Archive for December, 2009

We have a guest post today on Solitron Devices Inc (OTC:SODI) from Floris Oliemans. Floris is a recent graduate of the University of Maastricht in the Netherlands with a MSc in Finance. He also holds a BSc in Economics. He wrote his masters thesis on the performance of Net Current Asset Value stocks.  He currently works as a financial analyst for a Dutch multinational. He is very interested in applying the value concepts proposed by Graham, Whitman and Buffett, for the portfolio of his family and where ever it may be used professionally. Here his view of Solitron Devices Inc (OTC:SODI):

Solitron Devices is a manufacturer of Semiconductors for military, extraorbital and industrial purposes. It produces analog vs digital semiconductors (I dont quite know the difference, I lack a BA in engineering).

The reason I bought this stock is because it is trading at a 30% discount to NCAV. I believe the assets in place are of high quality. Its current market cap is 4,97 million. After subtracting all liabilities it has (roughly) 3,5 million in net cash. The remainder of the assets is tied up in 1 million of acc. rec (very high acc rev turnover) and 2,71 mio of inventory. The inventory consists mostly of raw materials and of goods already ordered by customers. It does not produce products that the customer has not ordered, therefore inventory can and should be liquidated at near 100% of nominal value. Furthermore it has an inventory reserve of nearly 1,4 mio which might or might not be too conservative.

The company is tiny, but it has been profitable for the last decade. Based on last years earnings the firm is yielding 16%. The reason for this high earnings yield is because it has a large tax loss carryforward worth 8 million. This tax loss carry forward is due to the bankruptcy of the firm in 1993, and lasts until 2023. With net income of 900,000 last year, and a tax rate of 30%, it will not be able to use the tax loss carryforward completely. This is one reason why the tax loss carryforward is only listed in the footnotes and not on the balance sheet. One can be safe to assume that the firm will not be required to pay taxes for the foreseeable future. This is an offbalance sheet asset that can definitely add value to the current shareholder.

I do not expect a massive increase in earnings but there are a couple of factors which could act as a catalyst to the firm:

1. The large tax loss carryforward. By buying this firm, a larger competitor could use this tax loss carryforward to lower incometaxes for the entire firm. This would unlock the value of this hidden asset. A cautionary note: The annual report states that a new majority owner of the firm might not be able to use all of the tax loss carryfowards.

2. A wrapping up of all bankruptcy proceedings. The firm has promised all previous creditors that it will not pay any dividends until all the bankruptcy obligations have been paid. As far as I can deduct, the firm is still obliged to pay 1.1 mio in accrued liabilities. At the current scheduled payment rate the firm will be done paying in 4 years. After this, the built up cash reserve could be used to redistribute to shareholders.

3. An increase in business due to the new ISO certification. The company recently received an ISO certification allowing it to produce semiconducters suitable for space. What the impact on the business will be, I have no clue, but it might be positive.

4. An increase in margins. Recently a large competitor left the market, motorola. A decrease in competition lifts the bargaining power of the firm and could increase margin. It could also increase its market share.


1. The backlog has decreased over the last 12 months. This could imply a sharp decrease in demand and lower sales volume/margins. The company has relatively few fixed assets in place, thus the risk of a decrease in NAV is minimal.
2. Fraud. Altough I have no reason to suspect fraud (the firms accounting is pretty simple), the majority shareholders could be misrepresenting the figures.
3. Majority shareholders abusing their voting rights. Majority shareholders could abuse their position to siphon of shareholder value and take Something Off the Top (SOTT). There are some options outstanding but they have not increased significantly.

4. I dont understand the business. I have no idea how a semiconductor is made or what function it has. I could be buying into a dying company and/or industry and not know about it.


The high quality of assets in place, the consistent earnings and the large tax loss carryforward make this a confident invesment. Something could happen that I have not foreseen in my analysis, but this is always a risk. I am just going to leave this stock for the next 2 years and see what happens. As Pabrai says “Low Risk, High Uncertainty”.

The stock is very thinly traded, so, if you’re inclined to do so, take care getting set.

[Full Disclosure:  I do not have a holding in SODI. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]


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The $1750 discount off the regular price of admission to the 2010 5th Annual Value Investing Congress West expires tomorrow, Tuesday, at midnight.

Though the Congress is more than 6 months away, over 40% of the seats have already been reserved. Register by midnight Tuesday, December 15, 2009 with discount code P10GB1 and you’ll save $1,750 off the regular price of admission.

