Archive for March, 2010

Yesterday I ran a guest post on the short case for Berkshire Hathaway Inc. (NYSE:BRK.A, BRK.B) by S. Raj Rajagopal, an MBA student at Johnson Graduate School of Management at Cornell University. The post generated several requests for the valuation supporting Raj’s short thesis, which Raj has provided and I’ve reproduced below.

Here is the valuation underpinning Raj’s short case for Berkshire Hathaway Inc. (NYSE:BRK.A,BRK.B):

(Click to enlarge)

Click here to download the full presentation including the updated valuation for the Berkshire Hathaway short case (.pdf).

Please contact Raj if you would like to discuss his valuation or his short case.

[Full Disclosure: I do not hold a position in BRK.A or BRK.B. 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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S. Raj Rajagopal has provided a guest post outlining his argument for a short position in Berkshire Hathaway Inc. (NYSE:BRK.A, BRK.B). Raj is an MBA student at Johnson Graduate School of Management at Cornell University graduating in May this year. He has worked as a portfolio manager at the Cayuga Fund, LLC, the Johnson Graduate School’s $12M hedge fund, and is currently seeking full-time employment in the investment management area. Here is his resume and his website, Gordian Knots. Please contact Raj if you would like to see his valuation on BRK.A / BRK.B.

Raj’s short case for Berkshire Hathaway Inc. (NYSE:BRK.A,BRK.B) is set out below:

(Click to enlarge)

Click here to download the Short Case for Berkshire Hathaway in full (.pdf)

[Full Disclosure: I do not hold BRK.A or BRK.B. 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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DHT Holdings Inc (NYSE:DHT) is an interesting activist situation. MMI Investments, DHT’s largest shareholder, 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 $4.15 close on Friday, DHT has a market capitalization of $202M and is trading at a little over 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 below). 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.

The full text of MMI’s letter appended to the most recent 13D follows:

March 2, 2010

Erik A. Lind
Chairman of the Board
DHT Holdings, Inc.
26 New Street
St. Helier, Jersey JE23RA
Channel Islands

Dear Mr. Lind:

A s the largest stockholder of DHT Holdings, Inc. (“DHT” or the “Company”), MMI Investments, L.P. (“MMI”) is greatly frustrated with the poor performance of DHT stock, which is near its all-time low, and DHT’s valuation, which is at a severe discount to its peer group (see attachment: “DHT Peer Valuation”). We believe this underperformance is directly related to repeated poor decisions by management and the Board, such as the elimination of the Company’s dividend, and that stockholder value will continue to erode unless immediate action is taken. The board should act immediately to reinstate the dividend at a $0.10 per share quarterly rate and appoint as a member of the Board, Robert N. Cowen, a shipping industry veteran with over 30 years experience (including with DHT’s former corporate parent, Overseas Shipholding Group, Inc. (“OSG”)), as detailed below:

1) Reinstate the Dividend

DHT’s dividend strategy has been consistently erratic, shifting between paying out all available cash flow to paying a regular $0.25 quarterly dividend “to provide shareholders with a stable and visible distribution”1, to the dividend’s complete elimination in September – six months after the stock market bottomed and began its historic rise. This last decision was particularly toxic to stockholders, causing shares to plummet by more than 21% on the day of its announcement, due in part, we believe, to its inexplicability in the face of the nearly $40 million in free cash flow virtually guaranteed to the Company by its long-term charter agreements with OSG.

DHT’s zero dividend policy is not only inconsistent with its own intrinsic fundamentals, it is also dramatically out-of-step with its peers. DHT’s free cash flow yield2 at 23% is more than quadruple the mean of its comparable companies, who average a 5.3% dividend yield and who all currently pay dividends, including those who previously eliminated their dividend during the crisis. MMI recommends a quarterly dividend of $0.10 per share, which would leave significant free cash flow for debt repayment or other deployment in 2010 and 2011, even with the scheduled amortization of debt in 2011 (see attachment: “DHT Dividend Analysis”). A $0.10 per share quarterly dividend would also make DHT’s dividend yield a robust 11.4%, at a premium to its peers – a virtual necessity for stock price appreciation, which would drive the yield closer to parity.

