20 to 40 percent of your assets out of the United States.

Jeremy Grantham, chief investment strategist at Grantham, Mayo, Van Otterloo: The recent rally has been very speculative, favoring risky assets over the past few months. I'm sorry if you missed investing at the market's March lows, but don't compound the damage to your portfolio by chasing gains in risky assets. We're at the beginning of a seven-year period of lean returns. You should only be buying the highest-quality blue-chip companies, where valuations are most attractive.

Bill Gross, co-chief investment officer at Pacific Investment Management: The biggest danger right now is that you'll earn zero percent on mattress money, or virtually zero percent in a money-market account or at the bank. Yes, that money is safe, but the economy and inflation may come roaring past you at higher levels. You also have to consider diversifying outside of the United States. The dollar is a weak currency, and as it devalues against other currencies, our standard of living will suffer. Higher returns relative to risk lie in Asia and Brazil.

Martin J. Whitman, co-chief investment officer at Third Avenue Management: Do what we do -- find extremely well-financed companies that do not rely on continuous access to the bond or stock markets for refinancing, that are run by competent management teams and that have favorable prospects for growth. Buy these companies' stocks when they are available at a meaningful discount. All other systems of investing are concerned with predicting stocks' near-term price movements.

Jim Rogers, chairman of Rogers Holdings: Diversification is garbage -- it's something brokers invented to avoid getting sued. You only need four or five good ideas in your life to get really rich if you avoid mistakes. And the one way to avoid mistakes is to stick with what you know. Then, when you see a major development in your area of expertise, you'll know better than Wall Street when to buy or sell.

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Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

Miguel Barbosa of Simoleon Sense, one of our favorite blogs on investing, recently interviewed up-and-coming value investor Sham Gad, author of The Business of Value Investing.

Click here to read the interview with Sham Gad.

Posted by manualofideas at 04:52 PM | Permalink | Comments (0)

Bruce Berkowitz of The Fairholme Fund held a call with investors on September 30th [listen to call; read transcript]. As always, we found Berkowitz's commentary lucid and helpful in understanding his approach to investing. Here are a few highlights from the call:

On The History of The Fairholme Fund

"In our first letter to shareholders, in May of 2000, we stated our goal of providing shareholders with superior investment performance, without risking permanent loss of capital. We accomplish our goal when we purchase securities at a significant discount to our estimate of their true worth; that is the cash generated over the life of the investment. In the case of common stocks, we estimate the cash a business will generate for owners over the life of the business. In 2000, the Fairholme Fund had over half its net assets in companies primarily involved in property and casualty insurance. At the time, these companies earned about 20 percent returns on book value, and we paid near book value for them. They were the ugly ducklings of their day that the crowd ignored."

"Since then, we have concentrated in areas such as telecommunications, with the junk bonds of WilTel, eventually acquired by Leucadia, and then Level Three Communications; and WorldCom, which became MCI, and then acquired by Verizon. Today, the fund has about 30 percent of its assets in pharma and managed healthcare. Despite the loud noise of the crowd and the administration's rhetoric, we believe our health-related companies are for essential services and products to an aging population, have few substitutes, and have strong free cash flows relative to market prices."

"While the securities in the portfolio have changed over the years, our adherence to a strategy of counting cash has only become more resolute. By focusing on free cash flows, we steered clear or the dotcom era debacles, as well as the recent financial services meltdown, which brought many once unassailable banks and financial companies to their knees. None of those failed companies could ever show us the money. While we can not predict the future with any high degree of success, we're confident that we can properly respond to whatever the future may bring, by adhering to our basic principles of vigilance, focus, commitment, and value. And by having the necessary cash to quickly act, in size, when the opportunities exist. Cash proves especially useful whenever the cashless are forced to sell without regard to price."

On The Investment Process

"In order to protect your capital, we will continually challenge ourselves by asking how might our investments fail. To help answer this question, we retain outside experts ... devil's advocates, if you will ... who have decades of hands-on operational experience in their respective fields, because knowing what you don't know and tapping those who do is one of the critical skills of investing."

"We're not asking our consultants to sell anything for us. We just really need to pick their brains and make sure we understand what we're getting into. And, by the way, this isn't new. Okay? This is not new. Other companies we've studied, with very long, successful records, have used the same process. So, again, we hire experts to corroborate our ideas, our assumptions; and, more importantly, try and disprove what we think is correct."

"When we commit your capital to an idea, it's because we've exercised vigilance in researching both the upside and especially the downsides of a given investment."

"When researching companies, we start with past SEC reports, conference calls, and investor presentations. We then focus on every business element that requires management to exercise judgment, and every element of accounting that may not reflect reality. For example, we check reserves for insurance claims, bad debts, lawsuits, healthcare liabilities, pension obligations, and Uncle Sam. We assume every estimate is too liberal, too light. We look for kitchen-sinking of real expenses, hidden for periods of time, which, in the aggregate, can reverse years of so-called profits.
Management is considered guilty until proven innocent."

"Then it's time to consider which way the winds are blowing. Is the underlying company facing economic, demographic, technological, political competitive headwinds? Is the business growing? Which way are interest rates heading? We then consider where our security lies within the capital structure of the company, and then assess the entire capital structure of the underlying entity. We look at leverage, return on assets versus the return on equity, tangible equity; we want to weigh the heft of the balance sheet, and review and search for all off-balance-sheet items. Can the business work without leverage? To what extent is the business dependent on the kindness of strangers? And by that I mean the capital providers. We also examine good will, which may or may not be a gift that can keep giving. Then it's on to reviewing customers, suppliers, competitors, substitutes, and think of the industry's concentrations of power. Then it's to review, consider, and think about all the different stakeholders in the company. Who are the owners? The regulators? Taxing authorities? Creditors? Retirees? Unions? How powerful are the employees?"

"And, of course, management must be carefully studied. How much does management take in total compensation? Do they under-promise and overdeliver? Do they respect owners? Are they true owners and not just option-holders? Do they allow a level playing field with owners? How good is the paper trail of key executives? Do they play in the center of the court? Do they have a deep understanding of the business? How have they allocated capital over time? It's awfully hard to make a good investment with bad people."

"We then consider illogical extremes. For example, we considered the U.S. Government's past desire for every family to own a home, and evaluated the effect on relevant financial institutions. We consider the worst case. Are there too many variables to monitor or estimate? What are the correlations with other investments? We try and understand the unknowns. Of course, we want to know how can we die with this investment. For example, we did not know how to quantify monumental derivatives risk."

"Then we return back to the price that we're willing to pay for the security. And while easy to say, it's near impossible to be exact with common stocks. And so we use a price range. Does the range reflect an average past environment and normal risk-free rates? Does it allow bad luck? Stress? And a margin of safety? Can we achieve a double-digit, growing, free cash yield, without risking principal? Are we playing Russian roulette? Are we picking up pennies in front of a steamroller? If we haven't killed the investment idea yet, we then compare it to our other investments. How does the investment compare to an investment in other securities of the underlying entities? How does it compare to our current portfolio investments?"