Every year hundreds of people from around the world converge at this not-to-be-missed event to network with other savvy, sophisticated investors and learn from some of world’s most successful money managers. At the upcoming event, all-star investors will share their thoughts on today’s tumultuous markets and present their best, actionable investment ideas. Just one idea could earn you outstanding returns.

See a slide show of the last Value Investing Congress in New York.

Don’t miss your opportunity to learn from these financial luminaries. The insights you gain could guide your investment decisions for years to come. Remember, you must register by midnight December 15, 2009 with discount code P10GB1 to take advantage of this special offer and SAVE $1,750 off the regular price to attend. Avoid disappointment – reserve your seat today.

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Forward Industries Inc (NASDAQ:FORD) has filed its 10K for the period ended September 30, 2009.

We started following FORD (see the post archive here) because it was trading at a discount to its net cash and liquidation values, although there was no obvious catalyst. Management appeared to be considering a “strategic transaction” of some kind, which might have included an “acquisition or some other combination.” I think a better use of the cash on the balance sheet is a share buy-back or a dividend. Trinad Management had an activist position in the stock, but had been selling at the time I opened the position and only one stockholder owned more than 5% of the stock. The stock is up 40.3% since I opened the position to close yesterday at $2.00, giving the company a market capitalization of $15.9M. Following my review of the most recent 10K, I’ve increased my estimate of FORD’s liquidation value to around $20.3M or $2.56 per share.

The value proposition updated

FORD continues to face difficult trading conditions, writing in the most recent 10K:

Trends and Economic Environment

We believe that the poor economy, high unemployment, tight credit markets, and heightened uncertainty in financial markets during the past two years have adversely impacted discretionary consumer spending, including spending on the types of electronic devices that are accessorized by our products. In response to the economic recession certain of our major diabetic case customers have significantly reduced their sales forecasts to us for blood glucose diagnostic kits, with which our products are packaged in box, therefore implying reduced sales revenues from these customers in future periods. We expect this challenging business environment to continue in the near term.

Our response to current conditions has been to cut operating expenses and reduce headcount; and we have attempted to limit increases in operating expenses except where we think increases are critical to potential future growth.

In response to increasing customer and sales concentration, we have focused marketing efforts on expanding our customer base. These efforts are meeting with some preliminary success, although the degree of success will not become apparent until we are deeper into Fiscal 2010. We have received small, initial orders from first time customers. The key question in Fiscal 2010 will be whether our overall net sales and net profit will primarily reflect revenue contribution from new customers or the decline in revenues from existing customers that have indicated reduced order flow in Fiscal 2010. See Part I, Item IA. of this Annual Report, “Risk Factors”, including “We have announced our intention to diversify our business by means of acquisition or other business combination.”

The company had another quarter that was better than the preceding one, generating positive cash from operating activities of around $0.35M (the “Book Value” column shows the assets as they are carried in the financial statements, and the “Liquidating Value” column shows our estimate of the value of the assets in a liquidation):

Summary balance sheet adjustments

I’ve made the following adjustments to the balance sheet estimates (included in the valuation above):

  • Cash burn: I’ve got no real idea about FORD’s prospects. It seems to have stopped burning cash over the last quarter and actually generated $0.35M. If we assume, as management has, that the company will face a tough operating environment over the next 12 months, I estimate that the company will generate no cash over that period.
  • Off-balance sheet arrangements: According to FORD’s most recent 10Q, it has no off-balance sheet arrangements.
  • Contractual obligations: FORD’s contractual obligations are minimal, totalling $0.8M.

Possible catalysts

FORD’s President and Acting Chairman, Mr. Doug Sabra, said in the letter to FORD shareholders accompanying the notice of annual shareholders’ meeting, that in 2008 “management began to implement operational and strategic initiatives in order to put [FORD]’s business on a stronger, more sustainable footing. …  This past August we retained an outside consultant to assist us in vetting possible partners for a strategic transaction.” It seems that the “strategic transaction” might include a “possible acquisition or other combination that makes sense in the context of [FORD’s] existing business, without jeopardizing the strong financial position that we have worked so hard to build.” My vast preference is for a sale of the company, buyback, special dividend or return of capital over an acquisition. Rather than spend the cash on their balance sheet, they should focus on the work on their desk and pay a big dividend.