2) Strengthen the Board

The Board’s non-dividend capital allocation decisions have also frequently seemed rash, and been dilutive to stockholder value. DHT’s only acquisitions since inception, the two Suezmax tanker purchases announced in 2007, were acquired at the top of the market for a total expenditure of $183 million. Today they are worth roughly half that amount in our opinion. In light of this poor acquisition track record, we believe the stated reason for eliminating the dividend, i.e. augmentation of the Company’s cash balance for potential acquisitions, only served to further unnerve stockholders.

We also believe this Board’s decision to complete an equity offering in March 2009 was similarly troubling and ill-timed. The offering came near the bottom of the stock market crisis, was priced less than a dollar above DHT’s all-time low stock price and at a dividend yield of 23% (which would subsequently become unsustainable because of the offering itself). Notably the unsustainable $0.25 per share quarterly dividend was eliminated only after it had been paid once to the new stockholders. As if to add insult to injury, at the time of the dividend elimination the offering proceeds were concurrently used to prepay debt in excess of the Company’s required covenant (ironically to the level at which DHT would be permitted to issue further dividends), and without receiving any concessions from its lender.

This past performance suggests that additional expertise and oversight at the Board level would benefit DHT and its stockholders. Therefore MMI strongly urges the immediate addition of Robert N. Cowen to the DHT board. Bob Cowen has over 30 years of experience in the oil tanker and dry bulk shipping business, having been Chief Operating Officer of DHT’s former parent company, OSG, and Chairman and Chief Executive Officer of OceanFreight Inc., a dry bulk shipping company for which he led its successful IPO and fleet start-up. The future opportunities afforded by the current industry weakness and the challenges presented by DHT’s escalating costs, both corporate and operating, require seasoned operational leadership which could augment the Board’s largely finance-related backgrounds. We believe Bob Cowen’s experience, intelligence and business acumen are well-suited to DHT’s challenges and opportunities, and that he would be a great asset to the Board.

We recommend expansion of the Board in part because of management’s comments on the February 16th, fourth quarter of 2009 earnings call, which suggest to us that they may not share stockholders’ frustration with the performance of DHT’s shares. Notably, Chief Executive Officer Ole Jacob Diesen’s remark that “…If we were to buy back shares, the share price has to be even lower” indicates an astounding belief that the stock is presently over-valued. We believe this is completely inconsistent with the facts. As we demonstrate in the attached “DHT Peer Valuation”, DHT’s stock price is presently at a 75% or greater discount to its value at its peers’ average multiples of 2010 and 2011 EBITDA, i.e. an implied stock price of approximately $6.16-$6.41 (versus $3.52 on 2/26/10) were it valued like its peers. On a net asset value basis (using management’s last estimate of DHT’s fleet value, $400 million) DHT is trading for less than its fleet value on an unchartered basis, despite the roughly $100 million at least in free cash flow to be collected by DHT through 2012 when the charters begin to roll off. This is in spite of the premium-worthy stability of DHT’s free cash flow generation from the long-term charters, and assumes virtually no additional hire in the next two years from improvement in rates. However, if market conditions continue to improve such that DHT does earn additional hire or fleet values rise, we believe the preceding valuation estimates will prove to be far too conservative.

In the six months since DHT eliminated its dividend its stock has dropped -30.7% whereas the average total return of its peers is +19.5%. We believe investors, many of whom chose DHT for its fundamental stability, have suffered more than enough capital loss and income disruption in service of a strategy so opaque and ill-communicated as to suggest there is no real strategy at all. We urge the immediate appointment of Mr. Cowen to the Board and reinstatement of the dividend to encourage strategic stability and focus and improved stock performance. Please inform us of your intentions regarding these two proposals by March 12, 2010. Mr. Cowen has indicated to me that he is available to discuss these issues with you, as are we. Please contact me at (212) 586-4333 with any questions.


Clay Lifflander


1 Company press release, 1/4/08, “Double Hull Tankers, Inc. Sets Dividend Policy to a Fixed Annual Amount of $1.00 per share”

2 Calculated as DHT consensus 2010 free cash flow divided by market capitalization of $171 million on 2/26/10. All references herein to stock price, performance, valuations and yields refer to DHT’s closing price of $3.52 on 2/26/10.

