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Archive for December, 2012

Quantitative Value Cover

I’m excited to announce that the book Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (hardcover, 288 pages, Wiley Finance) is now available.

In Quantitative Value, we make the case for quantitative value investment in stock selection and portfolio construction. Our rationale is that quantitative value investing assists us to defend against our own behavioral errors, and exploit the errors made by others. We examine in detail industry and academic research into a variety of fundamental value investing methods, and simple quantitative value investment strategies. We then independently backtest each method, and strategy, and combine the best into a new quantitative value investment model.

The book can be ordered from Wiley Finance, Amazon, or Barnes and Noble.

Look Inside

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Update: See Ryan’s interview on Bloomberg.

Great article from Businessweek about Ryan Morris, the 28-year-old Canadian managing partner of Meson Capital Partners, LLC who “resembles a sandy-haired Mitt Romney,” and seems to be all out of bubblegum:

Ryan Morris spent a week steeling himself for the showdown. Then 27 years old, he was in his first campaign as an activist investor, trying to wrest control of a small company named InfuSystem (INFU), which provides and services pumps used in chemotherapy. In the meeting, Morris would confront InfuSystem’s chairman and vice chairman, two men in their 40s, and tell them that as a shareholder, he thought the company was heading in the wrong direction.

Morris is competitive—his high school rowing teammates nicknamed him “Cyborg,” and he took a semester off college to race as a semi-pro cyclist—but face-to-face confrontation wasn’t something he relished. “I like the thrill of the hunt, but not the kill,” he says. To prepare, Morris outlined questions, guessed potential responses, and tried to anticipate what tense “pregnant moments” could arrive. He built his clout by lining up support from InfuSystem’s largest shareholder as well as a veteran activist investor. Morris knew his own looks—he resembles a sandy-haired Mitt Romney—could help mask his youth, and decided he’d wear a tie, much as he hates to.

The company, with just $47 million in revenue, was spending too much money, and in the wrong places. In the previous year, InfuSystem’s board and CEO earned more than $11 million combined. This was for a company whose stock had lost 40 percent of its value over the previous three years. Morris figured that as a shareholder voice on the board, he could help cut expenses—including the high pay—and, once it was clean enough to sell, reap a return for his own small hedge fund.

On Dec. 13, 2011, he finally sat at a conference table across from the two directors. After 45 minutes of discussion, he still didn’t think his concerns were being acknowledged. So he got to the point: He wanted three board seats.

It’s a great story. Read the rest of the article on Businessweek.

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Richard Zeckhauser’s Investing in the Unknown and Unknowable (.pdf) is a fantastic 2006 paper about investing in “unknown and unknowable” (UU) situations in which “traditional finance theory does not apply” because each is unique, so past data are non-existent, and therefore an obviously poor guide to evaluating the investment.

Zeckhauser gives as an example David Ricardo’s purchase of British government bonds on the eve of the Battle of Waterloo:

David Ricardo made a fortune buying bonds from the British government four days in advance of the Battle of Waterloo. He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Thus, he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.

The financing of 36 million pounds was floated on the London Stock Exchange. Ricardo took a substantial share. His frequent correspondent Thomas Malthus took 5,000 pounds on Ricardo’s recommendation, but sold out shortly before news of the Waterloo outcome was received. The evidence is clear that Ricardo, in his words, understood the “dismal forebodings” of the situation, including “its consequences, on our [England’s] finances.”

Zeckhauser’s Table 1 below shows the UU world:

UU Table

Zeckhauser says that many great investors, from David Ricardo to Warren Buffett, have made most of their fortunes by betting on “UUU” or unique UU situations:

Ricardo allegedly made 1 million pounds (over $50 million today) – roughly half of his fortune at death – on his Waterloo bonds.5 Buffett has made dozens of equivalent investments. Though he is best known for the Nebraska Furniture Mart and See’s Candies, or for long-term investments in companies like the Washington Post and Coca Cola, insurance has been Berkshire Hathaway’s firehose of wealth over the years. And insurance often requires UUU thinking.

Not all UU situations are unique:

Some UU situations that appear to be unique are not, and thus fall into categories that lend themselves to traditional speculation. Corporate takeover bids are such situations. When one company makes a bid for another, it is often impossible to determine what is going on or what will happen, suggesting uniqueness. But since dozens of such situations have been seen over the years, speculators are willing to take positions in them. From the standpoint of investment, uniqueness is lost, just as the uniqueness of each child matters not to those who manufacture sneakers.

These strategies are distilled into eight investment maxims:

  • Maxim A: Individuals with complementary skills enjoy great positive excess returns from UU investments. Make a sidecar investment alongside them when given the opportunity.

  • Maxim B: The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk.

  • Maxim C: When information asymmetries may lead your counterpart to be concerned about trading with you, identify for her important areas where you have an absolute advantage from trading. You can also identify her absolute advantages, but she is more likely to know those already.

  • Maxim D: In a situation where probabilities may be hard for either side to assess, it may be sufficient to assess your knowledge relative to the party on the other side (perhaps the market).

  • Maxim E: A significant absolute advantage offers some protection against potential selection. You should invest in a UU world if your advantage multiple is great, unless the probability is high the other side is informed and if, in addition, the expected selection factor is severe.

  • Maxim F: In UU situations, even sophisticated investors tend to underweight how strongly the value of assets varies. The goal should be to get good payoffs when the value of assets is high.

  • Maxim G: Discounting for ambiguity is a natural tendency that should be overcome, just as should be overeating.

  • Maxim H: Do not engage in the heuristic reasoning that just because you do not know the risk, others do. Think carefully, and assess whether they are likely to know more than you. When the odds are extremely favorable, sometimes it pays to gamble on the unknown, even though there is some chance that people on the other side may know more than you.

