Greenbackd

As of April 1, 2010, I have raised a modest amount of external seed capital for my maiden fund, Eyquem Global Value (“Eyquem” is Michel de Montaigne’s last name). The fund pursues a systematic deep value investment strategy with a focus on capital preservation. This means the fund is predominantly invested in special situations like liquidations, turnarounds and activist and private equity targets, but it is not limited to that universe. The fund will invest anywhere I can find overwhelming value at a good price.

About Greenbackd

I established Greenbackd to unearth deeply undervalued securities where a catalyst exists likely to remove the discount or unlock the value. The blog’s remit has broadened since then to include other issues relating to deep, absolute-return, value investing.

My core strategy is to systematically identify stocks trading at a discount to net cash value (stocks backed by a surplus of Greenbacks, hence “Greenbackd”), net current asset value or liquidation value. This strategy is often directed at small capitalization stocks, potential activist targets, and other special situations. My secondary strategy is to identify the cheapest stocks determined on the basis of some other proxy for value, including price-to-earnings or cash flow.

Research shows that such deep value strategies have in the past generated returns superior to the market throughout various market cycles. Studies also show that stocks trading at a significant discount to value, whether that value is determined on the basis of net current asset value, liquidation value, book value, or earnings, cash flow or sales multiples, have market-beating form, and at substantially lower risk than the market. Note that I define “risk”  in traditional value investing sense of the word, meaning the possibility of a permanent loss of capital, and not as volatility.

I believe that a systematic, disciplined and long-term application of these deep value strategies, combined with sensible risk management practices, should meet the requirements for a sound investment operation, providing reasonable safety of principal and an adequate return.

My investment philosophy

Fundamental, bottom-up, Grahamite deep-value investment

I pursue the “value” method of investment described by Benjamin Graham in his magnum opus, Security Analysis.  Chapters 43 (Significance of the Current-Asset Value) and 44 (Implications of Liquidating Value. Stockholder-Manager Relationships) of the 1934 Edition continue to provide the theoretical framework for all that I do. I owe a great intellectual debt to Benjamin Graham and David Dodd.

Undervalued asset situations

I seek securities trading at a substantial discount to asset value. Several studies demonstrate that undervalued asset strategies generate returns in excess of the market:

1. Roger Ibbotson, a Professor in the Practice of Finance at Yale School of Management and President of Ibbotson Associates, Inc., a consulting firm specializing in economics, investments and finance, published a study called “Decile Portfolios of the New York Stock Exchange, 1967 – 1984,” Working Paper, Yale School of Management, 1986, in which he studied the relationship between stock price as a proportion of book value and investment returns. Ibbotson found that stocks with a low price-to-book value ratio had significantly better investment returns over the 18-year period than stocks priced high as a proportion of book value.
2. A further study conducted by Werner F.M. DeBondt and Richard H. Thaler, Finance Professors at University of Wisconsin and Cornell University, respectively, examined stock price in relation to book value in “Further Evidence on Investor Overreaction and Stock Market Seasonality,” The Journal of Finance, July 1987. DeBondt and Thaler ranked all companies listed on the NYSE and AMEX, except companies that were part of the S&P 40 Financial Index, according to stock price in relation to book value and then sorted them into quintiles on December 31 in each of 1969, 1971, 1973, 1975, 1977 and 1979. DeBondt and Thaler then calculated the investment return against the equal weighted NYSE Index over the subsequent four years for all of the stocks in each selection period. The four-year returns against the market index were then averaged. DeBondt and Thaler found a cumulative average return in excess of the market index over the four years of 40.7%.
3. Research undertaken by Professor Henry Oppenheimer on Benjamin Graham’s liquidation value strategy between 1970 and 1983 called “Ben Graham’s Net Current Asset Values: A Performance Update” found “[the] mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.”
4. Value vs Glamour: A Global Phenomenon is a recent paper by The Brandes Institute updating Contrarian Investment, Extrapolation and Risk, the landmark 1994 study by Josef Lakonishok, Andrei Shleifer, and Robert Vishny. It investigates the performance of value stocks (defined as the lowest decile of stocks by price-to-book) relative to that of glamour securities in the United States over a 40-year period, and extends the scope of the initial study to include non-U.S. markets, to determine whether the value premium is evident worldwide. They conclude that value stocks tend to outperform glamour stocks and by wide margins.

Why might this be so? I venture three possible explanations below:

1. Assets are simpler to value than unknown future earnings. It’s been my experience that earnings are often difficult to forecast with any degree of accuracy and it’s simply not possible to value a security based on unknown future earnings. Assets, on the other hand, are known quantities at the time of filing, although this is not to say that the value of the assets recorded in the filing is the value I would ascribe to them. When I value the assets, I generally disregard intangible assets, heavily discount long-term and fixed assets, and apply a modest discount to receivables and inventories. I used to take cash and marketable securities at face value, but for a variety of reasons I’m now more careful about many marketable securities. For these reasons, I prefer that each security is predominantly backed by cash, hence the name, Greenbackd. Perhaps the most striking finding by DeBondt and Thaler in the “Further Evidence on Investor Overreaction and Stock Market Seasonality” study discussed above, and one that accords with my view about the difficulty of predicting earnings with any degree of accuracy, is the contrast between the earnings pattern of the companies in the lowest quintile (average price/book value of 0.36) and the highest quintile (average price/book value of 3.42). In the four years after the date of selection, the earnings of the companies in the lowest price/book value quintile increase 24.4%, more than the companies in the highest price/book value quintile, whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to the phenomenon of “mean reversion,” which noted deep value investors Tweedy Browne describe 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.”
2. By focusing on assets we are forced to consider the downside first, which is the security’s value in a liquidation.  This forces me to be conservative in my assessment of value.
3. Assets are a contrarian measure of value. It seems to me that, to the extent that Wall Street makes any assessment of value, it is obsessed with earnings. Wall Street no longer pays any attention to what a company owns. I believe that this presents an opportunity where a valuation based on a company’s earnings underestimates the company’s asset value. Research seems to support this view: Only 24% of value investors incorporate the classic value technique of focusing on tangible asset undervaluation.

My favorite stocks are those trading at a substantial discount to net current assets or liquidation value.

Contrarian

Value investors seek to exploit the suboptimal behavior of the typical investor by acquiring securities that have suffered significant declines in earnings or prices. Research demonstrates that such strategies produce superior returns because most investors don’t fully appreciate the phenomenon of “mean reversion,” which leads them to extrapolate past performance too far into the future. “Mean reversion” is the observation that significant declines (increases) in earnings or stock prices are followed by significant earnings or stock price increases (declines).

Systematic and disciplined

To avoid engaging in the suboptimal investor behavior discussed above, I favor a simple statistical or quantitative model to identify securities meeting my investment criteria. Research suggests that such simple statistical models consistently outperform expert judgements, even when experts are provided with the models’ predictions. Models outperform because humans are overconfident, biased, and suffer from “inertia”.

I have developed a proprietary investment model to rank the universe of undervalued and out-of-favour securities on factors that I believe to be predictive of future returns. I continuously refine the model, although the basic deep value and contrarian philosophy does not, and will not, change.

The catalyst

A catalyst is some form of corporate action that causes the market price of a security to rise to its asset value. It can take the form of a return of capital, special dividend, stock buyback, sale of a key asset, takeover or similar value-enhancing act. These actions can be undertaken by management, but are more often imposed on a company by activist investors or other stockholders dissatisfied with management. It is worth mentioning that the market does sometimes spontaneously recognize the underlying asset value and remove the discount.  Without a catalyst, however, the regression of the market price to the asset value can take a long time, if it occurs at all.  I prefer securities with the conditions in place for a likely catalytic event.

Activist investors are one such source of catalytic events. Research supports the view that stocks the subject of activist campaigns can generate above market returns:

1. In Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, April Klein and Emanuel Zur examined recent “confrontational activism campaigns” by “entrepreneurial shareholder activists” and conclude that such strategies generate “significantly positive market reaction for the target firm around the initial Schedule 13D filing date” and “significantly positive returns over the subsequent year.” The paper confirms my view that the filing of a 13D notice by an activist hedge fund is a catalytic event for a firm that heralds substantial positive returns in the stock. Klien and Zur found that “hedge fund targets earn 10.2% average abnormal stock returns during the period surrounding the initial Schedule 13D. Other activist targets experience a significantly positive average abnormal return of 5.1% around the SEC filing window. These findings suggest that, on average, the market believes activism creates shareholder value. … Furthermore, our target abnormal returns do not dissipate in the 1-year period following the initial Schedule 13D. Instead, hedge fund targets earn an additional 11.4% abnormal return during the subsequent year, and other activist targets realize a 17.8% abnormal return over the year following the activists’ interventions.”
2. In Hedge Fund Activism, Corporate Governance, and Firm Performance, authors Brav, Jiang, Thomas and Partnoy found that the “market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of [7%] seven percent, with no return reversal during the subsequent year.” Further, the paper “provides important new evidence on the mechanisms and effects of informed shareholder monitoring.”
3. Ramius Capital’s whitepaper, The case for activist strategies, seeks to explain how activist investment strategies create shareholder value and improve corporate governance by resolving conflicts of interest between shareholders, directors and management.

Another source of potential catalysts are reverse mergers in shell companies. In Shell Games: On the Stock Price Performance of Shell Companies, Ioannis V. Floros and Travis R. Sapp examined the stock price performance of shell companies over the period 2006 to 2008, finding that “[when] a takeover agreement is consummated, shell company three-month abnormal returns are 48.1%.”

Measuring performance

I believe that my performance should be assessed against a relevant benchmark, which I believe to be the S&P 500 Index because it is widely published and followed, and approximates the return of the general stock market. I founded Greenbackd on December 1st, 2008, at which time the S&P 500 Index stood at 896.24 (its November 28, 2008 close). For each security I identify, I record the most recent price for that security and for the S&P 500 Index so that, over time (two to five years), it will be possible to determine whether my strategy is worthwhile.

Syndication

Greenbackd is a “Gold Standard” contributor to Seeking Alpha, which means that I have agreed in writing to abide by Seeking Alpha’s full compliance standards.

I am a GuruFocus “Guru”.

I also contribute to The Manual of Ideas blog.

Contact me

I can be contacted at greenbackd [at] gmail [dot] com. I welcome all feedback.

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