MMI’s DHT Peer Valuation

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MMI’s DHT Dividend Analysis

(Edited to fit space)

Here is the press release announcing the resignation of DHT’s Chief Executive Officer, Ole Jacob Diesen, on Thursday last week:

DHT Names Board Member Randee Day Acting Chief Executive Officer

ST. HELIER, CHANNEL ISLANDS, Mar 11, 2010 — DHT Holdings, Inc. (NYSE: DHT) announced today that Board member Randee Day has been named acting Chief Executive Officer of DHT Holdings, Inc. and DHT Maritime, Inc., effective April 1, 2010. Ms. Day will remain on the Board of Directors of both companies, but will not continue on the Audit, Nominating and Corporate Governance, and Compensation Committees.

Ms. Day succeeds Ole Jacob Diesen, who will step down as Chief Executive Officer on March 31, 2010. Mr. Diesen, who has been CEO since DHT’s initial public offering in 2005, was instrumental in developing DHT Maritime’s existing operating platform and the new corporate structure announced last week. This transition follows a comprehensive review of DHT’s strategy by the Board and management beginning in 2009. The Board and Mr. Diesen concluded it would be in DHT’s best interests to turn to new leadership as the Company pursues a more growth-oriented strategy going forward. Mr. Diesen will continue to work with DHT as a consultant for the next six months.

The DHT Board of Directors will conduct a search over the next few months for a permanent CEO and will evaluate both internal and external candidates. Ms. Day has indicated she would be a candidate for this position.

Erik A. Lind, Chairman of the Board of Directors, said, “We are indeed pleased that Randee Day has accepted our offer to become DHT’s acting CEO. Her distinguished career in the shipping industry spans nearly 35 years, and she is one of the industry’s most highly regarded financial executives. Throughout her career, she has demonstrated strong leadership qualities, both as a business originator and the initiator of innovative financial solutions. We are confident she will successfully advance the strategic objectives and growth plans endorsed by the Board. Her appointment follows the recent creation of a new holding company structure and the appointment of veteran shipping executive Einar Michael Steimler to the Board, both important steps in the company’s evolution.”

Randee Day said, “I am very pleased to serve DHT in this position at this important juncture in the Company’s evolution and am committed to executing on our strategy. With DHT’s stable cash flows, proven ability to access the capital markets, strengthened balance sheet and financial flexibility, I believe it is well positioned to capitalize on prudent growth opportunities that are available to those able to deploy capital in the current shipping market.”

Ms. Day has served as a board member and Chair of the Audit Committee of DHT Maritime since the company’s initial public offering in 2005. Since 2004, she has been Managing Director and Head of Maritime Investment Banking at the Seabury Group, a global advisory and investment banking firm for transportation companies. Before joining Seabury, Ms. Day was CEO of Day and Partners, a strategic advisory and restructuring firm that she founded with UK private investors in 1985. Prior to the formation of Day and Partners, she headed up JP Morgan’s Shipping Group in New York.

She has been a board member of TBS International Ltd, since 2001, and serves as the Chair of the Audit Committee and is a member of the Governance Committee. From 2008 to 2009, she served as a director of Ocean Rig ASA, Oslo, Norway. Ms. Day holds a Bachelor of Arts degree in International Relations from the University of Southern California.

Here is the press release announcing the appointment to the board of Einar Michael Steimler:


ST. HELIER, JERSEY, CHANNEL ISLANDS, March 4, 2010 — DHT Holdings, Inc. (NYSE:DHT) announced today that it has appointed Einar Michael Steimler to its board of directors. The appointment of Mr. Steimler as a director, which expands the board from three to four independent directors, results from a rigorous process to identify prospective directors that will add valuable experience and insight to the board. Mr. Steimler is expected to join the company’s Audit, Compensation and Nominating and Corporate Governance Committees. This appointment will enable the board of directors to augment its commercial, operational and industry specific experience, particular within the tanker sector, where Mr. Steimler is a highly respected and well known industry executive.

Mr. Steimler, age 62, continues to serve as chairman of Tanker (UK) Agencies, the commercial agent to Tankers International, managers of the world’s largest VLCC pool. He was instrumental in the formation of Tanker (UK) Agencies in 2000 and served as its CEO until end 2007. Today, the Tankers International pool operates 41 ships including those of some of the world’s largest tanker companies.