Any sale transaction will require the consent of FORD’s board. While it has a free float of around 92%, the company’s so-called “Anti-takeover Provisions” authorize the board to issue up to 4M shares of “blank check” preferred stock. From the 10K:

Our Board of Directors is authorized to issue up to 4,000,000 shares of “blank check” preferred stock. Our Board of Directors has the authority, without shareholder approval, to issue such preferred stock in one or more series and to fix the relative rights and preferences thereof including their redemption, dividend and conversion rights. Our ability to issue the authorized but unissued shares of preferred stock could be used to impede takeovers of our company. Under certain circumstance, the issuance of the preferred stock could make it more difficult for a third party to gain control of Forward, discourage bids for the common stock at a premium, or otherwise adversely affect the market price of our common stock. In addition, our certificate of incorporation requires the affirmative vote of two-thirds of the shares outstanding to approve a business combination such as a merger or sale of all or substantially all assets. Such provision and blank check preferred stock may discourage attempts to acquire Forward. Applicable laws that impose restrictions on, or regulate the manner of, a takeover attempt may also have the effect of deterring any such transaction. We are not aware of any attempt to acquire Forward.


FORD is still trading at a substantial discount to its liquidation and net cash values. The risk to this position is management spraying the cash away on an acquisition. A far better use of the company’s cash is a buyback, special dividend or return of capital. Another concern is Trinad Management exiting its activist position in the stock. Those concerns aside, I’m going to maintain the position because it still looks cheap at a discount to net cash.

[Full Disclosure:  We have a holding in FORD. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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In yesterday’s post we discussed some informal analysis I’ve undertaken on the returns to the quantitative investment strategy known as “High Minus Low” or HML. The first step was an analysis of HML’s components, high and low BM stocks. I described the HML strategy in some detail and analysed the long-term diminution in the returns to those components. I think that the returns to both high BM and low BM stocks have been attenuating significantly over time. The phenomenon persisted over whichever recent period I analysed (since 1926 to the present day, or over the last 25, 20, 15 or 10 years). This suggested that it’s got harder over time to earn excess returns as a value investor employing a high BM strategy.

In today’s post, I analyse the returns to HML at the strategy level and ask whether the returns to HML are really just returns to a levered high BM strategy. In a Goldman Sachs Asset Management (GSAM) presentation, Maybe it really is different this time, GSAM argued that the returns to HML have diminished since August 2007 because too many investors are employing the same  strategy, a phenomenon GSAM describe as “overcrowding.” In summary, I agree with GSAM’s view that the returns to HML have indeed stagnated since late 2007. I’m not sure that this is attributable to “overcrowding” as GSAM suggests or just a function of the underlying market performance of the components of HML (i.e. everything has been and continues to be expensive, leaving little room for good returns). Interestingly, even accounting for the period of low attenuated performance between August 2007 and the present, the HML strategy has performed reasonably well over the last 10 years, which has been a period of diminished (or non-existent) returns for equities. The returns to a 130/30 HML strategy over the last 10 years significantly outpaced a high BM strategy and the market in general. Surprisingly (to me at least), the low BM short didn’t add much to HML returns. This is especially surprising give that the period analysed was one where the low BM stocks bore the brunt of the collapse. That observation requires some further analysis, but it’s a prima facie argument that most of the returns to HML are due to the leverage inherent in the strategy.

Returns to HML

Most hedge fund strategies being proprietary and, hence, closely guarded secrets, I’m not sure what the typical HML strategy looks like. For the sake of this argument, I’ve constructed three HML portfolios. The first is 30% short the low BM decile and 130% long the high BM decile, which is a not uncommon hedge fund strategy. The second is 100% short the low BM decile and 100% long the high BM decile, which highlights the low BM short and removes the effects of leverage from the high BM long. The third is 130% long the High BM decile and has no short, to remove the effect of the short and highlight the effect of the leverage. How would those strategies have fared over the last 10 years, which, as we saw yesterday, was a period of attenuated returns for equities?