On The Importance of Cash Flow

"At the end of the day, the only thing that we can spend is cash. We can't spend a click, or an eyeball, or a metric. I mean, we can spend cash to benefit our families. So we count cash. And the best way to understand how we try to count cash is to use the analogy of the corner grocery store ... 7-11, or before the time of credits cards, when there was one cash register, and purchases were made, and cash went into the register, and supplies came in, cash came out to pay for all the supplies, and for salaries, and insurance, and to keep the place looking good. And that's it. And then, at the end of a period, what was left in that cash register was for the owners. And then the owners had to decide how to allocate that cash, whether to spend it, whether to reinvest it back in the business to grow it, or rather to invest it in another business. So all we're trying to do with ... we say it a whole bunch of different ways, all we're trying to do is just to measure that cash and understand how it's reallocated, and understand how it eventually gets into our pockets, the owners of the company."

On Stocks versus Bonds

"At Fairholme, we treat common stock as the most junior bond in a company's capital structure, where the true earnings, the free cash flow of a company, are akin to a coupon without a maturity date. We get really excited when we can find more senior and secure bonds that yield better than average equity-like returns. We then compare market prices to our estimates of free cash flows, to determine
an expected return on investment. Price matters, and buying right is half the battle. Getting a reasonable estimate of expected free cash flow is the other half."

On Whether Large Fund Size Hurts Performance

"Basically, by having most of my family's money in the fund, I try to create the balance necessary for such decisions. Personally, I don't wish to sacrifice that which I have worked hard for and may need for that which I will not need. For now, size has helped. Having cash, when few do, has helped. Having heft makes a positive difference, and one of the few advantages against the unknown. Size also allows us to keep focused on the fund, while keeping fees relatively low for what we do. With scale, we can meet the ever-increasing costs of doing business. The bottom line, we have smart shareholders and directors, who are not afraid to voice their opinion on how our size is affecting our performance."

On Protecting The Portfolio From Inflation

"The best way we can protect against inflation is by finding companies that generate large amounts of free cash, which then can either be profitably reallocated into the company or paid to shareholders. And to find companies with that free cash flow, that coupon is growing. And studying history, it's my belief that that's the best we could possibly do. But, also, real, tangible assets will become more valuable, as it will take more dollars to buy those assets; hence, our recent focus on companies such as St. Joe [JOE]."

On Investing In Emerging Markets

"It's hard enough when you're the home team, investing in your own backyard. I don't want to play an away game, where I don't know all the rules. So the answer is no. There's plenty to do here."

On Sears Holdings (SHLD) (price was $65 on the date of the call)

"...the value of all the pieces, in death, is worth more than the current market price. And if Eddie Lampert turns around Sears and KMart, then it's going to be worth considerably more. In another area, if the stock price goes down, the company continues to buy back stock, great, we win. If the stock price just goes up, we win. I don't see ... this is a good example of how we invert the investment process. I can't see how we're going to lose."

Listen to Bruce Berkowitz's conference call on September 30, 2009.

Read the transcript.

Follow Bruce Berkowitz's top ideas—and get acclaimed analysis by the Manual of Ideas research team—in Portfolio Manager's Review.

Posted by manualofideas at 10:04 AM | Permalink | Comments (0)

Vito Racanelli writes an interesting article in Barron's on phrases that may spell trouble for investors:

"ANYONE WHO HAS SLOGGED THROUGH THE legalese of a thick Securities and Exchange Commission filing knows the devil is often in the footnotes or the appendix. A good rule of thumb, particularly for adverse corporate information, is that the further back in the report, the more important the information. The urge to skip sections of a 100-page 10K is a strong one, but you do so at your peril."

"Now that most regulatory filings are easily searchable on the Internet, investors can troll through the documents for key phrases suggesting something could be amiss -- let's call them dirty words."

Read the full Barron's article.

Posted by manualofideas at 09:44 AM | Permalink | Comments (0)

Joel Greenblatt is the founder and a Managing Partner of Gotham Capital and Adjunct Professor of Finance and Economics at Columbia Business School. He is the author of You Can Be A Stock Market Genius (Simon & Schuster, 1997) and The Little Book That Beats the Market (Wiley, 2005). He is the former Chairman of the Board of Alliant Techsystems, an NYSE aerospace and defense firm. Greenblatt is also Chairman of the Success Charter Network, a network of charter schools in New York City.

Greenblatt is famous in the investment world for his long-term investment track record, which ranks among the best ever and is believed to comprise returns of some 40% per year for more than two decades.

The following are books listed on the syllabus of the value and special situation investing course Greenblatt teaches at Columbia Business School:

• Greenwald, Bruce, et al., Value Investing – "required"
• Haugen, Robert, The New Finance (4th edition) – "required"
• Greenblatt, Joel, You Can Be a Stock Market Genius – "required"
• Greenblatt, Joel, The Little Book That Beats the Market – "required"
• Cunningham, Larry, The Essays of Warren Buffett – "required"
• Hooke, Jeffrey, Security Analysis on Wall Street – "recommended"
• O’Shaughnessy, James, What Works on Wall Street – "recommended"
• Dreman, David, Contrarian Investment Strategies: Next Generation – "recommended"
• Graham, Ben, The Intelligent Investor – "recommended"
• Plus – selections from Ben Graham, Thornton O’Glove, Mary Buffett
  

Posted by manualofideas at 02:20 PM | Permalink | Comments (0)

In a September 2009 interview with Portfolio Manager's Review, up-and-coming value investor Brian Gaines, founder of Springhouse Capital Management, provides the following book recommendations in response to a question:

Brian Gaines: "I tend to read and re-read more of the business history books as it is always useful to compare and contrast past periods to today’s times. Books like Barbarians at the Gate, The Vulture Investors or Merchants of Debt are consistently great reads. Market Wizards also provides some interesting comparisons to today’s markets. I recently read Lords of Finance about central bankers following World War I and through the Great Depression and it was fascinating."

See also books recommended by...

• Warren Buffett
• H. Kevin Byun
  
• Marc Faber
  
• Bill Gates
• Tom Gayner
• Eddie Lampert
• Peter Lindmark
  
• Dan Loeb
• Charlie Munger
• Mohnish Pabrai
  
• Guy Spier
  

Posted by manualofideas at 02:02 PM | Permalink | Comments (0)

By Ravi Nagarajan

In a conference call this afternoon, Bruce Berkowitz answered a number of shareholder questions regarding The Fairholme Fund, the state of the overall stock market, and prospects for health care reform.  Mr. Berkowitz’s record at The Fairholme Fund since its inception on December 29, 1999 has been nothing short of extraordinary.  Based on the fund’s semi-annual report dated June 30, 2009, annualized performance since inception has been a gain of over 12% annualized compared to a loss of over 3% annualized for the S&P 500.

This article documents some of the notes that I took during the call and are not necessarily direct quotations.  This is not a comprehensive transcript of the event, but focused on areas that I found particularly interesting.  A replay of the conference call should be available on The Fairholme Fund’s website in the near future.

Disclaimer:  I took notes quickly and while I believe the content of this post to be accurate, it is possible that some errors were made.