Since 1998, Mr. Steimler has served as a Director of Euronav. From 1999 to 2003, he also served as a Director of EXMAR, a CMB Group company. During his long shipping career, he has been involved in both sale and purchase and chartering brokerage in the tanker, gas and chemical sectors and was a founder of Stemoco, a successful ship brokerage firm that was sold in 1994. He graduated from the Norwegian School of Business Management in 1973 with a degree in Economics.

The initial term of Mr. Steimler’s appointment to the DHT board of directors will expire at the company’s 2011 annual meeting.

Together with the company’s recent creation of a new holding company structure, the appointment of Mr. Steimler to the DHT board of directors represents a continuing step in the company’s ongoing initiatives to identify attractive growth opportunities.

The company also notes the receipt of communication from certain of its shareholders regarding the company’s strategy. As always, the company’s directors and management value the input of all of the company’s shareholders regarding the company’s direction and will continue to engage constructively with our shareholders regarding such input.

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

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

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

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

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

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

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

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

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

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

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

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

Small-Cap Stocks Outperform

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

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

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

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

More to come.

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

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

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

Endangered species report

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

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

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

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

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

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

Stocks trading at a discount to private company valuations

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

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

And the punchline:

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

Increasing M&A activity

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

Darwin’s Darlings

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

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

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

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

The emergence of activists

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

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

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

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

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

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

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

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

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

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

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I’m a huge fan of James Montier’s work on the rationale for a quantitative investment strategy and global Graham net net investing. Miguel Barbosa of Simoleon Sense has a wonderful interview with Montier, covering his views on behavioral investing and value investment. Particularly interesting is Montier’s concept of “seductive details” and the implications for investors:

Miguel: Let’s talk about the concept of seductive details…can you give us an example of how investors are trapped by irrelevant information?

James Montier: The sheer amount of irrelevant information faced by investors is truly staggering. Today we find ourselves captives of the information age, anything you could possibly need to know seems to appear at the touch of keypad. However, rarely, if ever, do we stop and ask ourselves exactly what we need to know in order to make a good decision.

Seductive details are the kind of information that seems important, but really isn’t. Let me give you an example. Today investors are surrounded by analysts who are experts in their fields. I once worked with an IT analyst who could take a PC apart in front of you, and tell you what every little bit did, fascinating stuff to be sure, but did it help make better investment decisions, clearly not. Did the analyst know anything at all about valuing a company or a stock, I’m afraid not. Yet he was immensely popular because he provided seductive details.

Montier’s “seductive details” is reminiscent of the discussion in Nicholas Taleb’s Fooled by Randomness on the relationship between the amount of information available to experts, the accuracy of judgments they make based on this information, and the experts’ confidence in the accuracy of these judgements. Intuition suggests that having more information should increase the accuracy of predictions about uncertain outcomes. In reality, more information decreases the accuracy of predictions while simultaneously increasing the confidence that the prediction is correct. One such example is given in the paper The illusion of knowledge: When more information reduces accuracy and increases confidence (.pdf) by Crystal C. Hall, Lynn Ariss, and Alexander Todorov. In that study, participants were asked to predict basketball games sampled from a National Basketball Association season:

All participants were provided with statistics (win record, halftime score), while half were additionally given the team names. Knowledge of names increased the confidence of basketball fans consistent with their belief that this knowledge improved their predictions. Contrary to this belief, it decreased the participants’ accuracy by reducing their reliance on statistical cues. One of the factors contributing to this underweighting of statistical cues was a bias to bet on more familiar teams against the statistical odds. Finally, in a real betting experiment, fans earned less money if they knew the team names while persisting in their belief that this knowledge improved their predictions.

This is not an isolated example. In Effects of amount of information on judgment accuracy and confidence, by Claire I. Tsai, Joshua Klayman, and Reid Hastie, the authors examined two other studies that further that demonstrate when decision makers receive more information, their confidence increases more than their accuracy, producing “substantial confidence–accuracy discrepancies.” The CIA have also examined the phenomenon. In Chapter 5 of Psychology of Intelligence Analysis, Do you really need more information?, the author argues against “the often-implicit assumption that lack of information is the principal obstacle to accurate intelligence judgments:”

Once an experienced analyst has the minimum information necessary to make an informed judgment, obtaining additional information generally does not improve the accuracy of his or her estimates. Additional information does, however, lead the analyst to become more confident in the judgment, to the point of overconfidence.