The essay is brilliant. Zeckhauser acknowledges in the conclusion that it offers “more speculations than conclusions,” and its theory is “often tentative and implicit” in seeking to answer the question, “How can one invest rationally in UU situations?” but, if anything, it’s the better for it. Thinking as Zeckhauser proposes about UU situations may vastly improve investment decisions where UU events are involved, and should yield substantial benefits because “competition may be limited and prices well out of line.”

Read Investing in the Unknown and Unknowable (.pdf).

h/t @trengriffin via @mjmauboussin

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Zero Hedge has an article Buy Cash At A Discount: These Companies Have Negative Enterprise Value in which Tyler Durden argues that stock market manipulation has led to valuation dislocations, and gives as evidence the phenomenon of stocks trading with a negative enterprise value (EV):

With humans long gone from the trading arena and algorithms left solely in charge of the casino formerly known as “the stock market”, in which price discovery is purely a function of highly levered synthetic instruments such as ES and SPY or, worse, the EURUSD and not fundamentals, numerous valuation dislocations are bound to occur. Such as company equity value trading well below net cash (excluding total debt), or in other words, negative enterprise value, meaning one can buy the cash at a discount of par and assign zero value to all other corporate assets.

Just as the fact of your paranoia does not exclude the possibility that someone is following you*, you don’t need to believe in manipulation to believe that negative EV is a “valuation dislocation.” Negative EV stocks are often also Graham net nets or almost net nets, and so perform like net nets. For example, Turnkey Analyst took a look at the performance of negative EV stocks (click to enlarge):

Long story short: they ripped, but they were few (sometimes non-existent), and small (mostly micro), which means you would have been heavily concentrated in a few mostly very small stocks, and regularly carried a lot of cash. If you eliminated the tiniest (i.e. the smallest 10 or 20 percent), much of the return disappeared, and volatility spiked markedly. Says Wes:

A few key points:

  1. After you eliminate the micro-crap stocks, you end up being invested in a few names at a time (sometimes you go all-in on a single firm!)
  2. Sometimes the strategy isn’t invested.
  3. The amazing Bueffettesque returns for the “all firms” portfolio above are exclusively tied to micro-craps.

Here’s the frequency of negative EV opportunities according to Turnkey (click to enlarge):

No surprise, there were more following a crash (1987, 2001, 2009) and fewer at the peak (1986, 1999, 2007). If your universe eliminated the smallest 20 percent (the green line), you spent a lot of time in cash. If your universe was unrestricted (the red line), then you’d have had some prospects to mine most of the time. Clearly, it’s not an institutional-grade strategy, but it has worked for smaller sums.

Zero Hedge screened Russell 2000 companies finding 10 companies with negative enterprise value, and then further subdivided the screen into companies with negative, and positive free cash flow (defined here as EBITDA – Cap Ex). Here’s the list (click to enlarge):

Including short-term investments yields a bigger list (click to enlarge):

Like Graham net nets, negative EV stocks are ugly balance sheet plays. They lose money; they burn cash; the business, if they actually have one, usually needs to be taken to the woodshed (so does management, for that matter). Frankly, that’s why they’re cheap. Says Durden:

Typically negative EV companies are associated with pre-bankruptcy cases, usually involving large cash burn, in other words, where the cash may or may not be tomorrow, and which may or may not be able to satisfy all claims should the company file today, especially if it has some off balance sheet liabilities.

You can cherry-pick this screen or buy the basket. I favor the basket approach. Just for fun, I’ve formed four virtual portfolios at Tickerspy to track the performance:

  1. Zero Hedge Negative Enterprise Value Portfolio
  2. Zero Hedge Negative Enterprise Value Portfolio (Positive FCF Only)
  3. Zero Hedge Negative Enterprise Value (Inc. Short-Term Investments) Portfolio
  4. Zero Hedge Negative Enterprise Value (Inc. Short-Term Investments) Portfolio (Positive FCF Only)

I’ll check back in occasionally to see how they’re doing. My predictions for 2013:

  1. All portfolios beat the market
  2. Portfolio 1 outperforms Portfolio 2 (i.e. all negative EV stocks outperform those with positive FCF only)
  3. Portfolio 3 outperforms Portfolio 4 for the same reason that 1 outperforms 2.
  4. Portfolios 1 and 2 outperform Portfolios 3 and 4 (pure negative EV stocks outperform negative EV including short-term investments)

Take care here. The idiosyncratic risk here is huge because the portfolios are so small. Any bump to one stock leaves a huge hole in the portfolio.

* Turn around. I’m right behind you.

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New research co-authored by London Business School’s Elroy Dimson suggests that investors who actively engage with the companies they own to improve governance and strategy outperform more passive rivals.

The paper, Active Ownership with Oguzhan Karakas and Xi Li, focuses on corporate social responsibility engagements on environmental, social and governance issues.

The authors find average one-year abnormal return after initial engagement is 1.8%, with 4.4% for successful engagements whereas there is no market reaction to unsuccessful ones. The positive abnormal returns are most pronounced for engagements on the themes of corporate governance and climate change:

We find that reputational concerns and higher capacity to implement corporate social responsibility changes increase the likelihood of a firm being engaged and being successful in achieving the engagement objectives. Target firms experience improvements in operating performance, profitability, efficiency, and governance indices after successful engagements.

Figure 1 from the paper shows cumulative abnormal returns around corporate social responsibility engagements (click to enlarge):

Returns to CSR Activism

Dimson is perhaps best known for his global equity premia research (for example, Triumph of the Optimists and Equity Premia Around the World) with LBS colleagues Paul Marsh and Mike Staunton.

A version of the paper can be found on SSRN here.

Via Financial News’ Studies reveal the value of activism.

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