Archive for March, 2010

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.


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In a post in late November last year, Testing the performance of price-to-book value, I set up a hypothetical equally-weighted portfolio of the cheapest price-to-book stocks with a positive P/E ratio discovered using the Google Screener, which I called the “Greenbackd Contrarian Value Portfolio“. The portfolio has been operating for a little over 4 months, so I thought I’d check in and see how it’s going.

Here is the Tickerspy portfolio tracker for the Greenbackd Contrarian Value Portfolio showing how each individual stock is performing:

(Click to enlarge)

And the chart showing the performance of the portfolio against the S&P500:

[Full Disclosure:  No positions. 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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Zero Hedge has another interesting post, A Quick And Dirty LBO Screen, on the potential for a wave of going private deals. Zero Hedge uses “a simplistic template from UBS” to identify the thirty companies that would “generate the highest stock return should they get acquired.”

Zero Hedge assumes:

…a 4.5x Debt/EBITDA pro forma leverage (as much as TPG would like, 10x leverage is not coming back…Unless Joe Cassano is hired to run Chrysler’s take private group), and also assuming a 40% equity portion in the transaction. In other words, these are the companies that at least on paper have the highest equity expansion potential in a 7.5x EV/EBITDA.

Zero Hedge employs its typically elegant reasoning to identify the companies:

While this analysis ignores whether or not any of these companies actually generate substantial cash flow to cover pro forma interest, or are a logical fit for any financial acquiror, any company not on this list is likely already equity heavy and as a result even if acquired will not result in material upside.

This below list by no means suggests that any of these companies on it will be LBOed: it should merely be used a benchmark for modeling purposes.

Here’s the screen:

(Click to enlarge)

[Full Disclosure: No positions. 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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Greenbackd Report

I’ve received sufficient inquiries about the subscription-only service aimed at identifying stocks similar to those in the old Wall Street’s Endangered Species reports to proceed with it. Thank you for your support.

If you would like to receive a free trial copy of the report when it is produced in exchange for providing feedback on its utility (or lack thereof), you can still send an email to greenbackd [at] gmail [dot] com.

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I’m considering launching a subscription-only service aimed at identifying stocks similar to those in the old Wall Street’s Endangered Species reports. Like the old Wall Street’s Endangered Species reports, I’ll be seeking undervalued industrial companies where a catalyst in the form a buy-out, strategic acquisition, liquidation or activist campaign might emerge to close the gap between price and value. The main point of difference between the old Piper Jaffray reports and the Greenbackd version will be that I will also include traditional Greenbackd-type stocks (net nets, sub-liquidation values etc) to the extent that those type of opportunities are available. The cost will be between $500 and $1,000 per annum for 48 weekly emails with a list of around 30 to 50 stocks and some limited commentary.

If you would like to receive a free trial copy of the report if and when it is produced in exchange for providing feedback on its utility (or lack thereof), would you please send an email to greenbackd [at] gmail [dot] com. If there is sufficient interest in the report I’ll go ahead and produce the trial copy.

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Zero Hedge has an interesting article, How To Capitalize On The Upcoming Irrationally Exuberant LBO Bubble, about “the imminent tidal wave of going private deals.” Privatisations are one of the means by which undervalued small capitalization stocks can “close their value gap.” Said Daniel J. Donoghue, Michael R. Murphy and Mark Buckley in Wall Street’s Endangered Species:

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.

Bank of America’s Jeffrey Rosenberg sets the scene for what Zero Hedge calls “the LBO bubble v2:”

They’re back. The combination of the credit market resurgence and tight spreads, attractive equity valuations and ample private equity “dry powder” create the conditions for increasing the volumes of [leveraged buy-outs (LBOs)]. Whether deals will strike at the heart of the high grade market in the form of mega size transactions ($10b+) remains unclear, though the possibility clearly now exists. Unlike the most recent era, lower leverage and more prevalent change of control protections help to limit cram down losses. The IMS Health LBO illustrates the new LBO market dynamics – a $5.9B LBO funded with $3B in debt – where bank and mezzanine debt investors now augment the role of CLOs as key debt providers.

CLOs are “collateralized loan obligations,” which Wikipedia says “are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation:”

Each class of owner may receive larger payments in exchange for being the first in line to lose money if the businesses fail to repay the loans. The actual loans used are generally multi-million dollar loans known as syndicated loans, usually originally lent by a bank with the intention of the loans being immediately paid off by the collateralized loan obligation owners. The loans are usually “leveraged loans”, that is, loans to businesses which owe an above average amount of money for their kind of business, usually because a new business owner has borrowed funds against the business to purchase it (known as a “leveraged buyout”) or because the business has borrowed funds to buy another business.

