Archive for August, 2010

Michael Bigger’s Bigger Capital blog has a great “field trip” report on McDonald’s Corporation (NYSE:MCD) from 1965. You could have picked up MCD then for a split-adjusted $0.06 per share, giving you a twelve-hundredfold return to date. Says Michael:

A good friend of mine, a talented research analyst, covered McDonald’s (MCD) in the sixties. One of his field reports is posted below. My friend liked the company and bought the stock at a price of $.06 (post split). He still holds a major portion of his original stake. The investment has returned more than one thousand times.

The lesson of this story is that you will most likely stumble upon one or two great companies like MCD in your lifetime. If that happens and your insight leads you to buy the stock, hold on to it for a long period of time. Don’t get shaken out of your position.


Read the report.

No position.


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The CXO Advisory Group blog has a great post about the indicators of persistence in hedge fund performance. CXO examines a July 2010 paper, “Hedge Fund Characteristics and Performance Persistence”, by Manuel Ammann, Otto Huber and Markus Schmid, in which the authors investigate hedge fund performance persistence over periods of six to 36 months based on portfolios of hedge funds formed via double sorts on past performance and another fund characteristic, which might include the following:

  • size;
  • age;
  • relative funds flow;
  • closure to new investments;
  • length of withdrawal notice period;
  • length of redemption period;
  • management and incentive fees;
  • leverage;
  • management personal investment; and,
  • a Strategy Distinctiveness Index (SDI) defined as a strategy-normalized form (ten different strategy types) of one minus the R-squared of monthly returns regressed against an equally-weighted strategy index over the prior two years.

CXO reports the authors’ findings thus:

Using characteristics and groomed performance data for a broad sample of hedge funds over the period 1994-2008, they find that:

  • Based on past performance alone:
    • Persistence of raw returns is economically meaningful up to two years (but statistically significant only for six months).
    • Persistence of multi-factor alpha is both economically and statistically highly significant up to three years. The difference in monthly future alpha between the top and bottom fifths (quintiles) of past alpha is 2.8%, 2.3%, 1.6% and 1.0% for rebalancing frequencies of six months, one year, two years and three years, respectively.
  • Based on double sorts that divide each past alpha quintile into a high and low half for some other fund characteristic, SDI is the only characteristic that systematically improves prediction of future performance.
    • The difference in monthly alpha between the tenth of funds with highest past alpha and higher SDI and the tenth of funds with the lowest past alpha and lower SDI is 3.0%, 2.6%, 1.8% and 1.0% for rebalancing frequencies of six months, one year, two years and three years, respectively.
    • These results translate to annualized alpha improvements of about 4.0% and 2.3% for annual and biennial rebalancing, respectively.
  • Results are robust to different factor models for calculating alpha, changing the order of double sorts, different demarcations for initial sorts (fifths, fourths, thirds, halves) and alternative definitions for SDI. However, the prediction enhancement of SDI disappears during the 2008 credit crisis, indicating that high-SDI funds have large idiosyncratic risks exposed by crises.

In summary, evidence indicates that hedge fund investors should focus on funds with the best past performances and the most distinctive (uncorrelated) strategies.

While past performance may be no guarantee of future results, it seems that past performance is a pretty good indicator of future performance.

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Saturna Capital has an interesting take on the calculation of the Graham / Shiller PE10, otherwise known as the Cyclically Adjusted Price Earnings ratio (CAPE). Saturna argues that The Market May Be Cheaper Than It Looks because the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS) understates the true rate of inflation, a key input to the CAPE calculation:

Potentially Understated Inflation

Given that inflation estimates play an influential role in the calculation of the P/E10, it is important to investigate the assumptions behind the calculation of inflation. Traditionally, inflation is measured using the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS). The CPI estimates inflation by measuring fluctuations in the average price of a basket of consumer goods and services that is deemed to be typical of the average urban consumer. However, due to a variety of reasons, largely political, the methodology used to calculate CPI has undergone many changes in the past 10 to 20 years. One of the most controversial changes was to alter the composition of the basket to reflect changes in consumer behavior over time.