Due Diligence Process

Here are some of Mr. Berkowitz’s comments in response to a shareholder question regarding how he goes about performing due diligence on prospective investments:

• Review all securities in the capital structure of a company rather than just the common stock.  Common stock should be viewed as the most junior “bond” in a company’s capital structure.  The free cash flow generated by the business is akin to a coupon without a maturity date.  Count the cash after all bills, interest on senior securities, and maintenance capital expenditures.  The free cash flow can then be compared to market prices to come up with free cash flow yields.
• Fairholme reviews SEC reports, company conference calls, presentations, and other sources when researching an investment.  It is important to focus on every business element that requires management to exercise judgment.  Examine the accounting carefully and pay particular attention to pensions, health care liabilities, regulatory, and tax issues.  Management is “guilty until proven innocent” if there are inconsistencies between the balance sheet, income statement, and cash flow statements.  Be particularly wary of “kitchen sink” charges that could enter into the picture.
• Examine whether a business model can exist without leverage.  Avoid having to rely on the “kindness of strangers” whenever possible.  Examine where the security being analyzed lies within the overall capital structure.
• Examine whether managers are true owners rather than just option holders.  This test can be applied by determining whether an executive has actually purchased shares in the open market rather than only through option grants.  It is hard to make a good investment with bad people.  Examine their capital allocation decisions over time.
• Try to “kill the investment idea”.  If you cannot kill the idea, then it should be compared to other investment candidates that have gone through the same research process as well as existing portfolio companies.  Fairholme focuses on fewer investments than most others in order to have superior understanding of the businesses.  They try to avoid growing their circle of competence too quickly if the risk is losing money.
• Fairholme uses industry experts and consultants as part of the research process in order to contain costs by avoiding the need to retain such experts on payroll on a full time basis.

Health Care Reform

Many of The Fairholme Fund’s investments are concentrated within the health care sector.  A number of shareholders submitted questions asking about the impact of health care reform on the portfolio holdings.  Mr. Berkowitz turned this part of the call over to Charlie Fernandez.

• The fund’s analysts and managers are following developments in health care reform on a daily basis.  The mission of the various reform proposals is to expand health coverage for 20 to 25 million Americans and will result in modifying insurance rules and changing rules for Medicare payments.  Mr. Fernandez expects that a bill will pass this year and should cost around $900 billion.  He noted that most reforms do not begin until 2013 and that the plans under discussion include ten years of revenues to pay for seven years of the program.
• Medicaid expansion will result in opportunities for insurers while the key hospital groups and the pharmaceutical industry have already cut deals with President Obama.  Mr. Fernandez noted that hospitals will have lower bad debt expenses under the reform proposals and that part of the benefit will flow to pharmaceutical firms which typically have claw back agreements with hospitals related to bad debt expenses.  He expects that a 5% increase in revenues for pharmaceutical companies could result from lower bad debt expense for hospitals.
• Pfizer is The Fairholme Fund’s largest holding and a number of shareholders submitted questions or concerns regarding the investment.  Mr. Fernandez believes that the Wyeth merger will close in Q4 and probably prior to Thanksgiving.  $6 billion in cost reductions are expected within 18 months.  Within one year of the merger, no product will represent more than 10% of profits, a statistic similar to Johnson & Johnson.  Pfizer is also expanding its presence in generics.  The company has growth from 13th to 8th place in the United States in generic drugs.  Fairholme believes that double digit free cash flow yields will accrue to buyers of Pfizer common stock at current market prices.

Other Comments

• Inflation. Mr. Berkowitz believes that the best way to protect against inflation is to find companies with large and growing free cash flows which are either paid out or reinvested in the business at satisfactory rates of return.  Also, tangible assets will become more valuable if inflation accelerates which is one of the reasons behind the fund’s investment in St. Joe, a large real estate development company in Florida.
• Sears Holdings. Mr. Berkowitz does not appear to be concerned with the factors discussed in a recent bearish article on Sears that appeared in Barrons.  He still believes that the value of the sum of the parts of Sears is worth more than the current stock price.  If Sears Chairman Eddie Lampert can turn around Sears and K Mart, the shares would be worth considerably more, but this is not central to the thesis.  If Sears Holdings stock price declines, more repurchases of shares are likely and this will benefit shareholders.  If the stock price goes up, shareholders also win.
• Any Interest In Emerging Markets? Mr. Berkowitz believes that it is hard enough when you’re the home team and he doesn’t want to play “an away game” where he doesn’t know the rules.  There is plenty to do here in the United States.
• Thoughts on Berkshire and Leucadia. Although a great deal of information is available on these investments, both can be considered “blind trusts”, but being an investor for decades makes it sort of like marriage.  Mr. Berkowitz fully respects the managers of both companies.  He previously sold shares of Berkshire due to the company’s size, age of management, and Warren Buffett’s statement that Berkshire cannot be expected to beat the S&P 500 by large margins.  However, now that Mr. Buffett has put a significant amount of cash to work at higher returns, Fairholme bought back some shares at the “excellent prices” offered earlier in the year.

Value investors would be wise to pay close attention to The Fairholme Fund’s holdings as well as future statements by Mr. Berkowitz.  While SEC filings are available for The Fairholme Fund’s holdings, GuruFocus.com makes it easy to monitor Mr. Berkowitz’s moves along with the activities of many other super-investors.  Investors should always do their own work on any idea, regardless of who is buying a stock.  However, there is no shame in using super-investors as idea sources and coat-tailing when it makes sense to do so.

The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure:  The author does not own shares of The Fairholme Fund or any of the other companies discussed in this post with the exception of Berkshire Hathaway.

Posted by manualofideas at 09:12 PM | Permalink | Comments (0)

Posted by manualofideas at 12:50 PM | Permalink | Comments (0)

In a recent CNBC interview, Warren Buffett was asked to identify one economic indicator that he would consider most relevant for evaluating overall economic conditions if he was stranded on a desert island for a month and had no other access to information.  He immediately mentioned rail car loadings as a top candidate for this “desert island indicator”, and has made similar comments in the past.

Let’s assume that Mr. Buffett received the Association of American Railroads September Rail Time Indicators report and had to draw some conclusions regarding the state of the overall economy.  The report actually includes a significant amount of information that is not directly related to rail shipments, so let’s just focus on a few of the indicators published in the report that pertain to railroad indicators:

• “U.S. freight railroads originated 1,116,182 carloads in August 2009, down 16.4% (218,593 carloads) from August 2008 and the 10th straight double-digit monthly carload decline. However, the percentage decline in August was the lowest since February 2009.”
• “Average weekly carloads on U.S. railroads in August 2009 (279,046) were more than 15,000 carloads higher than in July 2009 and higher than any previous month in 2009, though seasonal factors account for some of that increase…”

Looking at the report’s breakdown of rail traffic by commodity type, nearly every category still shows double digit declines from the prior year, although as the report indicates, traffic has improved significantly from the depths of the recession earlier this year. There are numerous charts in the report that show more granular details.