Rosenberg argues that the total pool of available LBO capital is ~$70B. Zero Hedge says, “Should CLOs indeed come back, look for this number to explode:”

Figure 1 below highlights our estimates of the maximum aggregate LBO volume supported by debt and equity fund raising capacity. These amounts represent only the limit on the size of LBO volumes, not our expectations of volumes in 2010. What is clear is that the return of the availability of senior debt financing is key to the ability to fund LBOs and this availability is supported by the new (relative to the earlier era) role of mezzanine debt in the “typical” LBO structure. According to these estimates of market capacity across senior, mezzanine and equity financing, expansion in senior debt financing capacity appears the constraint on the aggregate amount of LBO activity.

Note that this aggregate analysis does not describe the limits on mega size transactions – the $10B and above size transactions that garner greater attention and potential losses to cram down debt holders – as well as gains to public equity holders. That constraint remains the ability to absorb concentrated positions in a single fund. And as we describe more here, that constraint includes the new mezzanine debt financing capacity that contributes to today’s increasing amounts of debt funding capacity for LBOs.

Rosenberg has a noteworthy approach to identifying LBO candidates:

After having argued for the potential for increasing volumes for LBO risk, the starting point for managing that risk is to identify names that are more likely candidates. Since definitively identifying LBO candidates is impossible, we take the other approach: exclude names in which an LBO is infeasible. By limiting the universe down to feasible LBO candidates, we create a starting point for designing hedging strategies. Moving beyond this step is both an art and a science. In the sample trading strategies below, we employ both quantitative approaches as well as bottoms up input from our team of fundamental analysts to identify this small sample of feasible (though not necessarily probable) LBO candidates.

Click here to see Rosenberg’s LBO risk hedging strategies (via Zero Hedge).

Most useful for predominantly long equity investors like us, Zero Hedge also provides a copy of Goldman Sachs’ recently updated LBO screener (.xls), which looks like this (click to enlarge):

Says Zero Hedge:

The companies included represent the names most likely to be looked at actively by PE firms, and where a go private outcome would seem the highest. As such, buying the stock in a basket of the likeliest LBO candidates would be a relatively sure way to shotgun out a few quick LBO-type returns.

This is similar, in essence, to the approach of Donoghue, Murphy and Buckley as described in Wall Street’s Endangered Species, a strategy that performed well over the last 10 years.

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Dr. Michael Burry has been a very popular topic on Greenbackd recently as a result of Michael Lewis’s The Big Short and the Vanity Fair article Betting on the Blind Side. I have posted a link to Burry’s techstocks.com “Value Investing” thread (now Silicon Investor) and another to Burry’s Scion Capital investor letters, but the thirst for all things Burry remains undiminished. The New York Times now has an article, The Origins of Michael Burry, Online, discussing some of Burry’s early postings on his techstocks.com thread. Here Burry discusses his strategy for shorting:

I mentioned that I pick stocks to short based on valuation, not ratios (I ask you to find the correct free cash flow — I bet most people don’t kow they’re working with negative net working capital, either). But I ENTER based on technical analysis. KO could go up or down. The odds are down, technically, but that’s what buy stops are for. This isn’t a long term short by any means. Research on shorts show that profitable shorts make money with small gains, not by waiting for businesses to bankrupt. The small gains are usually there for the picking. Another indicator — if it’s mentioned in Barron’s as a buy three different times <g> — set me onto Wells Fargo.

What’s there to understand about Coke? The business is a KISS model. This gets to my value/short strategy. When people start claiming a business deserves a special valuation above all reasonable fundamental analysis (because of the “franchise”, because there’s so little institutional ownership for a big cap growth stock, because Buffett’s in it, because global expansion will provide endless opportunity, because ROE is so damned high, because it’s nearly a monopoly, because Buffett’s in it…), that’s a short, IMO.

I just read a bunch of Graham, and he doesn’t deal with shorts (I assume it would be “speculation”), but EMT isn’t all that its panned to be either, IMO.

Just trying to think independently,


The NYT has also unearthed a Forbes magazine article from 2000:

VALUESTOCKS.NET www.valuestocks.net Supposedly for value investors, though Warren Buffett might not agree with this definition of value. Run by a 28-year-old neurology resident, Dr. Michael Burry, Valuestocks.net showcases Burry’s own $50,000 portfolio, which includes some surprising choices including Pixar, the maker of Toy Story. Has good information on how to identify net-net stocks (trading for less than assets minus all conceivable liabilities). Accompanying all this are Burry’s incisive reports, as good as anything from Wall Street. One of the site’s best features is a list of essential finance texts, including thumbnail reviews and links to Amazon.com (Burry’s only source of revenue, since he doesn’t accept banner ads). BEST: Original analysis, links to great finance sites, and a must-read book list for value investors. WORST: Limited content is sometimes dated.