In doing so, the BLS hoped to remove biases that cause the CPI to overstate the true inflation rate. Former chairman of the Federal Reserve Alan Greenspan advocated this alternative methodology, arguing that if the price of steak went up, consumers would choose to eat more hamburger meat instead.² He therefore concluded that unless hamburger meat replaced steak in the basket, inflation would be overstated because consumers were not actually spending more money. Skeptics view these changes as government manipulation, the purpose of which is to understate the true inflation rate, as well as the wage and other rate increases indexed to it (think Social Security).

Saturna uses an alternative measure of inflation: the Shadow Government Statistics’ (SGS) Alternate CPI:

Over time this recalibration of the CPI has produced lower inflation estimates than the “old school” method. In fact, the discrepancy has become rather large… Unlike Mr. Greenspan, however, we prefer steak to hamburger meat. Accordingly, we tend to believe the truth lies somewhere in between the BLS’s CPI and the Shadow Government Statistics’ (SGS) Alternate CPI.

The implications for CAPE using Shadow Government CPI are as follows:

The wide gap between the government-sanctioned CPI and the Shadow Government CPI presents a competing set of assumptions about how to measure the effect of rising prices on the average consumer and the market as a whole. The relevance to investment analysts is that higher inflation figures can have a dramatic impact on the current P/E10 ratio. For example, if inflation is assumed to be 5% annually, $1 in nominal earnings from 10 years ago would be worth approximately $1.63 in today’s dollars. At 10% annually, $1 in nominal earnings from 10 years ago would be worth about $2.59 today. Using a higher inflation estimate therefore increases average real earnings over the 10-year period, and thus lowers the P/E10 ratio. If we assume the SGS figures are correct, then the current P/E10 based on the average closing price during the month of June is about 14x (see chart below). This ratio is much lower than the current P/E10 of near 20x using traditional CPI figures.

Click to View

Read the article.

Hat tip Ben Bortner.

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Vitaliy Katsenelson’s Contrarian Edge has a great post on Medtronic Inc. (NYSE:MDT) (Barron’s is wrong on Medtronic). Katsenelson’s post is a rebuttal to a Barron’s article, Should Medtronic Investors Lose Heart?, in which the author argues that MDT is a sick man. His post is a superb line-by-line refutation of Barron’s thesis:

“The stock looks cheap, trading at about 8.2 times expected forward earnings, but the company’s 10% long-term-earnings growth rate is below the industry average…

At 8.2 times earnings, the market prices in zero growth. If any growth is produced, even half of its “below-industry-average” growth, the stock will not be trading at 8.2 times earnings, but at a much higher valuation. Ironically, today’s low valuation gives MDT earnings a yield of 12%. If MDT remains at this valuation for a long time, it can buy back 12% of the company year after year, and this in itself would result in 12% earnings growth.

“… and it carries a fair amount of debt….

The amount of debt seems high at first, at $10.5 billion; but the company has $3.9 billion in cash and short-term investments, thus net debt is closer to $6.6 billion. MDT generates $3.4 billion of free cash flows – it can pay off ALL of its net debt in less than two years. Also, don’t confuse MDT with low-quality, highly cyclical stocks that were in vogue in the first half of 2010. This is a company that maintained a return on capital of over 20% for decades – an indication of a significant moat. Its revenues are extremely predictable, cash flows are very stable, and thus debt levels are very reasonable. Medtronic’s stock was punished with a 10% decline for lowering its guidance by an astonishingly minor 2%.

“The stock is also a historical underperformer, turning in losses year-to-date, as well as in the last one-, two-, and five-year periods that are greater than its peers in the Dow Jones U.S. Medical Equipment Index and the overall market….