The rail indicators seem to show an economy that is improving but still significantly depressed compared to the period prior to the September 2008 meltdown in financial markets.  Average weekly carloads still falls far short of the levels seen in 2006 and 2007.  While year over year comparisons will improve starting in October, it does not appear that predictions of a “V” shaped recovery can be supported by this indicator.

Obviously rail traffic is just one indicator of economic activity but it deserves special consideration given Mr. Buffett's recommendation and is something to keep in mind for those who are making investment decisions predicated on an assumption of rapid improvements in economic activity in the 4th quarter.

In general, making investment decisions based only on macroeconomic factors is not consistent with a value investing approach.  However, the investment thesis for many companies can be influenced to some degree based on whether an investor is assuming a quick return to rapid growth or a longer period of relative stagnation in the economy.  It is dangerous to look at average earnings of a company from 2005 to 2008 and assume a rapid return to those levels if the company is particularly exposed to macroeconomic factors.

The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 04:00 PM | Permalink | Comments (1)

1. "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1"

2. "In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond."

3. "The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable."

4. "Be fearful when others are greedy. Be greedy when others are fearful."

5. "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

6. "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

7. “You only find out who is swimming naked when the tide goes out.”

8. "Risk comes from not knowing what you're doing."

9. "If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

10. "Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down."

11. "I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will."

12. "Price is what you pay. Value is what you get."

13. "I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over."

14. "If a business does well, the stock eventually follows."

15. "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

16. "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well."

17. "The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."

18. "Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

19. "Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

20. "Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid."

21. "I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out."

22. "We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely."

23. "In the business world, the rearview mirror is always clearer than the windshield."

24. "The investor of today does not profit from yesterday's growth."

25. "Someone's sitting in the shade today because someone planted a tree a long time ago."

(Thanks to David Lau for this collection.)

Posted by manualofideas at 08:46 AM | Permalink | Comments (0)

The author of this post is John Mihaljevic, CFA, editor of Downside Protection Report.

So far we have focused on finding good stocks to buy and bringing them to you. In doing so, we have assembled a portfolio of ideas that has trounced the broader market (see scorecard on page 8). As our featured ideas hopefully make money for you, the question of when to sell becomes increasingly important.

Knowing when to sell a stock that has outperformed is no small task. The danger is dual: We can either sell too early, foregoing future gains; or we can sell too late, giving back the gains we have enjoyed on paper. There are additional wrinkles that complicate the decision to sell, including taxes and broader portfolio considerations.

Selling too early is a common “mistake” of value investors. While we make money on undervalued stocks that become less undervalued, we also frequently “leave money on the table.” Avoiding this predicament is difficult, perhaps even impossible — for it’s the same value-driven mindset that gets us to buy an undervalued company and to sell it when it trades closer to fair value. If we could hold onto a stock as it rises in price from fairly valued to overvalued, we might lack the mindset that allows us to buy the same stock at a bargain price in the first place.

Selling too late is rarer among value investors, but the danger exists nonetheless. We have a tendency to hang onto something that’s been good to us — a winning stock falls into this category. We may become emotionally attached or view a stock as our idea. The pain of selling and then seeing someone make more money from our idea might be too much to bear, influencing us to hold onto a company too long. There’s also the danger of keeping losers around merely because we want to break even. Facts, rather than “mental accounting,” should dictate the timing of a sale.

This brings us to two companies that we’re putting on the sell list this month — PDL BioPharma (PDLI) and Sierra Wireless (SWIR). Whether or not to sell is a “good problem” in each case, as PDLI shares have gained 15% since we featured them in our July 13th issue, while SWIR has gained 192% since March 23rd.

In the case of PDLI, while our analysis remains intact, one of the key validations of our work is no longer in place: Seth Klarman’s investment. When a superinvestor like Seth Klarman of The Baupost Group sells a company we own, the question must be, “How confident are we that we either know more than Klarman, or that our judgment is superior to his, or that he was selling for non-fundamental reasons?” In the case of PDLI, prudence requires us to take our gain and move on.

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In the case of Sierra Wireless, we have obviously enjoyed a strong gain in a short time, and we hope you have as well. We simply cannot make a no-brainer valuation-driven case for Sierra any longer, even as the company has many other things going for it.

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Finally, just as with buying a stock, the decision to sell must be driven by your own particular circumstances. There may be tax or other considerations that make holding onto a stock the correct decision, even if the valuation gap has narrowed.

Start 30-day FREE trial of Downside Protection Report.

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Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

Santa Clara University Professor Meir Statman wrote an interesting article on behavioral finance for today’s Wall Street Journal.  The Mistakes We Make—and Why We Make Them focuses on eight key mistakes that investors typically make particularly when coming to terms with unrealized losses in their portfolios.  Although most value investors already recognize these behavioral tendencies and have an investment framework equipped to counter the worst of these psychological impulses, all investors are subject to emotion and are well served to keep the subject of behavioral finance in mind.

The Pain of Unrealized Losses

Prof. Statman identifies one of the worst psychological tendencies related to unrealized investment losses:

Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize “paper” gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it.

Value oriented investors have the intellectual framework to counter this tendency because the focus is always on the intrinsic value of a business versus the current quotation rather than a comparison between the current quotation and the cost basis.  This is a critical distinction.  The vast majority of investors psychologically anchor to their cost basis in a security and are reluctant to sell at a loss because they want to “break even”.  On the other hand, value investors are constantly evaluating the intrinsic value of their holdings and comparing that value to the market quotation.  The time to sell a security is when the market quotation approaches intrinsic value and has nothing to do with the investor’s cost basis.

Of course, the cost basis does matter to the extent that an investor seeks to make money in his operations over time.  However, once a security is owned, the relevant factor shifts to the current market quotation vs. the intrinsic value of the security.  If a mistake is made by paying too much for a security due to a faulty estimation of intrinsic value, it may make sense to sell at a loss if the market quotation is at or above the corrected estimate of intrinsic value.

Value Investors Have Advantages But Still Face Behavioral Risks

All investors are human beings with emotions and that obviously includes those of us who have adopted a value approach.  The intellectual framework provided by value investors such as Benjamin Graham, Warren Buffett, Charlie Munger, Philip Fisher, and others provides a key advantage but it is up to all of us to control our emotions and to act rationally both in times of exuberance and despair.  If we fail to do so and act emotionally, the advantages provided by the value approach will be lost and we will have no advantages over speculators.