The 130/30 HML strategy

“Low BM” is the lowest BM decile, marked in red. This is Decile 1 from the Average monthly returns to decile BM portfolios chart in yesterday’s post. “High BM” is the highest BM decile, marked in blue. This is Decile 1o from yesterday’s chart. The green “HML” line is -30% of the return on the low BM decile and 130% the return on the high BM decile. “Delta,” in purple, is the difference between the return on the low and high BM components of the HML strategy. Here’s the chart:

Several observations can be made about the chart. First, as at September 2009, the “Low BM” strategy (in red) is down 3%, which approximates the return on the market as a whole over the last 10 years. The “High BM” strategy (in blue) is up about 95%, which is not a great return over 10 years, but well ahead of the market in general and the Low BM portfolio. The HML portfolio is up around 124%, well ahead of both the Low BM and High BM portfolios. As recently as 2003, the 130/30 HML portfolio was underwater and it nearly accomplished this feat again in 2009. It performed almost in line with the High BM portfolio while the market was tanking, which is when I would have expected the Low BM short to protect the return on the HML, affording only a little protection. It seems that the return on the 130% long component of the High BM portfolio caused the HML strategy to tank with the High BM portfolio, although it also caused it to recover much faster. While GSAM is correct that HML returns have been reduced since late 2007, the 10-year return on the 130/30 HML is attractive.

The 100/100 HML strategy

In this chart the green “HML” line is -100% of the return on the low BM decile and 100% the return on the high BM decile:

The 100/100 HML chart illustrates several points. First, as at September 2009, the HML portfolio is up 98%, in line with the High BM portfolio. Where the Low BM portfolio falls, the 100% low BM short in the HML protects it. For the last 10 years, it has generally protected the HML return. Of course it hurts the HML’s performance when the low BM short rises, which, as we saw yesterday, has generally been the case since 1926.

The Levered High BM strategy

This chart shows the High BM portfolio levered at the same rate as the 130/30 HML strategy (i.e.130%), but without the low BM short:

The Levered High BM portfolio tracks (visually) almost identically to the 130/30 HML strategy (Levered High BM closed up 123%, HML closed up 124%). This suggests to me that most of the additional gains in the 130/30 HML strategy over the High BM strategy are simply attributable to the leverage in the HML, and not out of any protection afforded by the low BM short.

Recent returns to HML depressed

A casual perusal of any chart above illustrates that HML has not progressed since August 2007. GSAM argues that this is a secular phenomenon due to overcrowding. I’m not convinced that it’s a secular phenomenon, but it’s certainly noteworthy. I’m also not entirely convinced that it’s due to overcrowding. It could just as easily be a function of the high price for equities in August 2007 and again now. GSAM argues that your view on the phenomenon as being either cyclical or secular is key to how you position yourself for the future. If you believe it’s cyclical, you’re a “Sticker,” and, if you believe it’s secular, you’re an “Adapter”. The distinction, according to Zero Hedge, is as follows:

The Stickers believe this is part of the normal volatility of such strategies

• Long-term perspective: results for HML (High Book-to-Price Minus Low Book-to-Price) and WML (Winners Minus Losers) not outside historical experience

• Investors who stick to their process will end up amply rewarded

The Adapters believe that quant crowding has fundamentally changed the nature of these factors

• Likely to be more volatile and offer lower returns going forward

• Need to adapt your process if you want to add value consistently in the future

I’m in the cyclical camp, but it may be other players withdrawing from the field that causes the cycle to turn.


Despite GSAM’s protestations to the contrary, and despite the diminution of equity returns at both the value and glamour ends of the market, HML remains an attractive strategy. Over a 10-year period of attenuated equity returns, a 130/30 HML strategy performed very well. It seems, however, that most of the returns to the 130/30 strategy are attributable to the leverage in the high BM portfolio, rather than any protection in the low BM short. As we saw yesterday, the low BM decile, while generating a lower return than the high BM decile over time, has mainly generated positive returns. This means that the low BM short will generally hurt the HML strategy’s performance.

My vast preference remains a leverage-free, long-only, ultra-high BM portfolio for a variety of reasons not connected with the chronic underperformance of the short, most notably that it’s the lowest risk portfolio available (despite what Fama and French say). In my opinion, the diminution in returns to the high BM strategy we observed yesterday is a cyclical phenomenon. 25 years is a long time for a cycle to turn, but I’m reasonably confident that the high BM strategy will again generate average monthly returns in line with the long-run average on yesterday’s chart, which means average monthly returns in the vicinity of 1.2% to 1.4%. I don’t foresee this occurring any time soon, and I think dwindling returns are the order of the day for the next 5 or 10 years. If I had to be anywhere in equities, however, I’d start in the cheapest decile of the market on a price-to-book basis and work my way through to those with the highest proportion of current assets. That’s a proven strategy that served Graham and Schloss very well, and, as far as I can see, there’s no reason why it shouldn’t continue to work.