This argument fails to draw a distinction between fundamental performance and stock performance. Over the last ten years, MDT grew both sales and earnings per share at 14% a year. It increased dividends 17% a year. These are not the vital signs of an “underperformer.” As the article pointed out, MDT’s stock has gone nowhere over the past decade – that is true, but not because MDT was mismanaged or failed to grow, but rather because at the turn of the last century MDT was trading at almost 50 times earnings. Medtronic is a typical sideways-market stock: it was severely overvalued at the end of the secular bull market, thus its earnings and cash flows grew while P/Es contracted. This happened to a battalion of stocks, from Wal-Mart to J&J to Pepsico. In fact when I hear the statement that a stock has “not gone anywhere,” I immediately start looking at the stock to see if it is a buy.

Read the article.

No position.

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One of my favorite strategies is the Endangered Species / Darwin’s Darlings strategy I discussed in some detail earlier this year (see Hunting endangered species and Endangered Species 2001). The strategy is based on a Spring 1999 Piper Jaffray 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 of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.

The NYTimes.com has an article, Accretive Uses “Take Private” Tactic In Equities, discussing hedge fund Accretive Capital Partners, which uses a strategy described thus:

Accretive Capital’s strategy is to buy long-only stakes in small- and micro-cap stocks that [founder Rick] Fearon believes would be attractive “take private” companies. The benefits of being public just don’t add up for such companies, he said.

Years ago when Fearon was a principal at private equity firm Allied Capital, he was struck by the wide gap in value the public and private equity markets assigned companies.

In private equity, companies were valued at six to seven times their cash flow, while public companies, especially the smallest businesses, were valued at almost half that, he said.

Fearon believes that market inefficiency, where prices often fail to reflect a company’s intrinsic value, and the $400 billion or so that pension funds and endowments currently have committed to private equity, will help spur returns.

Fearon is fishing in waters where, because the market capitalization of the smallest companies is less than $100 million, Wall Street research fails to adequately cover their operations. In addition to helping create an inefficient market, it has eroded the benefits of being a public company.

With an undervalued stock, stock options are never in the money, erasing the use of stock as a motivator for management and employees; cash becomes preferable to stock for acquisitions, and management holds on to undervalued shares.

“Management teams that have a strategy of A, B, C and D for creating shareholder value may in the back of their minds be thinking, ‘Well, maybe strategy E is the take private transaction, or we sell the company to a strategic buyer, because we’re not recognizing any of the benefits of being public,'” Fearon said.

In essence, the strategy is Endangered Species / Darwin’s Darlings. How has Accretive Capital performed?

Accretive Capital has been involved in 19 take-private transactions, or about one-third of the positions it has closed over the past decade.

Fearon has managed to take the $2 million in capital he started with from mostly high-net worth friends and family to about $20 million on his own. His fund plunged in 2008, but returned 132 percent last year and is up about 20 percent as of July.

Assuming no additional outside capital, turning $2M into $20M in ten years is a compound return of around 25%, which is impressive. [Update: As Charles points out in the comments, the article clearly says he’s returned 4x, not 10x, which is a compound return of around 15%, which is still impressive in a flat market, but not as amazing as 25%.]

Says Fearon of the investment landscape right now:

“We’re not lacking investment ideas or opportunities, our primary restraint is capital right now.”

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This is your last chance to grab substantial savings for the Value Investing Congress. The event takes place on October 12th & 13th in New York City. Greenbackd readers can save $1,700 with discount code N10GB6. Register in the next six days before the price increases by $400. Get your ticket now.

The Value Investing Congress is the place for value investors from around the world to network with other value investors. I went to the May event earlier this year in Pasadena, and it was well worth it. The speakers seem to mingle freely and are generally available for a chat. Weather permitting, I’ll be in New York for this event.

Speakers include:

  • David Einhorn, Greenlight Capital Management
  • Lee Ainslie, Maverick Capital
  • John Burbank, Passport Capital
  • J Kyle Bass, Hayman Capital
  • Mohnish Pabrai, Pabrai Investment Funds
  • Amitabh Singhi, Surefin Investments
  • J. Carlo Cannell, Cannell Capital
  • Zeke Ashton, Centaur Capital Partners
  • Whitney Tilson & Glenn Tongue, T2 Partners

Take advantage of the substantial discount while it lasts. The price increases in six days, so get your ticket to the Value Investing Congress using discount code N10GB6.