For most investors, the key to avoiding emotionally driven decision making rests with appropriate asset allocation.  Any investor or speculator who lacks sufficient cash to pay current expenses is likely to be emotional when security prices fluctuate.  By having an appropriate cash allocation sufficient to cover several years of expenses, an investor is liberated from focusing on short term fluctuations and can look at intrinsic value in a more detached manner.   Attempting to allocate funds to stocks that will be required in the near future for expenses will allow emotion to overrule rational thinking for nearly any investor.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 07:16 PM | Permalink | Comments (0)

David Lau forwards the following maxims of Bruce Berkowitz's Fairholme Capital Management:

1)    A to Z (research all aspects of a company)
2)    Back to front (dig into the minutiae)
3)    Cash counts (it’s the only thing you can spend)
4)    Don’t guess (know!)
5)    Expanding universe (extend our competence)
6)    Focus sharpens returns (only own your best ideas)
7)    Get more than you give (our objective)
8)    Happy is sad (you make your money in difficult times)
9)    Ignore the crowd (don’t be a lemming)
10)    Jam tomorrow today (the magic of compounding)
11)    Keep it simple (focus on what’s important)
12)    Lumpy over smooth (a lumpy 15% return beats a smooth 10)
13)    Management (can’t do a good deal with a bad guy)
14)    New new things (ideas taken to extremes cause pain)
15)    Owners know best (“skin in the game”)
16)    Price matters (buy with a margin of safety)
17)    Quirky can work (consider the unusual)
18)    Rip it up (try to kill ideas)
19)    Surfing waves (get in front of the trends)
20)    Talking and walking (we really do eat our own cooking)
21)    Under our hat (it’s not in your interest for us to tell all)
22)    Value is all that (…matters)
23)    What they want? (understand who wants what)
24)    X-ing the lines (research across disciplines)
25)    You’re the one (we do what’s right for you)
26)    Zero can’t grow (Don’t lose)

Posted by manualofideas at 01:27 PM | Permalink | Comments (0)

Marty Whitman of Third Avenue Funds is a value investing pioneer. Here are some great videos about investing.

On Graham and Dodd (and Today's Academics):

Thanks to Greenbackd for the find.

On Risk:

On Wall Street versus Main Street:

Background on Marty Whitman:

Posted by manualofideas at 05:27 PM | Permalink | Comments (0)

Official intro, dated July 2009: "This week Consuelo Mack WealthTrack "Great Investors" summer series features the wisdom of the legendary Peter Bernstein, who died in June at age 90. Bernstein, an economist, financial consultant, and author of ten books, including Against the Gods: The Remarkable Story of Risk , appeared in several exclusive television interviews with Consuelo in 2005 and 2007. His timeless observations about investing and the importance of understanding risk are even more relevant today."

Posted by manualofideas at 01:22 PM | Permalink | Comments (0)

The business “grapevine” is a remarkable thing.  It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company.  … Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge.  (Common Stocks and Uncommon Profits, page 17)

In addition to competitors, Mr. Fisher suggests approaching vendors, customers, researchers, trade associations, and others who can shed light on the standing of a business within its industry.

For anyone who has attempted to actually put this advice into practice over the past few years, it is likely that some frustration has been encountered because most business executives are not willing to speak to investors due to regulations designed to “level the playing field” for all investors.  Many investors also lack the contacts required to seek informal “off the record” input.

How can Twitter be useful for modern scuttlebutt?  Many will dismiss this idea entirely since it is often assumed that Twitter is merely a platform for people who wish to share what they had for lunch with the world.  I had this attitude until earlier this year when I began to use the service in conjunction with starting this website (follow me on Twitter).  Since then, I have found some interesting ways to use Twitter to gain some insight into the “word on the street”.  It is amazing how much people are willing to say directly about company developments, morale issues, layoffs, and other topics in what is perceived as an informal and unguarded environment.  Here are some steps that can be used to follow tweets on a company you are interested in learning more about.

Search for Keywords

Twitter has a powerful search feature that allows a user to identify tweets containing keywords.  For example, I set up this search to follow tweets related to Paychex.  If you look at the results, you will see a number of recent tweets related to Paychex:

None of these tweets are particularly earth shattering from an investment insight perspective, but you can see that Paychex is attempting to hire staff at their Rochester headquarters, that someone is not all that pleased with Paychex, and some other tweets that are somewhat meaningless.

You can also see that there are roughly five tweets that have been posted about Paychex in the past day.  Similar searches can be set up for Paychex’s ticker symbol, although I have found that searching on ticker symbols typically yields less useful results.

It should be noted that searching for tweets works well on some companies but not on others.  Typically the largest companies will have an overwhelming amount of chatter on Twitter and the “noise” makes it less useful than similar searches on smaller companies.  For one extreme example, try searching for Microsoft on Twitter.  At the time of this writing, there were literally dozens of tweets posted over the past four minutes.

Monitoring Twitter

Although Twitter has a good search interface, it would be highly inefficient to manually search for this information all the time.  Luckily, Twitter allows us to set up customized RSS Feeds based on the results of a search.  Click on the “Feed for this query” link on the search results page shown below:

Depending on your browser settings, you will see various options related to how the feed results should be delivered to you.  I personally use Google Reader to consolidate all of my RSS Feeds in a central location that I monitor on a daily basis.  Incidentally, the same approach can be used to keep up with SEC Filings since it is also possible to sign up for RSS feeds for periodic SEC reports.

What About the Noise?

Intelligent investors would never make capital allocation decisions based on what someone is tweeting on a given day.  Anyone can set up a Twitter account and stock scam artists and other promoters have been known to misuse the service.  To leverage Twitter appropriately from a scuttlebutt perspective, an investor needs to be able to filter out the noise and identify potentially useful tweets that shed light on a business.  Usually, reputable people using Twitter will have a reasonable number of followers and will post links and other useful information in addition to 140 character messages.  Many also have links to their website and other pertinent information.

Twitter should be viewed as an online water cooler where you can eavesdrop on people talking about all sorts of topics.  In some cases, Twitter has been the first communication medium in which layoffs, poor earnings, and other relevant news has been informally reported.  While it is always ill advised to make investment decisions based on unverified rumors, I have found that monitoring Twitter can sometimes lead to interesting insights that can be independently verified.  Used in this manner, I think that Phil Fisher would approve of Twitter as one of many ways in which today’s investor can seek information on investment candidates.

Disclosure:  The author, Ravi Nagarajan, owns shares of Paychex which is used as an example in the illustrations.  No statement or recommendation on Paychex as an investment candidate is being made in this article.

The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

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View full model portfolio performance and disclosures.

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The inaugural issue of Watheeqa Investment Journal

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The blog Zero Hedge has posted a lecture by Eric Rosenfeld of Long-Term Capital Management fame. Says Zero Hedge about the video,

"A great way to spend an hour and a half and understand just how black swans can annihilate seemingly riskless portfolios, especially those with a preponderance of Ph.D.'s as portfolio managers who claim to understand "risk". If nothing else fast forward to the 1 hour mark to listen to Eric's discussion of endogenous risk and LTCM's trading of liquidity in a crisis, and how it can all go horribly wrong when you have too many people on the same side of the trade. Prime Brokers, especially those of preferential banks, likely can see all the "liquidity" exposure from their counterparties and nudge their own institutions to react appropriately. (hat tip *.*)."

Posted by manualofideas at 12:42 PM | Permalink | Comments (0)

BusinessWeek shares some of the sage retirement investing advice of respected investor John Bogle, founder of The Vanguard Group:

The Stock Market

"If you can't afford to lose one more penny," says Bogle, "get out. But, if you're in your 20s to 40s, keep going. These are good values. The stock market has taken an awful lot of this mess into account, and it's hard for me to believe that common equities won't do better than Treasuries from this point on." Bogle thinks that a 7% nominal return -- more than twice Treasury bonds -- is realizable over the next decade.