Experienced analysts have an imperfect understanding of what information they actually use in making judgments. They are unaware of the extent to which their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information. Analysts actually use much less of the available information than they think they do.

Click here to see the Simoleon Sense interview.

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This is a reminder that our exclusive 30% discount for the Value Investing Congress expires at midnight (PST) on March 16, 2010. On March 17, 2010 the price will go up by $1,300. Join us at the 5th Annual Value Investing Congress West, May 4 & 5, 2010, to learn from some of the world’s most successful money managers. The all-star speakers will share invaluable insights on how to navigate today’s uncertain markets ….and present their best stock picks. The wisdom you’ll gain will enhance your investing results in 2010 and beyond.

If you’re unfamiliar with the Value Investing Congress, then here’s what you need to know: One good investment idea could more than pay your cost of admission to this event and net you some great returns. The wisdom gained listening to these great investors is difficult to overstate. For a slide show of last year’s event see HERE.

Confirmed speakers include:

  • Bruce Berkowitz, Fairholme Capital Management
  • Eric Sprott, Sprott Asset Management
  • Mohnish Pabrai, Pabrai Investment Funds
  • Paul Sonkin, The Hummingbird Value Funds
  • Thomas Russo, Gardner, Russo & Gardner
  • David Nierenberg, The D3 Family Funds
  • Lloyd Khaner, Khaner Capital
  • J. Carlo Cannell, Cannell Capital
  • Patrick Degorce, Thélème Partners
  • Whitney Tilson & Glenn Tongue, T2 Partners
  • Guy Spier, Aquamarine Fund
  • Amitabh Singhi, Surefin Investments
  • Richard Vogel, Alatus SA
  • Lei Zhang, Hillhouse Gaoling Capital Management

    Click here to receive the 30% discount to VIC

    You must use discount code: P10GB8 to receive the full discount. Hurry and register!

    You’ve got exactly one week to get signed up with these savings. The regular price of the two day event is $4,295. However, Greenbackd readers pay only $2,995. That’s a 30% discount and savings of $1,300!  If you’re from out of town, the Congress has also negotiated lower room rates at the Langham Huntington for attendees.

    It’s going to be an awesome and insightful event, to say the least. Make sure you get our exclusive discount for the Value Investing Congress hereRemember that you MUST use the discount code P10GB8 to receive the full discount!

    Please let me know if you have any questions or problems when trying to register with the discount code.

    Again, the early bird rate is expiring at midnight (PST) on March 16, 2010. On March 17, 2010 the price will go up by $1,300.

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    Mean reversion is a favorite investment topic here on Greenbackd (see, for example, my posts on Mean reversion in earnings, Contrarian value investment and Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation, and Risk).

    The premise of contrarianism is mean reversion, which is the idea that stocks that have performed poorly in the past will perform better in the future and stocks that have performed well in the past will not perform as well. Benjamin Graham, quoting Horace’s Ars Poetica, described it thus:

    Many shall be restored that now are fallen and many shall fall that are now in honor.

    LSV argue in their paper that most investors don’t fully appreciate the phenomenon, which leads them to extrapolate past performance too far into the future. In practical terms it means the contrarian investor profits from other investors’ incorrect assessment that stocks that have performed well in the past will perform well in the future and stocks that have performed poorly in the past will continue to perform poorly.

    The outstanding Shadowstock blog has identified five “strong candidates for mean reversion.” To see John’s Shadowstock.com analysis, click here.