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Recently we discussed a Goldman Sachs Asset Management (GSAM) presentation, Maybe it really is different this time, in which GSAM argued that High Minus Low or HML, a quantitative investment strategy that seeks to profit from the performance differential between high and low book value-to-market value (BM) stocks, had underperformed since August 2007 due to “overcrowding.” Robert Litterman, Goldman Sachs’ Head of Quantitative Resources, was quoted as saying that “strategies such as those which focus on price rises in cheaply-valued stocks…[have] become very crowded” since August 2007 and therefore unprofitable. The GSAM presentation included a variety of slides showing the reduction in the returns to HML and the growth in the number of practitioners in the space (See my summary of the GSAM presentation and Zero Hedge’s take on it).

Over the last week I’ve run my own informal analysis of the returns to HML and its components, high and low BM stocks. The resulting post has metastasised into an epic (by my standards), so I’ve broken it into two parts, Component returns (Part 1) and HML returns (Part 2). In today’s post, Component returns, I describe the HML strategy in some detail and analyse the long-term diminution in the returns to the components of HML, namely, high BM (low P/B) stocks and low BM (high P/B) stocks. The results are stunning. The returns to the high BM and low BM stocks have been attenuating significantly over time. Further, the phenomenon persists over whichever recent period we elect to choose (since 1926, or the last 25 years, 20 years, 15 years or 10 years). This suggests that it’s got harder over time to earn excess returns as a value investor employing a high BM strategy.

In tomorrow’s post, I analyse the returns to HML at the strategy level and ask whether the returns to HML are really just returns to a levered high BM strategy. In summary, the returns to HML have indeed stagnated since late 2007. I’m not sure that this is attributable to “overcrowding” as GSAM suggests or just a function of the underlying market performance of the components of HML (i.e. everything has been and continues to be expensive, leaving little room for good returns). Interestingly, GSAM’s argument that HML is dead as of August 2007 aside, the HML strategy has performed reasonably well over the last 10 years, which has been a period of diminished (or non-existent) returns for equities. The returns to a 130/30 HML strategy over the last 10 years significantly outpace a high BM strategy and the market in general. Surprisingly (to me at least), the low BM short didn’t add much to HML returns. This is especially surprising give that the period analysed was one where the low BM stocks bore the brunt of the collapse. That observation requires some further analysis, but it’s a prima facie argument that most of the returns to HML are due to the leverage inherent in the strategy.

A primer on HML

As I mentioned above, HML is a quantitative investment strategy that seeks to profit from the performance differential between high and low book value-to-market value stocks. It’s interesting to me because it appears to be a value-based strategy. In actuality, it finds its roots in the Fama and French Three-Factor Model, which is an attempt to explain the excess returns attributable to value stocks within an efficient markets context. HML also owes an intellectual debt to the various studies demonstrating the relative outperformance of low price-to-value stocks over higher price-to-value stocks – Roger Ibbotson’s Decile Portfolios of the New York Stock Exchange, 1967 – 1984 (1986), Werner F.M. DeBondt and Richard H. Thaler’s Further Evidence on Investor Overreaction and Stock Market Seasonality (1987), Josef Lakonishok, Andrei Shleifer, and Robert Vishny’s Contrarian Investment, Extrapolation and Risk (1994) as updated by The Brandes Institute’s Value vs Glamour: A Global Phenomenon (2008) – but it is most closely associated with Fama and French.

Fama and French observed in their 1992 paper, The Cross-Section of Expected Stock Returns, that there is “striking evidence” of a “strong positive relation between average return and book-to-market equity” [“BE” is book equity and “ME” is market equity, so “BE/ME” is just BM, the inverse of P/B]:

Average returns rise from 0.30% for the lowest BE/ME portfolio to 1.83% for the highest, a difference of 1.53% per month.

Note also that the strong relation between book-to-market equity and average return is unlikely to be a [beta] effect in disguise.*

[Although] BE/ME has long been touted as a measure of the return prospects of stocks, there is no evidence that its explanatory power deteriorates through time. The 1963-1990 relation between BE/ME and average return is strong, and remarkably similar for the 1963-1976 and 1977-1990 subperiods. Second, our preliminary work on economic fundamentals suggests that high-BE/ME firms tend to be persistently poor earners relative to low-BE/ME firms.