Simple Math

Bogle's "relentless rules of humble arithmatic" show the importance of being vigilant about costs. A dollar invested over 50 years at 8% a year compounds to just under $47. But dock just 2% for expense ratios and transaction costs and you're down to $18. Back out another three percentage points for inflation and you're at $4.38 -- less than a tenth of your potential catch.

On Timing and Chasing the Sector du Jour

"The stock market's day-to-day is actually a distraction to the business of investing," according to Bogle. His point: The past century of data show that American businesses have grown at an annual rate of about 9.5%, with 4.5% from dividend yields and the remaining 5% from earnings growth. The simultaneous aggregate return on bonds averaged 5%. These are the realistic benchmarks to focus on. "It's all simplicity, mathematics, and common sense," he says. In other words, calibrate your expectations to these long-term figures, a discipline that requires you to ignore the pull of solar, B2B, nanotech, or whatever last year's hot sector was.

Sales Ethics and Practice

Caveat emptor for investors: Don't assume your retirement provider or money management firm espouses a standard of honesty, full and fair disclosure, or putting its clients' interests first. The industry is quietly bifurcated into salesmen and professionals. That is why Bogle is urging Washington to enact a federal standard of fiduciary duty to mandate prioritizing clients, avoiding conflicts, and disclosing all fees.

Overextended Treasuries

"Bond prices are already high. Stocks should do 3 or 4 percentage points better than bonds."

Act Your Age

The percentage of your portfolio in bonds should roughly match your age. For example, a 30-year-old investor would be 30% in fixed income -- a 75-year-old, 75%.

Where's the End?

This downturn could last 1 years to 2 years. But the stock market will recover months before a turnaround comes. Don't try to time your entry.

Read the full article.

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The author of this post is hedge fund manager Nick Gogerty.

Occasionally, a bored business publication, goes to the zoo, rents a monkey and pits him or her against a mutual fund manager.  Lo and behold the monkey who doesn't know a beta from a bunghole beats a significant majority of the active managers.  Barron's should probably create a yearly Monkey Roundtable.

These Journalists must be pretty good monkey pickers and should probably start a MFoF (Monkey Fund of Funds) charging 2% and 20%.  We are the Third Chimpanzee and it seems as if evolution must have robbed us of our stock picking skills, but boy can we pick monkeys.

So what is going on?  Charlie Munger and Warren Buffett both hint at it in various writings and books, my favorite is Charlie's Poor Charlie's Almanack.  Warren calls it de-worsification, or the fact that many portfolios get worse as more components are added to them.  The theory which he pretty well proves via his actions is that the more holdings you have the less likely you are to know a lot about any of them.   He doesn't say it, but most managers also jump the median, the investment equivalent of jumping the shark.  Buffett and Munger both hint at investing being similar to pari mutuel betting.

The reason mean monkeys beat median jumping clowns is that most fund managers really don't understand the sustainable economic value drivers behind the businesses they invest in and therefore can't allocate well at the individual equity level.

Mean monkeys picked by journalists have one of the key behavioral principles in investing -- ignorance.  They don't know or even pretend to know anything. 

Stock returns, as exhibited on page 73 of Meb Faber's great new book, The Ivy Portfolio, show the problem.  Stock returns are log normally distributed, having fat tails. 

The charts are sourced from Blackstar funds and reflect data from 1983-2007.

The mean-ignorant monkeys

When I tell my wife that ignorance and apathy are key investment traits, she just rolls her eyes.  Put another way, know what you don't know and be patient; activity kills in this game. Ignorant Mean Monkeys beat funds because they allocate naively, ie, equally, in their portfolios. God forbid the monkeys start running mean variance optimizers or the game is over.  Mean variance portfolio allocation is probably one of the most costly rear view mirrors of all time.

Suppose that out of the Universe of 8,000 equities above Mr. Mean Monkey takes on Mr. or Ms. Median-Jumping Manager by throwing his darts.  Most of these competitions stop right there.  Rarely do the journalists ask the monkey about next quarter's earnings projections or where the Dow will be next week. The Monkeys bets are spread equally across the selected equities and the race with the clowns is on. The clowns' performance is usually measured by their funds' returns. 

The Monkeys should perform roughly the same as a naive (unweighted) index with a small cap bias.  Why?  The monkeys are simply taking a random sample of the markets, so the returns should be roughly equivalent to the chart above.  The smaller cap bias will reflect the greater number of smaller cap firms present in any sampled universe of investable firms.

Imagine that from the 8,000 stocks the monkey selects 8.  One could think of the chart above broken into 8 bins.  That is what the monkey's return will equate to.  The monkey is an approximate unbiased sample of the market.

Send in the median jumping Clowns

The active fund manager "median jumper" clown does the same thing with his or her 8 picks, ideas, gambles, allocations or whatever glossy euphemism he or she uses in their marketing literature.  But the clown is at a disadvantage because they don't know what they don't know, so they decide to weight the portfolio according to the "best" picks.  Uh oh, here is where the trouble starts, they just jumped the median and probably picked something closer to the mode, the most commonly occurring sample.

The median is not the mean

The statistical mean is what most people consider the average of returns.  More importantly is the median and mode, the most likely sample to be chosen and the number separating the higher and lower half of the sample.  It works like this.  You and 7 of your friends find yourself in a room playing bridge with Bill Gates and Warren Buffett.  The mean (average) net worth of the individuals in the room is measured in the billions, but you don't feel any richer because most likely you are one of the 8 representing the mode or most common sample in the room which is below the median and the mean.

The median and mode for shares' returns are actually well below the cap-weighted index, which is closer to the mean.  The charts above indicate 64% of shares underperform the index.  This means that managers who "tilt" or weight their portfolio to their best idea are statistically taking a random sample and doing bad things, increasing the odds of picking a sub-index performer and in so doing also diminishing the allocations to the potentially significantly positive outliers that help deliver the mean performance. 

This is classic behavior flaw 101, people with more information believe they know more about something.  So the fund managers take the useless sell side research reports, technical analysis and other hocus pocus that they haven't back-tested or thought through, and they park a few more chips on red. 

Few managers really understand businesses.  Not many money managers have actually run a competitive business and understand the dynamics of a "market for goods and services".  When it comes to fund management and equity selection, I will bet on a humble person who has run a successful small business over somebody who can tell me what they think the Fed is doing. 

Stock "business" selection skills are different from macro economic analysis and best learned by doing.  People straight from school and fed into the investment banking world are put into an environment that demands answers even when there any.  Smart people who don't have answers or admit ignorance get weeded out.  This is an environment rarely interested in posing interesting new questions, which is a far more interesting and important skill requiring imagination.  Even Buffett ran a gas station into the ground and probably learned as much from it as from his Columbia MBA.

Transaction and operational costs etc. also injure manager returns.  This is the case of apathy/ patience proving things out.  Fund managers are like trapped animals.  They get caught, then get nervous and waste energy trading and allocating instead of sitting quietly and thinking about what the dynamics of the game they play truly are.  My suggestion: Shut off the screen and blackberry and go fishing etc. for awhile and reflect, maybe a few answers will pop into your head, if you are truly lucky a profound question will arise.