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Zero Hedge has a great post on the quarterly Goldman Hedge Fund Trend Monitor. The most interesting aspect of the piece is the relative performance of stocks with the highest concentration of hedge fund holders against the performance of stocks with the lowest concentration of hedge fund holders:

We define “concentration” as the share of market capitalization owned in aggregate by hedge funds. The strategy of buying the 20 most concentrated stocks has a strong track record over more than eight years. Since 2001, the strategy has outperformed the market by an average of 312 bp per quarter (not annualized). The back test suggests that this strategy works in an upward trending market but tends to perform poorly during choppy or flat markets. The stocks in the basket tend to be mid-caps (at the lower end of the S&P 500 capitalization distribution), which have outperformed large-caps from 2004 to 2007, contributing to the attractive back-test results. The baskets are not sector neutral versus the S&P 500.

As you might have guessed, the “least concentrated” basket has outperformed the “most concentrated” portfolio since 2007:

The stocks with the “most concentrated” hedge fund ownership have outperformed the S&P 500 in 2010 ytd by 191 bp (+1.1% vs. -0.8%). The “most concentrated” stocks underperformed steadily for most of 2007 and 2008, but significantly outperformed in 2009. Our “most concentrated” basket outperformed the S&P 500 by 237 bp in 1Q 2010 (+7.7% vs. +5.4%) but lagged by 303 bp in 2Q 2010 (-14.5% vs. -11.4%).

Our “least concentrated” basket has outperformed the S&P 500 in 2010 ytd by 693 bp (+6.1% vs. -0.8%). The “least concentrated” basket outpaced the market by 50 bp in 1Q 2010 (+5.9% vs. +5.4%) and by 440 bp in 2Q (-7.0% vs. -11.4%).

So which stocks are currently in the “least” and “most” concentrated baskets:

Read the article.

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Richard H. Thaler, Chicago School economist and co-author (along with Werner F.M. DeBondt) of Further Evidence on Investor Overreaction and Stock Market Seasonality, and the “Thaler” in Fuller & Thaler Asset Management, has written an opinion piece for the NYTimes.com “The Overconfidence Problem in Forecasting.”

Thaler says:

BUSINESSES in nearly every industry were caught off guard by the Great Recession. Few leaders in business — or government, for that matter — seem to have even considered the possibility that an economic downturn of this magnitude could happen.

What was wrong with their thinking? These decision-makers may have been betrayed by a flaw that has been documented in hundreds of studies: overconfidence.

Most of us think that we are “better than average” in most things. We are also “miscalibrated,” meaning that our sense of the probability of events doesn’t line up with reality. When we say we are sure about a certain fact, for example, we may well be right only half the time.

He then discusses a recent paper that shows that overconfidence permeates the top reaches of large companies:

In that paper, three financial economists — Itzhak Ben-David of Ohio State University and John R. Graham and Campbell R. Harvey of Duke — found that chief financial officers of major American corporations are not very good at forecasting the future. The authors’ investigation used a quarterly survey of C.F.O.’s that Duke has been running since 2001. Among other things, the C.F.O.’s were asked about their expectations for the return of the Standard & Poor’s 500-stock index for the next year — both their best guess and their 80 percent confidence limit. This means that in the example above, there would be a 10 percent chance that the return would be higher than the upper bound, and a 10 percent chance that it would be less than the lower one.

It turns out that C.F.O.’s, as a group, display terrible calibration. The actual market return over the next year fell between their 80 percent confidence limits only a third of the time, so these executives weren’t particularly good at forecasting the stock market. In fact, their predictions were negatively correlated with actual returns. For example, in the survey conducted on Feb. 26, 2009, the C.F.O.’s made their most pessimistic predictions, expecting a market return of just 2.0 percent, with a lower bound of minus 10.2 percent. In fact, the market soared 42.6 percent over the next year.

Thaler concludes:

Two lessons emerge from these papers. First, we shouldn’t expect that the competition to become a top manager will weed out overconfidence. In fact, the competition may tend to select overconfident people. One route to the corner office is to combine overconfidence with luck, which can be hard to distinguish from skill. C.E.O.’s who make it to the top this way will often stumble when their luck runs out.