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    When I started out investing I summarized Warren Buffett’s letters to shareholders into a document I jokingly called the “Tractatus Logico-Valere.” The title, Latin errors aside, was intended to be an homage to Ludwig Wittgenstein’s Tractatus Logico-Philosophicus (which, according to Wikipedia, may in turn have been an homage to the Tractatus Theologico-Politicus by Baruch Spinoza). The idea was to create a comprehensive summary of Buffett’s investment process set out in a succinct, logical fashion. I kept Wittgenstein’s seventh and final proposition – “Whereof one cannot speak, thereof one must be silent” – as my own and interpreted it to mean “where you can’t value something, don’t invest” or “stay in your circle of competence.” My Tractatus wasn’t very good, and I’m not Warren Buffett’s shoelace. Consequently, I didn’t do very well with it. (Wittgenstein was not similarly burdened with self-doubt. Wikipedia says that he concluded that with his Tractatus he had resolved all philosophical problems, and upon its publication retired to become a schoolteacher in Austria.) My abortive experience attempting to create a comprehensive guide to earnings and growth-based investing has given me a great appreciation for those who are able to successfully create such a document and live by it. One investor who has done so is setting out his process for the world to see at The Fallible Investor.

    The author of The Fallible Investor is a private investor who has “previously worked for a private hedge fund in Bermuda and Bankers Trust in Sydney, Australia.” He calls himself The Fallible Investor because he “often makes errors when he invests, and says, “Recognising such a weakness is also useful. As Taleb says:

    Soros… knew how to handle randomness, by keeping a critical open mind and changing his opinions with minimal shame… he walked around calling himself fallible, but was so potent because he knew it while others had loftier ideas about themselves. He understood Popper. He lived the Popperian life.

    I have found particularly useful his elucidation of the linkage between return-on-invested-capital, market value, replacement value, and sustainable competitive advantage:

    I define the replacement value of a business as what the business’s assets would be worth if it’s ROIC was equal to its cost of capital.

    The market value of a business with a high ROIC and no sustainable competitive advantage should (assuming the market eventually prices a business at its intrinsic value[1]) fall to its replacement value. This should happen because if an incumbent business has a high ROIC, and no sustainable competitive advantage, other businesses will enter this industry, or expand within the industry, to seek these higher returns. These competitors will drive down the incumbent business’s profits until its ROIC declines to the average return of a commodity business. Once this occurs, the incumbent business can only be worth the cost of replacing the business’s assets.

    Professor Greenwald has another way of describing this process. He points out that if an incumbent business, with no competitive advantage, has a replacement value of $100 million and its market value is $200 million[2], competitors will drive its market value down to $100 million. Competitors will calculate that by spending $100 million to reproduce the assets of that business they can also create an enterprise with a market value higher than $100 million. These competitors will think, correctly, there is no reason for why they should have a different economic experience from the incumbent because there is nothing it can do that they cannot. Remember the incumbent business has no sustainable competitive advantage. Competitors, by reproducing the assets of the incumbent business, will increase the supply of products or services in the industry. There will now be more competition for the same business. Either prices will fall or, for differentiated products, each producer will sell fewer units. In both cases, the incumbent’s profits will decline and the market value of its business will decline with them. This process, capacity continuing to expand, and the profits and the market value of the incumbent’s business falling, will continue until the incumbent’s market value falls to the replacement value of its assets ($100 million). Its competitors will suffer the same fate.

    Greenwald points out that while this process does not happen smoothly or automatically it will eventually turn out this way. It happens because the incentives for businesspeople to take advantage of the market’s excessive valuation of the incumbent’s business are too powerful.[3]

    The market value of a business with a sustainable competitive advantage can, by contrast, stay much higher than its replacement value simply because it can sustain a high ROIC.

    [1] The intrinsic value of a business is what I think the business is worth to a rational businessperson.

    [2] Assuming the business has a high market value because it has a high ROIC.

    [3] P38, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

    The Fallible Investor has provided me with a full copy of his notes. I highly recommend following his posts as he sets out his investment process on the site.

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    Seth Klarman’s teachings, which I’ve covered on this site on several occasions (see, for example, Klarman on calculating liquidation value, on identifying catalysts, and on investing in liquidations), are always worth reading. In his most recent investor letter Klarman has provided a list of twenty investment lessons of 2008 (via the always superb Zero Hedge):

    1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
    2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
    3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
    4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
    5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
    6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
    7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
    8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
    9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
    10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
    11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
    12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
    13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
    14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
    15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
    16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
    17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
    18. When a government official says a problem has been “contained,” pay no attention.
    19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
    20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

    See also Klarman’s False Lessons of 2009.

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