It seems Greenbackd is rapidly, if unintentionally, becoming Mike Burry’s Of Permanent Value, which is Andrew Kilpatrick’s encyclopedic collection of stories about Warren Buffett. Incidentally, my copy of Of Permanent Value is around ten years old, which means it’s one-third the size of the 2010 edition (I’m not even joking. Mine came in a single volume, and it now seems to be a three-volume extravaganza. Buffett has been busy over the last 10 years).

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The New York Times has a fantastic profile on Carl Icahn called Does Icahn Still Make Them Tremble?

He is one of Wall Street’s most colorful, controversial and complicated characters.

Wearing slightly rumpled khakis and waving his eyeglasses to punctuate key points, Mr. Icahn is constantly jumping from one topic to another in an endless stream of dialogue. In that respect, he more closely resembles an absent-minded professor than a master of the universe.

Corporate executives visiting his offices walk through hallways adorned with paintings of battle scenes and sculptures of cowboys on bucking broncos. One large painting in the conference room features a lion gazing at the bones of an animal in a desert.

Yet he bristles at being labeled a “raider,” despite the fact that he is widely viewed as a founding member of the clan that roamed Wall Street in the 1980s, occasionally pursuing hostile takeovers with ruthless abandon.

He prefers to paint his role in those years with the same “activist investor” brush he holds today, arguing that he has created tens of billions of dollars of value for shareholders in companies in which he invested. (In conversations, he declares that he has created $30 billion, $40 billion and even $50 billion worth of value for shareholders. What is a few billion among friends?)

This is Icahn’s thesis for his investments in the biotechnology sector:

“The biotechs have been his big winners recently,” particularly investments in ImClone Systems and MedImmune, said Mr. Young at Institutional Shareholder Services. “His thesis, which is no secret, is that biotech firms should be purchased by Big Pharma, which is always in need of new products. In his mind, that’s a match made in heaven.”

I love this story:

Mr. Icahn does not seem to let anything, including a very close friendship, get in the way of protecting his and his investors’ profits. Late in 2008, through his hedge fund, he sued Realogy, a real estate company controlled by Leon Black, the head of the private equity firm Apollo Management. Mr. Black was trying to reduce Realogy’s hefty debt load by offering to exchange some of the debt with bondholders.

Mr. Icahn, a bondholder who has known and been friends with Mr. Black for decades — the two have been longtime tennis partners — objected to some terms of the exchange and sued.

“Carl and I have been good friends for over 25 years,” Mr. Black said in an e-mail message. “Occasionally we skirmish as couples are wont to do, but I believe we both feel that when the chips are down that the friendship is paramount.”

How, exactly, does one sue and still be good friends with someone on Wall Street? Mr. Icahn smiles sagely over his cup of coffee: “The two of us have a saying that we always use whenever there is friction in our business dealings. We always say, ‘there’s only one Maltese Falcon.’ ”

At one point in that classic 1941 film, a character chasing a valuable figurine says to a close associate, “You’ve been like a son to me,” Mr. Icahn explains, paraphrasing from the movie.

Then, lowering his voice with mock intensity, Mr. Icahn adds that the character says that if you lose a son, it’s possible to get another — “but there’s only one Maltese Falcon.’ ”

Click here to see the rest of the article.

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MMI Investments, the largest holder of DHT Holdings Inc (NYSE:DHT) stock, has announced that it sent a letter to Erik A. Lind, Chairman of DHT, formally nominating Robert N. Cowen for election to the DHT board.

We started following DHT on Monday. MMI Investments is calling for DHT to reinstate the company’s dividend and appoint Robert N. Cowen, a “shipping industry veteran with over 30 years of experience including with DHT’s former parent company, Overseas Shipholding Group, Inc., to the DHT Board of Directors.” At its $4.03 close yesterday, DHT has a market capitalization of $196M and is trading at 5x 2010 expected free cash flow. MMI has set out its peer valuation and dividend analysis as an annexure to its latest 13D filing (set out in the original post). The board of DHT has responded by appointing a new independent director, Einar Michael Steimler. DHT’s Chief Executive Officer, Ole Jacob Diesen, has also stepped down. Says Clay Lifflander, President of MMI:

In the six months through February since DHT eliminated its dividend, a move that was never necessary in our view, the stock price dropped more than -30% at the same time as the average total return of its peers, all of whom currently pay dividends, was +19.5%. We believe DHT’s stockholders deserve better returns on their investment and improved performance from management and the Board. We therefore strongly urge the reinstatement of a dividend of $0.10 per share quarterly and the appointment of Bob Cowen to DHT’s Board of Directors.