Ibbotson (1986), DeBondt and Thaler (1987), Lakonishok, Shleifer, and Vishny (1994) and The Brandes Institute (2008) all make similar findings. Low P/B stocks outperform higher P/B stocks in the aggregate, and in rank order, the cheapest decile, quintile, quartile etc outperforming the next cheapest and so on. This phenomenon obviously presents a problem for the efficient markets crowd because the historic excess returns of value stocks over glamour stocks cannot be explained by the traditional CAPM model. Fama and French’s solution is the Three-Factor Model.

Fama and French attribute the variation in average returns between high and low BM stocks to “relative distress,” arguing that value strategies (i.e. high BM stocks) produce abnormal returns because they are fundamentally riskier. This observation is the impetus for the inclusion of “value” as a factor in Fama and French’s Three-Factor Model, where it is accounted for as “HML”. (It was also the impetus for Piotroski’s F_SCORE, which seeks to use “context-specific financial performance measures to differentiate strong and weak firms” within the universe of high BM stocks.)

HML in the Fama and French context measures the historic excess returns of value stocks over growth stocks, which break the traditional CAPM model. Here’s how they circumvent the problem: By splitting out HML from the market return and labelling the portion of the excess return attributable to HML as “riskier,” Fama and French can explain away those excess returns. They then simply apply an HML coefficient to a portfolio of value stocks and – abracadabra – the expected return is higher than the market return but explainable within the efficient markets world because of the additional risk attributable to value. The proponents of the efficient markets hypothesis breathe a sigh of relief and continue to believe that no one can make excess returns once those returns are adjusted for risk. (Don’t mention that value is not, per se, riskier, because such an observation would break the model all over again.) It’s worth noting that Lakonishok, Shleifer, and Vishny (1994) disagree with Fama and French’s assertion that the returns are due to financial distress, arguing instead that the returns to value are the result of a bias that leads investors to extrapolate past performance too far into the future, not fully appreciating the phenomenon of mean reversion.

Whatever the basis for the returns to value, the phenomenon has attracted a substantial following in the world of quantitative investing. So much so that GSAM thinks the field is now “overcrowded” and that explains the diminution in returns since August 2007. The attraction of the HML strategy to a quant is easy to understand: They’re agnostic to the reason for the excess returns, and more than happy to earn some and remain market neutral. The solution is to split out from the market return the excess return attributable to HML. How does one do that in practice? One simply buys the value stocks and sells the glamour stocks. This means buying high BM stocks and selling short low BM stocks. It’s extraordinary that, despite the tortured EMH reasoning, HML is a strategy that a value investor would recognize and (shorting, leverage and aggregation notwithstanding) probably approve of in its general terms. Before looking at the returns to the HML strategy, I think it’s useful to look under the hood and consider the “engine” of the strategy, which is the returns to the underlying components.

* One of the observations made by Fama and French (1992) is that “average returns for negative BE firms are high, like the average returns of high BE/ME firms. Negative BE (which results from persistently negative earnings) and high BE/ME (which typically means that stock prices have fallen) are both signals of poor earnings prospects.” This is very interesting. I’ve never heard of a negative BM strategy. While it makes me a little nervous to think about, it’s possible that negative BM stocks are an untapped source of returns. Perhaps it’s just the leverage at the company level, but it warrants a further investigation and a later post. Let me know if you’ve got any data or studies on the subject.

Returns to HML’s components: High BM and Low BM

There are two components to the HML strategy: The high BM long and the low BM short. The strategy seeks to remain market neutral by selling short low BM stocks, which are expected to fall back to the mean market BM value, and using leverage to buy high BM stocks, which are expected to rise to the mean market BM value. To see how each component performs, I’ve produced a chart of average monthly stock returns since 1926. Before I present the graph, a quick disclaimer: What follows does not amount to a formal academic study into the relative performance of high BM and low BM over time. It’s nothing more than me messing around with COMPUSTAT return data and plugging it into an Excel spreadsheet. Stocks were divided into ten deciles based on book value-to-market value. Average returns for each decile were calculated on a monthly basis over five different time periods:

  • “All” from July 1926 to September 2009
  • “25 Years”, from October 1984 to September 2009
  • “20 Years”, from October 1989 to September 2009
  • “15 Years”, from October 1994 to September 2009
  • “10 Years”, from October 1999 to September 2009

“Decile 10” is formed from the portfolio of stocks with the highest BM ratio (lowest P/B), “Decile 1” is the portfolio of stocks with the lowest BM ratio (highest P/B) and so on. Here’s the chart:

For me, three observations leap out from the chart. First, the relationship between high and low BM deciles is relatively unchanged over time. The relatively high BM stocks in deciles 10, 9, and 8 tend to outperform the relatively lower BM stocks in deciles 1, 2, and 3. With few exceptions, the higher the ratio of book to market, the better the performance.