The well-known reality is that most fund managers underperform a passive representative index.  Managers don't know what they don't know.  They are often in the giving answers business as they rise from analysts to portfolio managers, some are just great salesman stock brokers.  Cramer is the worst public example of an analyst gone wild.  He is a bottomless pit of useless answers filling the airwaves to pimp cars, cereal and pills for CNBC.  Felix Salmon has his own equivalent answer hole in Ben Stein. 

An answer hole (my term) is a bottomless pit where questions are thrown in and answers are always on offer.  The only thing not found in the answer hole is an honest phrase such as "I don't know."

Most Mutual Fund Managers could significantly increase their long term performance with an equivalent naive asset allocation across the board and less activity, assuming they have a random sample.  They could at least aspire to mean monkey performance and still get the fun of throwing darts while causing less harm.

Read more at Gogerty.com.

Posted by manualofideas at 09:43 AM | Permalink | Comments (0)

Thanks to SimoleonSense for finding this video.

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Tweedy, Browne has compiled a complimentary booklet entitled What Has Worked In Investing. It describes over 50 academic studies of certain investment criteria that have produced high rates of return. In the studies included in What Has Worked In Investing, exceptional returns were found for stocks with one or more of the following investment characteristics: low stock price in relation to book value; net current assets; earnings; cash flow; dividends or previous share price; small market capitalization and a significant pattern of stock purchases by one or more insiders (officers and directors), or by the company itself.

Download this Paper.

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GMO's Jeremy Grantham has published an excellent piece on deploying capital in financial markets even when fear of losses might prevent one from doing so.  Writes Grantham:

It was psychologically painful in 1999 to give up making money on the way up and to expose yourself to the career risk that comes with looking like an old fuddy duddy. Similarly today, it is both painful and career risky to part with your increasingly beloved cash, particularly since cash has been so hard to raise in this market of unprecedented illiquidity. As this crisis climaxes, formerly reasonable people will start to predict the end of the world, armed with plenty of terrifying and accurate data that will serve to reinforce the wisdom of your caution. Every decline will enhance the beauty of cash until, as some of us experienced in 1974, ‘terminal paralysis’ sets in. Those who were over invested will be catatonic and just sit and pray. Those few who look brilliant, oozing cash, will not want to easily give up their brilliance. So almost everyone is watching and waiting with their inertia beginning to set like concrete. Typically, those with a lot of cash will miss a very large chunk of the market recovery.

There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis, what I recommend is a few large steps, not many small ones. A single giant step at the low would be nice, but without holding a signed contract with the devil, several big moves would be safer. This is what we have been doing at GMO. We made one very large reinvestment move in October, taking us to about half way between neutral and minimum equities, and we have a schedule for further moves contingent on future market declines. It is particularly important to have a clear definition of what it will take for you to be fully invested. Without a similar program, be prepared for your committee’s enthusiasm to invest (and your own for that matter) to fall with the market. You must get them to agree now – quickly before rigor mortis sets in – for we are entering that zone as I write. Remember that you will never catch the low.
Sensible value-based investors will always sell too early in bubbles and buy too early in busts. But in return, you may make some important extra money on the roundtrip as well as lowering the average risk exposure.

Read the full article.

Posted by manualofideas at 04:21 PM | Permalink | Comments (0)

Forbes.com reminds us of three timeless principles from the great value investor Benjamin Graham.

1.     Always invest with a margin of safety.
2.     Expect volatility and profit from it.
3.     Know what kind of investor you are.

Below you will find a table of stocks Forbes recently identified based on the Benjamin Graham screen of the American Association of Individual Investors.

Posted by manualofideas5 at 10:28 PM | Permalink | Comments (0)

Mohnish Pabrai is founder and managing partner of Pabrai Investment Funds, a family of value-oriented investment partnerships with a fee structure similar to that of the Buffett Partnerships of the 1950s and '60s, i.e. no management fee and 25% performance fee above 6% annual hurdle rate.

While Pabrai Funds struggled in 2008, they continue to have a long-term track record that is vastly superior to that of the S&P 500 Index. Pabrai follows a concentrated investment strategy built upon the principles of Ben Graham, Warren Buffett and Joel Greenblatt.

The following are some of Mohnish Pabrai's favorite books, as listed on the website of Pabrai Investment Funds:

• Common Sense on Mutual Funds, by John Bogle (says Pabrai: "Wonderful Book. I highly recommend all of John Bogle's writings to any investor. John's views are strongly grounded with both theory and extensive empirical data.")
  
• The Essays of Warren Buffett, by Warren Buffett and Larry Cunningham (says Pabrai: "The only book on Buffett endorsed by him. It's a good book to pick up after having read the last 20 years of letters to shareholders. He did a terrific job.")
  
• Security Analysis, by Ben Graham (says Pabrai: "Wonderful Book. There is a lot of terrific data in this book. Needs to be read slowly and carefully - and then re-read. Strongly recommended.")
  
• The Intelligent Investor, by Ben Graham (says Pabrai: "Make sure you read the 1934 edition. It is a terrific work and should be digested slowly.")
• The Essential Buffett, by Robert Hagstrom (says Pabrai: "I recommend all of Hagstrom's books on Buffet. One should read them in sequence - "The Warren Buffett Way" followed by "The Warren Buffett Portfolio" followed by "Latticework" and finally "The Essential Buffett.")
• The Wealth and Poverty of Nations, by David Landes (says Pabrai: "Good book with some great insights")
• Damn Right, by Janet Lowe (book about Charlie Munger; says Pabrai: "Great book. Highly Recommended")
• Buffett: The Making of an American Capitalist, by Roger Lowenstein (says Pabrai: "Another good Buffett Biography...")
  