Here’s the latest press release from MMI:


NEW YORK, NY, March 17, 2010 – – MMI Investments, L.P., the largest stockholder of DHT Holdings, Inc. (NYSE:DHT), announced today that it has sent a letter to Erik A. Lind, Chairman of the Board of DHT, formally nominating, in accordance with DHT’s bylaws, Robert N. Cowen, a shipping industry veteran with over 30 years of experience including with DHT’s former parent company, Overseas Shipholding Group, Inc., for election to the DHT Board of Directors at the upcoming annual meeting, tentatively scheduled for June 17, 2010. Mr. Lind has acknowledged receipt of the nomination.

Hat tip Ben Bortner.

[Full Disclosure: I do not hold DHT. 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 the Introduction to my 2003 copy of Philip A. Fisher’s Common Stocks and Uncommon Profits and Other Writings, his son, Kenneth L. Fisher, recounts a story about his father that has stuck with me since I first read it. For me, it speaks to Phil Fisher’s eclectic genius, and quirky sense of humor:

But one night in the early 1970’s, we were together in Monterey at one of the first elaborate dog-and-pony shows for technology stocks – then known as “The Monterey Conference” – put on by the American Electronics Association. At the Monterey Conference, Father exhibited another quality I never forgot. The conference announced a dinner contest. There was a card at each place setting, and each person was to write down what he or she thought the Dow Jones Industrials would do the next day, which is, of course, a silly exercise. The cards were collected. The person who came closest to the Dow’s change for the day would win a mini-color TV (which were hot new items then). The winner would be announced at lunch the next day, right after the market closed at one o’clock (Pacific time). Most folks, it turned out, did what I did – wrote down some small number, like down or up 5.57 points. I did that assuming that the market was unlikely to do anything particularly spectacular because most days it doesn’t. Now in those days, the Dow was at about 900, so 5 points was neither huge nor tiny. That night, back at the hotel room, I asked Father what he put down; and he said, “Up 30 points,” which would be more than 3 percent. I asked why. he said he had no idea at all what the market would do; and if you knew him, you knew that he never had a view of what the market would do on a given day. But he said that if he put down a number like I did and won, people would think he was just lucky – that winning at 5.57 meant beating out the guy that put down 5.5 or the other guy at 6.0. It would all be transparently seen as sheer luck. But if he won saying, “up 30 points,” people would think he knew something and was not just lucky. If he lost, which he was probable and he expected to, no one would know what number he had written down, and it would cost him nothing. Sure enough, the next day, the Dow was up 26 points, and Father won by 10 points.

When it was announced at lunch that Phil Fisher had won and how high his number was, there were discernable “Ooh” and “Ahhhh” sounds all over the few-hundred-person crowd. There was, of course, the news of the day, which attempted to explain the move; and for the rest of the conference, Father readily explained to people a rationale for why he had figured out all that news in advance, which was pure fiction and nothing but false showmanship. But I listened pretty carefully, and everyone he told all that to swallowed it hook, line, and sinker. Although he was socially ill at ease always, and insecure, I learned that day that my father was a much better showman than I had ever fathomed. And, oh, he didn’t want the mini-TV because he had no use at all for change in his personal life. So he gave it to me and I took it home and gave it to mother, and she used it for a very long time.

Common Stocks and Uncommon Profits and Other Writings is, of course, required reading for all value investors. I believe the Introduction to the 2003 edition, written by Kenneth Fisher, should also be regarded as required reading. There Kenneth [Edit:, an investment superstar in his own right,] shares intimate details about Phil from the perspective of a son working with the father. As the vignette above demonstrates, Phil understood human nature, but was socially awkward; he understood the folly of the narrative, but was prepared to provide a colorful one when it suited him; and he understood positively skewed risk:reward bets in all aspects of his life, and had the courage to take them, even if it meant standing apart from the crowd. What is most striking about this sketch of Phil Fisher is that it could just as easily be a discussion of Mike Burry or Warren Buffett. Perhaps great investors are like Leo Tolstoy’s happy families:

Happy families are all alike; every unhappy family is unhappy in its own way.

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