Second, the returns to all deciles have attenuated significantly over time. This was one of the questions I had after reading The Brandes Institute’s Value vs Glamour: A Global Phenomenon update of the Contrarian Investment, Extrapolation and Risk. The Brandes Institute paper didn’t split out from Lakonishok, Shleifer, and Vishny’s paper the more recent returns to high BM stocks, but the blended return was lower in the later study, suggesting that returns had diminished in the intervening period. As far as this simple analysis goes, it seems to confirm that impression.

The third observation is that the low BM decile – Decile 1 – has for most of the time had a positive monthly return. It is only over the last 10 years that the monthly returns for the lowest BM decile have been negative. This is significant because this means that, the last 10 years aside, one employing the HML strategy would have lost money on the low BM short, and would have earned better returns without the short. Over the last 10 years, however, one would expect that the low BM short has paid off handsomely. As you’ll see tomorrow, this is not actually the case.

Hat tip to the Ox for the return data.

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The wonderful Miguel Barbosa of Simoleon Sense has interviewed Joe Calandro, Jr., author of Applied Value Investing. The interview is first class. Joe Calandro, Jr. is an interesting guy. Deep value? Check. Activist investing? He’s for it. Austrian School of Economics? Check. I think I just wet myself.

Here’s Joe’s take on value:

Q. Can you give me an example of some of your best investments?

A. In the book I profile a value pattern that I call “base case value” which is simply net asset value reconciling with the earnings power value. Firms exhibiting that pattern, which sell at reasonable margins of safety have proved highly profitable to me. In the book, I show examples of this type of investment.

“Value investing” in general has 3 core principles:

(1) The circle of competence, which essentially relates to an information advantage and holds that you will do better if you stick to what you know more about than others.

(2) The principle of conservatism. You will have greater faith in valuations if you prepare them conservatively.

(3) The margin of safety. You should only invest if there is a price-to-value gap: when the gap disappears you exit the position.

Here’s Joe on activist investing:

Q. You’re primarily in the corporate sector now; in your book you touch upon the failure of corporate M&A groups to apply value investing.  Why do you think this is the case? What is your take on activist value investors?

A. That’s a good question and I don’t have a definitive answer for it. My take on it is that Corporate America hasn’t been trained in Graham and Dodd. For example, if you get away from Columbia and some of the other top schools you really don’t have courses of study based on Graham and Dodd. I think this lack of education carries over to practice. If educational institutions aren’t teaching something, then executives are going to have a difficult time applying it. And if they do try to apply it, their employees and boards may not understand it. Hopefully, my book will help to rectify this over time.

Regarding activist investors, I think every investor should be active. If you allocate money to a security (either equity or debt) you have the responsibility of becoming involved in the respective firm because, as Benjamin Graham noted, you invested in a business, not in a piece of paper or a financial device. This is real money in real businesses so there is a responsibility that comes with investing.

And Joe’s view on economics:

Q. Can you give us a tour of the major insights you obtained from the Austrian School of Economics.

A. I have two big academic regrets: I did not study Graham and Dodd or Austrian economics until I was in my mid 30’s. One of the major theories of Austrian economics is its business cycle theory. Just the other day (11/6/2009), that theory was mentioned in the WSJ by Mark Spitznagel, who is Nassim Taleb’s partner, in his article “The Man Who Predicted the Depression.” As you know, Taleb has also spoken highly of Austrian economics as have other successful traders/practitioners such as Victor Sperandeo, Peter Schiff and Bill Bonner.

Austrian economics finds success with practitioners because, I think, Austrian economists are truly economists; they do not try to be applied mathematicians. Therefore, Austrians tend to see economics for what it is; namely, a discipline built around general principles that can be applied broadly to economic phenomena. As a result, Austrian economics is generally very useful in areas such as the business cycle and the consequences of government intervention, which are very pertinent topics today.

Read the rest of the interview while I run out to buy the book.

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Greenbackd is dedicated to unearthing undervalued asset situations where a catalyst exists likely to remove the discount or unlock the value. My favorite stocks are those trading at a substantial discount to net current assets or liquidation value, with an activist pushing for a catalyst to unlock the value. Those opportunities, however, are few and far between. I can frequently find deeply undervalued asset situations with no obvious catalyst. I can often also find activists in stocks that are not undervalued on a Graham asset basis.