• Beating the Street, by Peter Lynch (says Pabrai: "I strongly recommend all of Peter Lynch's book esp. this one and One up on Wall Street.")
• Secret Formula, by Frederick Allen (says Pabrai: "Great Book to help understand Coca-Cola")
• Titan, by Ron Chernow (says Pabrai: "Very compelling biography on John D. Rockefeller – a must read")
• The Making of a Blockbuster, by Gail DeGeorg (says Pabrai: "The Wayne Huizenga Story. On my Top Ten List. Awesome. An inspiration.")
• Leadership Jazz, by Max DePree (says Pabrai: "Max was the CEO of Herman Miller and a terrific leader. Great book")
• Personal History, by Katherine Graham (says Pabrai: "Highly Recommended")
• Only the Paranoid Survive, by Andy Grove (says Pabrai: "On my Top Ten List. Great Book. Grove was CEO of Intel.")
• Pour Your Heart Into It, by Howard Schultz (says Pabrai: "Good book. The Starbucks Story")
• Made in America, by Sam Walton (says Pabrai: "Awesome book. The Sam Walton/Walmart Story. On my Top Ten List. Inspiration for me during the first year at TransTech")
• How to Drive Your Competition Crazy, by Guy Kawasaki (says Pabrai: "Awesome book. On my Top Ten List. CEO of garage.com and a friend")
• Ogilvy on Advertising, by David Ogilvy (says Pabrai: "Ogilvy is a brilliant guy and a terrific writer. Really enjoyed this book and learned a lot.")
• The Innovator's Dilemma, by Clayton Christensen (says Pabrai: "Awesome book.")
• The Soul of a New Machine, by Tracy Kidder (says Pabrai: "Tracy won a Pulitzer Prize for this book. Must-read for anyone in a product development or a startup environment.")
• Men are from Mars, Women are from Venus, by Dr. John Gray (says Pabrai: "If you're a man and married, read and follow this book. Very helpful.")
• Use Both Sides of Your Brain, by Tony Buzan (says Pabrai: "Very Interesting little book")
• City of Djinns, by William Dalrymple (says Pabrai: "Awesome book. Great way to get a perspective on Delhi's present and past.")
• What Do You Care What Other People Think, by Richard Feynman (says Pabrai: "Richard Feynman's books are awesome. Very bright physicist. Must-read!")
• The Geodesic Network, by Peter Huber (says Pabrai: "Peter is a Forbes columnist, a Senior Fellow at the Manhattan Institute and a very very brilliant man. I think he's a lawyer from Harvard Law School and an MIT-trained Electrical Engineer. I love to read his column in Forbes. This is a brilliant work written after the break-up of the Bell System via divestiture.")
• The Deceiver, by Frederick Forsyth (fiction; says Pabrai: "Frederick Forsyth is one of my favorite fiction authors. His worldly wisdom is terrific and difficult to put his books down after you start.")
• Titans, by Tim Green (fiction; says Pabrai: "Tim Green is a former NFL player. Now he's a writer and an attorney. His fiction centered in the NFL is great - even for a non-sports fan like me.")
• The Blue Bedspread, by Raj Kamal Jha (fiction; says Pabrai: "Jha is a IIT, Kharagpur grad (engineer) who went on to become a journalist. This is his first book and is terrific. Deals with the subject of incest in an Indian setting")
• The Golden Gate, by Vikram Seth (fiction; says Pabrai: "Set in verse, it's a wonderful read")
• Cracking India, by Bapsi Sidhwa (fiction; says Pabrai: "Bapsi is a awesome writer. Wonderful book. Part of it was made into the film “Earth” by Mira Nair. Recommend the movie and the book")
• The Bonfire of the Vanities, by Tom Wolfe (fiction; says Pabrai: "Tom Wolfe is really good at chronicling our times. This was a wonderful book on the 1990s NY scene")
• A Man in Full, by Tom Wolfe (fiction; says Pabrai: "The South in our times. Well chronicled. Wonderful book")

Finally, we recommend the following two books authored by Pabrai:

• The Dhandho Investor
• Mosaic: Perspectives on Investing
  

Posted by manualofideas at 08:18 PM | Permalink | Comments (2)

Watch a CNBC interview with Ari Kiev, the psychologist who assists top traders in staying poised, objective and focused even in the most turbulent market environments.

Thanks to Yaser Anwar for this link.

Posted by manualofideas at 11:05 PM | Permalink | Comments (0)

Carol Loomis recently wrote an article in Fortune recalling valuable advice by the late John Loeb of Loeb, Rhoades & Co. Here are Loeb's ten pieces of advice, as presented by Loomis:

1. Once in every seven to ten years, there is a period of excessive general speculation culminating in a severe panic or depression when the man who is borrowing money is at great disadvantage and he who has ready cash stands like a tower, four-square to the ill winds that blow.
2. Extreme situations do not last, no matter what the apparent justification. While we may have "new eras," old laws will still operate.
3. Avoid commitments, particularly of the delayed variety; they are more insidious. Also, be definite about commitments made to you by others. When the storm comes, misunderstandings are so easy and so natural.
4. In both 1920 and 1929, the so-called "big fellows" in general said everything was okay. But if the big fellows in general thought otherwise the stage could not be set for the unexpected. Panics occur because the leaders themselves have lost their way.
5. Never borrow money without continually reviewing and questioning your ability to pay it back under the worst conditions.
6. It's right to be an optimist, but always be prepared for the worst.
7. People borrow money in good times and pay it back in bad times - just the opposite of what they should do.
8. The public is just as blind in recognizing the bottom of a depression as it is in recognizing the top of a boom. While there is no ladder that reaches to Heaven, the ladder that reaches all the way down to Hell in a country like America is just as fantastic.
9. A reputation for fair and honest dealing will be your greatest asset.
10. As my father used to say, "Don't forget, the soup is never eaten as hot as it is cooked."

Read the full Fortune article.

Thanks to Dah Hui Lau (David) for this article.

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Downside Protection Report is pleased to bring you another free special edition featuring an essay on the art of investing. In this special report, we share a lesson on developing the right intuition for making good investment decisions. We'd love to hear your feedback.

Posted by manualofideas at 11:09 PM | Permalink | Comments (0)

Outspoken, contrarian and usually right-on-the-money Yale economics professor Robert Shiller lectures on stocks:

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One of the most widely respected asset allocators, Yale chief investment officer David Swensen, lectures on his subject of expertise. If you want to become a better asset allocator, you will not want to miss this presentation.

Thanks to Simoleon Sense for finding this video.

Posted by manualofideas at 08:33 PM | Permalink | Comments (0)

By John Mihaljevic, CFA
Managing Editor, The Manual of Ideas

If you’re like me, you’ve been a subject of indoctrination. Your professors taught you that markets are efficient and that all available information is already priced into stocks. Above-average investment performance is due to luck, not skill. Reading this article is a waste of time.

Since you are reading this article, I assume you are open to the argument that markets are not always efficient. Unfortunately, your residual regard for the Efficient Markets Hypothesis (EMH) may be impacting your ability to act contrary to the conventional wisdom. You may hesitate to invest in an obviously cheap stock because you think, “It must be cheap for a reason.” (I know this line of thinking because I’ve been susceptible to it.) While cheap stocks are indeed cheap for a reason (by definition), all reasons are not created equal. If a stock is cheap because its market cap is so small that no informed investor has discovered it, you may be looking at an excellent investment opportunity. If, on the other hand, a stock is cheap because it faces significant risk of bankruptcy, you may want to stay away.

I have developed a mind trick that allows me to make the EMH work for me, and I hope it can work for you too. Next time you encounter a security that appears cheap after thorough analysis, don’t simply say “it must be cheap for a reason” and move on. Instead, consider that if the efficient markets hypothesis is true, the stock must be efficiently priced, i.e., you would be buying it at a price that fairly reflects the risks involved. Regardless of how things turned out, your decision to buy the stock would not have been obviously stupid. So use the EMH to overcome your fear of the downside when all factors point to the likelihood of nice upside.

Economist Meir Statman argues that “finance scholars would do well to accept market efficiency in the beat-the-market sense but reject it in the rational prices sense.” Statman’s argument that markets are inefficient but cannot be beat strikes me as unsatisfactory. If we know that markets are inefficient, we should have a fairly good sense of why they are inefficient, providing long-term investors with a starting point for outperformance.

Say Goodbye to the EMH

Investment success requires a depar