The second lesson comes from Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Read the article.

For more on Richard H. Thaler, see the post archive.

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Minyanville has an article analyzing Liberty Media Corp (Capital) (NASDAQ:LCAPA) on a sum-of-the-parts basis:

The key for investors: Liberty Capital stock trades at a 58% discount to the value of all the assets that back it. The stock recently sold for $48 [now $45], but the collection of assets it represents add up to $82 after debt, according to Robert Routh a media analyst with Wedge Partners.

What does a share of LCAPA represent?

As a tracking stock, Liberty Capital represents the value of the stock holdings of its parent Liberty Media in Sirius XM Radio, Time Warner Cable (TWC), Time Warner (TWX), Sprint Nextel (S), Viacom (VIA), Motorola (MOT), AOL (AOL), Live Nation Entertainment (LYV), and CenturyLink (CTL). All of this plus a few other stocks and the value of some media assets recently added up to $107 per share for Liberty Capital, calculates Routh, who regularly makes some great calls on media stocks. Subtract around $25 in debt, and you get an enterprise value of around $82 for Liberty Capital. That’s the tracking stock that sells for just $48.

Why the discount?

First of all, a lot of mutual funds cannot own tracking stocks, which reduces demand for the Liberty Capital tracker. Second, Liberty Capital is saddled with a “complexity discount” — meaning the situation is so confusing many investors just avoid it. Plus, there’s no guarantee the discount will ever go away.

Any catalysts?

For buy-and-hold investors, what might make that happen? One catalyst will be ongoing share buybacks, believes Scott Stevens of Strata Capital Management, which owns the Liberty Capital tracking stock. Stevens is worth listening to because Strata Capital Management was up 11.1% year-to-date net of fees as of August 17, compared to a 2% decline for the S&P 500. Next, believes Stevens, Liberty Capital has over $2 billion in cash, and it might use some of for an accretive acquisition

And eventually, Liberty Capital should be converted from a tracking stock to a regular asset-backed common stock, which would help the complexity discount go away. Malone should get the ball rolling on this front when he converts another stock tracking assets in the Liberty Media parent company. That tracker is Liberty Media Interactive (LINTA) which represents the Liberty Media’s home-shopping channel QVC and a stake in Home Shopping Network.

The conversion should happen around the end of this year or in the first quarter of 2011. That alone might wake other investors to the potential in Liberty Capital because it’s on the same track, and put a bid underneath the stock. A third Liberty Media tracker will also be converted at some point, or Liberty Starz Group (LSTZA) which represents Liberty Media’s Starz Encore pay TV channel. Another catalyst might be the sale of the Atlanta Braves by the end of 2011.

Read the article.

Nop positions.

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Carl Icahn’s former lieutenant Mark Rachesky has opened a position in Seahawk Drilling Inc (NASDAQ:HAWK), a stock I’ve covered in some detail (see the post archive here). Rachesky holds the position in his investment vehicle, MHR Fund Management LLC. Rachesky’s most recent 13F filing indicates he picked up around 1.2M shares for around $11.4M, which implies an average purchase price of about $9.72 per share. According to Business Insider:

Rachesky, 49, spent six years working for Icahn, including serving as a senior investment officer and chief investment advisor for his last three years at Icahn Holding Corporation. He left Icahn in 1996 and opened his own New York-based firm, MHR Fund Management, for which he still serves as president.

Rachesky is perhaps best known for his position in Lions Gate:

He first took a 5.9% stake in Lionsgate in August 2005, but he boosted his ownership to 14.1% as of last July and has rapidly increased the size of his position over the past two months—at the same time Icahn enhanced his own stake—after Lionsgate reported its disastrous third-quarter earnings. Up until last week, Rachesky’s investment in Lionsgate was passive, meaning he didn’t seek to influence the company’s operations. But now he’s an active investor in the studio.

The $11.4M holding in HAWK represents around 0.8% of Rachesky’s $1.4B fund.

Hat tip JG.

Long HAWK.

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