A little over a year ago in a post titled Net Net vs Activist Legend I started a thought experiment pitting Dataram Corporation (NASDAQ:DRAM), a little Graham net net, against activist investing legend Carl Icahn and his position in Yahoo! Inc. (NASDAQ: YHOO) (click on the links to laugh at how rudimentary Greenbackd looked then). The idea was simple: Compare the performance of two stocks, one a net net / net cash stock lacking a catalyst, and the other a stock not obviously undervalued on an asset basis, but nonetheless pursued by an activist investor, Carl Icahn.

In the blue corner, YHOO, the super heavyweight

Here’s what I had to say about YHOO at the time:

YHOO is a stock that is not cheap on an asset basis but it does have a prominent activist investor with a 5.5% stake and two seats on the board. At its Friday close of $11.66, which is around two-thirds lower than Microsoft’s May 2008 $33 bid, YHOO still trades at a 70% premium to our $6.82 per share estimate of its asset value. Activist investor Carl Icahn’s presence on the register, however, indicates that he believes YHOO is worth more. Icahn has paid an average of $23.59 per share to accumulate his 5.5 percent stake. At $11.66, YHOO must more than double before Icahn will see a profit. He’s unlikely to sit idly by to see if that happens.

YHOO is not cheap on any theory of value we care to employ. It is trading at a substantial premium to its asset backing, which means the market is still generously valuing its future earnings. It is generating substantial operating cash flow and earnings, which in a better market might be worth more, but it’s not obviously cheap to us.

The best thing about YHOO from our perspective is the presence of Carl Icahn on the register. His holdings were purchased at much higher prices than are presently available and he is unlikely to sit idly by while the stock stagnates.

Buying YHOO at these prices is a bet that Icahn can engineer a deal for the company. Given his legendary status as an activist investor earned through canny acquisitions over many years, we think that’s a good bet. But a bet is what it is – it’s speculation and not investment. If speculation is your game, then we wish you the best of luck but know that the price might fall a long way if he sells out. If you’re an investor, the price is too high.

YHOO closed Friday at $11.66 and the S&P 500 Index closed at 876.07.

And in the red corner, DRAM, a light flyweight

Here’s my take on DRAM’s chances:

DRAM, at 58% of its liquidating value and 76% of its cash backing, is very cheap. We believe that it is worth watching but, with no obvious catalysts and a high cash burn rate, probably one to avoid unless you are willing to bet that its remaining cash might attract an activist or the business will turn around before it runs out of money.

The risk with DRAM, as it is with any net net or net cash stock, is that the company might not make a profit any time soon and won’t liquidate before it dissipates its remaining cash. As we said above, we’ve got no insight into DRAM’s business and don’t know whether it can trade out of its present difficulties and back to at least a positive operating cash flow. According to the 10Q, the company is authorized to repurchase 172,196 shares under a stock repurchase plan but this is an immaterial amount in the context of the 8.9M shares on issue and the plan has been in existence since 2002. The best hope for the stockholders is that the company re-institutes its dividend, which, given its $16M in cash, it certainly seems able to do. No noted activists have disclosed a holding in the company, which means management have no incentive to do anything so stockholder friendly.

Let’s get ready to rumbllllllllllllllllllllllllle…..

Here’s the call of the fight:

The first 10 rounds were to YHOO, but DRAM landed a crushing blow at the end of the 10th. From there, DRAM pounded away while YHOO got the staggers. At the final bell, YHOO managed a respectable 34.2%, but it wasn’t in DRAM’s league, up an incredible 192.8%.

Post mortem

There’s nothing statistically significant about this little experiment, but, regardless, I think it’s interesting. As I’ve discussed in previous posts, small investors have a huge advantage over larger, professional investors. There is nothing easier to analyse than a Graham net net or liquidation play (here’s my post on Graham’s liquidation value methodology), and, as Professor Henry Oppenheimer demonstrated, the returns to a very simple buy-and-hold-for-a-year-and-repeat strategy will put investment professionals to shame. Graham’s methodology is robust and has withstood the test of time. With a little patience, investing like Graham did provides a tailwind that forgives many investing sins. Here’s to the little guys.

Gonna fly now

Go. Go. Go. Go. Go. Goooooooooo…..

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